Accounting fraud within major corporations

Accounting fraud is defined as the "intentional misstatement of financial reports, in violation of generally accepted accounting principles, with the objective of making certain people act in detriment to their best interests" (Wuerges & Borba, 2010). The GAAP are the principles by which financial accounting statements are produced, and for a public company these need to be followed, so deviating from GAAP will constitute a violation. Where it becomes a criminal fraud case is usually when the errors are deliberate. They may overstate the company's financial position (i.e. cooking the books), or they may understate that position for the purposes of committing tax fraud. In the famous case of Enron, not producing financial statements in a timely manner can also be considered accounting fraud, along with the general lack of accuracy of those statements.

Accounting fraud can be committed in a number of ways, but the underlying reason almost always has to do with the principles of a corporation seeking to enhance their wealth. It would be unusual to find a case of accounting fraud where the principles did not benefit in some way, given the risks associated with fraud cases. Wuerges & Borba (2010) estimate that only a very small percentage of fraud cases are discovered, although their methodology used a lot of proxies, and assumed guilty a little too readily, based on their interpretation of what a fraud case might look like.

For the most part, accounting fraud is conducted at the highest levels of the organization. Sharma and Panigrahi (2012) levied what I would say is an unfair critique, arguing that internal auditing systems were failing to detect accounting fraud. Most frauds happen at levels above the internal auditing system, and in cases like Enron it was the internal auditing system that detected the fraud. More realistically, the fault in accounting fraud lies with the perpetrators -- CEOs, CFOs -- and the external auditors who accept all suppositions contained in the financial statements at face value. The Sarbanes-Oxley Act was written with this reality in mind, and placed additional emphasis on the roles of these bodies in fraud.

In the early 2000s, accounting fraud was front page news, because of the large number of high profile examples that were uncovered. Enron was probably the most famous of these, because the company was considered to be so successful. At the heart of this fraud, the CEO, Chairman and other senior managers were hiding the debts that the company had, and overstating revenues. There was very little disclosure, and for some reason the SEC let that slide. The major issue with Enron was arguably not that the fraud was committed or that it was a massive fraud, but that regulatory authorities and Wall Street turned a blind eye to it. Enron was a well-connected company, connected in the White House, and that in part allowed it to escape regulatory attention. Furthermore, the external auditor, Arthur Andersen, did little to nothing about the fraud, rubber stamping any financial reports that the company did produce. That Arthur Andersen actually ordered its employees to destroy Enron's financial records shows the depth of the fraud, and the active partnership that AA and other stakeholders played in ensuring that the fraud went undetected for as long as it did (Seabury, 2014).

Global Crossing was another major accounting fraud situation. In this situation, as with Enron, senior executives were major beneficiaries, because of the stock options that they held -- if they made the company look more successful, the stock price would rise, and they would make more money upon exercise of those options. What is interesting is that we know accounting fraud is driven by personal motivation. Yet, in many of these high profile cases, many people who profited were allowed to keep their profits. With Global Crossing, for example, many executives who avoided prosecution were able to profit generously from their company's fraud (Fabrikant & Romero, 2002). A lack of punishment invariably creates incentives to commit fraud.

It should be self-evident that most people are against accounting fraud. What fraud does that it undermines the entire financial system. When investors cannot trust capital markets, they will be hesitant to invest, which means much less investment capital available. Our economy is in part dependent on the efficient distribution of capital from those who have it to those who need it, via the capital markets. Thus, the gains that one company might get in the short run are vastly outweighed by the negative consequences in the long run (Sadka, 2006). Wall Street insiders like to whine about Sarbanes-Oxley, but they accepted a system of oversight and a culture that supported strong capital markets in the first place, SOX would never have been necessary.