AIG accounting fraud and financial collapse

AIG Accounting Fraud

One of the ethical principles of accountants who are in compliance with Generally Accepted Accounting Principles (GAAP) of the United States is the concept of full disclosure. All of the relevant information pertaining to a financial decision should be openly disclosed and based upon an honest assessment of the costs to the party or two parties involved in the transaction. However, this was not the case in the dealings between AIG and General Re, the former a unit of Berkshire Hathaway. AIG used the transaction in question to help cover its recent financial difficulties by an accounting "sleight of hand" (Kay 2005). In a reversal of common practice, the reinsurance firm General Re paid AIG a $500 million premium so AIG would assume the risk of General Re's policies (Kay 2005). This was not illegal per se, what was illegal was the method used to disclose this upon the AIG balance sheet.

The result of the deal, therefore, was that AIG received $500 million from General Re, money that it would eventually have to pay back to General Re but without the risk of having to pay more money. General Re received a substantial fee from AIG in exchange for this deal. Similar arrangements are generally categorized as loans on financial statements, as AIG essentially received an amount of cash that it would later have to pay back plus interest in the form of the fee to General Re. However, "to categorize the $500 million as a loan would reduce the company's income" on its balance sheet (Kay, 2005). AIG was unwilling to do this, given its current financial losses. Instead, AIG categorized the deal as a normal insurance contract, and accounted the $500 million it earned as income to improve its financial image, although according to GAAP a transaction of this kind is a loan, as it was virtually risk-free.

Of course, the idea of what constitutes risk is somewhat problematic, as it could be argued that the definition of risk varies from investor to investor and company to company. Strictly speaking, the accounting regulations of the Federal Accounting Standards Board call any action without a significant amount of risk a loan, without any clear definition of what significant means. In this case, however, the risk does seem to be fairly negligible, and part of a consistent pattern of fraud on the part of AIG in terms of its income. It consistently manipulated its revenue to present a more pleasing financial picture to current and potential investors.

The collusion between insurance companies and large corporations through fictive investments that are really secure loans is common. Take the case of another AIG scam, selling insurance to the Brightpoint Inc. cellular phone company, after the cell phone company had already incurred losses. The company paid premiums to AIG, and AIG took over the payments so the cell company could record these as receivables and improve its own projected state of financial health on its balance sheet.