Net Worth Theory and Corporate Fraud

Danske Bank's Money Laundering Scandal
Madinger (2006) points out that the net worth method is among the most common used in accounting forensics when it comes to detecting illegal income, such as by way of money laundering. The case of Danske Bank and its money laundering escapades from 2007 to 2015 through an Estonian branch where a quarter of a trillion dollars flowed is a prime example of a situation in which the net worth method could be applied to investigate this corporate fraud.
As Schwab (1961) states, the net worth theory rests upon the idea that if one’s net increase exceeds the income reported, the corporation has understated its income; additionally, “if there is no increase in net worth but if the taxpayer has expended larger amounts than his reported income on nondeductible items, there has been an understatement of income” (p. 78). With Danske Bank, billions were passing through its Estonian branch from several different sources in dozens of different currencies. If net worth is the difference between assets and liabilities, which equals equity, then one can begin with the equity of the firm and move on from there. With Danske Bank, the increase in equity has to be the result of income. So the first steps in addressing the red flags at Danske would be to:
1. Go to the bank’s records
2. Obtain information from the bank’s informants, i.e., cooperating individuals
3. Assess loan applications, financial statements, tax returns, etc.
4. Catalogue assets and liabilities and expenses.
These steps will provide the foundation for proceeding into the next stage of investigation (Madinger, 2006).
This phase starts by looking at assets valued at cost without accounting for depreciation or appreciation. With Danske, “the Estonian branch generated 11 per cent of Danske’s total profits before tax that year, despite only accounting for 0.5 per cent of the bank’s assets” (Milne & Winter, 2018). In other words, assets were not aligning with income. Because 99% of the bank’s customers were non-Estonian customers, it was another signal of laundering.
After looking at assets, the next step is to use the same accounting techniques that the subject was using, and all items pertaining to the calculation should be included in the investigation even if they do not alter from one year to the next (IRS, 2017). Cash on hand and expenses can become problem areas. For Danske, the company was engaging in mirror trades of many billions of dollars a year to get money out of countries like Russia. The extent to which cash on hand figured into these has to be known and that is where interviews with individuals involved can come into play.
Danske had a whistleblower who blew the whistle on the money laundering scheme and this would be the person that the forensic accountant would want to interview first because he can lead the forensic accountant to the figures that would explain what was going on. At any rate, one has to find the starting point in the company’s fraud, so picking a start point is necessary. Cash on hand can be the place to start. Holding funds or assets is one way that banks will hide the source of the money, concealing the ownership
Thus, looking at how the Estonian branch was holding money and who was delivering the money and allowing it to pass through the bank would be the next step in determining what Danske was doing in its Estonian branch. With so many non-resident customers it would be clear that the bank was facilitating a purpose outside of normal, legal banking activities. Money was being funneled through, and that could be made apparent by looking at the holdings.
Larger cash transactions are supposed to be reported, but the branch was not doing that—and so the reason for this lack of regulatory compliance would be the next thing to investigate. Why was the bank being allowed to flout regulation and essentially be non-compliant? It does not help that the bank’s branch manager was now the CEO of Danske at the time that the laundering was going on. This would have been yet another sign of a cover-up.
What layering techniques are being conducted to clean dirty money through a series of transactions, such as mirror trading? This could help to indicate how holdings were being distributed through the bank, coming in dirty and going out clean at the other end. This is a type of bookkeeping trick that the forensic accountant would have to be on the lookout for. The emphasis would be on tracking the holdings and making sure that they are not being lost or hidden behind an accounting trick.
The integration of the laundered money into the clean money supply where it can be withdrawn from a legitimate account would be the next process to examine. One process, which is known as smurfing, involves breaking up a large quantity of money into many different small deposits and using them in various different accounts so as to avoid detection. Thus the forensic accountant would look for a pattern in deposits among accounts to see how money is coming in and where it is going. Currency exchanges would also be another indication, which is what was happening at the Estonian branch of Danske.
Depositing large cash amounts into the bank in foreign accounts would allow for criminals to launder their money by way of currency swaps. The forensic accountant would have had to examine these exchanges and examined the foreign accounts, which would also give an idea of holdings and how it was impacting equity.
The bank clearly had something to hide and the CEO was not willing to stop the bank’s activities as it was too profitable for the company overall. Neither did he want anyone investigating the matter for he knew what it would uncover. Net worth theory would show that the equity of the branch was not equal to its income and that the holdings of the branch were different from what was being reported. This was how the firm was laundering money and why no investigation was permitted. An investigation would have shown right away using net worth method that the accounting tricks of the branch were hiding dirty money.
The net worth method is thus a useful way to uncover the facts of a corporation’s holdings and its net worth—i.e., equity—that has to be connected to income but in a money laundering situation cannot be directly linked or else it would show what the bank was really up to. Thus there has to be a means of hiding the money coming in via currency swaps and mirror trading so as to dupe regulators. Because the bank was clearly not even attempting to stay in compliance with regulations by reporting large deposits from non-resident customers, there should have been a red flag immediately. The forensic accountant should be interviewing those involved and definitely should be interviewing any whistleblowers as they can provide direct firsthand knowledge of the reality of the situation. It is not just about looking at the bookkeeping; it is also about talking to those involved.
References
IRS. (2017). Retrieved from https://www.irs.gov/irm/part9/irm_09-005-009
Madlinger, J. (2006). Money laundering: A guide for criminal investigators. CRC Press.
Milne, R. & Winter, D. (2018). Danske: anatomy of a money laundering scandal. Retrieved from https://www.ft.com/content/519ad6ae-bcd8-11e8-94b2-17176fbf93f5
Schwab, R. D. (1961). The Civil Aspects of the Net Worth Method. Wm. & Mary L. Rev., 3, 65.