Accounting fraud is the intentional manipulation of financial statements to create or hide corporate transactions or create a false appearance of financial health. It can involve individuals or groups of managers, accountants, and other employees in an organization, misleading investors and shareholders, legal and regulatory authorities, and the public. A company can falsify its financial statements by overstating its revenue, not recording expenses, and misstating assets and liabilities.
- Accounting fraud is the illegal alteration of a company’s financial statements to manipulate a company’s apparent health or to hide profits or losses.
- Overstating revenue, failing to record expenses, and misstating assets and liabilities are all ways to commit accounting fraud.
- Accounting fraud is not the same as corporate or occupational fraud and not all acts of aggressive accounting count as illegal fraud.
- The Enron scandal is one of the most famous examples of accounting fraud in history.
Understanding Accounting Fraud
Accounting fraud involves misrepresenting a company’s financial statements and documents or deliberately hiding transactions, accounts, and important financial matters necessary for inclusion in financial statements. The American Institute of Certified Public Accountants notes that two kinds of fraud result in distorted financial statements: fraudulent financial reporting and theft of assets.
It’s helpful to begin by differentiating words and phrases that are often substituted for one another but that have different legal, regulatory, and financial consequences.
Aggressive accounting covers a host of phrases used in the U.S.—such as “earnings management” and “income smoothing.” These phrases refer to legal practices used to smooth out earnings or present what management thinks is a more accurate or better picture of a firm’s financial health. Practices might include
- Moving up or delaying investments
- Transferring expenses, income, and invoices between divisions in a company
- Selling assets and then repurchasing them
- Selling properties to produce outsized results in a given accounting period.
When taken to an extreme—if the intent is simply to mislead outsiders—a firm could be looking at investigations from the Securities and Exchange Commission (SEC), federal, and state agencies, as well as shareholder lawsuits. Until then, these are legal activities.
Corporate fraud is the broad category of illegal activities carried out by a company or individuals within it. Accounting fraud falls under this umbrella. Corporate fraud also includes insider trading, bribery, money laundering, tax evasion, and other forms of financial and nonfinancial misconduct. A study by the Association of Certified Fraud Examiners put the cost of this broad category of fraud at 5% of organizational revenue, or $4.7 trillion globally, per year.
Occupational fraud is done by employees for personal gain at the expense of their employers. These actions include stealing assets, payroll fraud, and reimbursing for fake or limited expenses. This type of fraud could cross with accounting fraud if financial records are manipulated, but many acts of occupational fraud don’t involve financial reporting. The Association of Certified Fraud Examiners reports that, globally, about 9% of all occupational fraud involves accounting fraud, with a median loss to the company of $593,000.
Accounting fraud specifically refers to the act of intentionally manipulating a company’s financial records to present a false picture of its financial health, performance, or profitability. Examples include overstating revenue, understating expenses, hiding debts and material financial events, and falsifying financial documents.
For accounting fraud to occur, a firm must deliberately falsify financial records. For example, if a company reports earnings in a given quarter and then revises them, no accounting fraud has occurred since, in most cases, the errors were not deliberate. Now, suppose the CEO of a publicly traded company knowingly makes false statements about the firm’s prospects to investors. The SEC may well charge that CEO with fraud. However, it wouldn’t necessarily be accounting fraud unless financial records were falsified.
For accounting fraud, the costs are hard to estimate, given the professionals involved and the limited auditing abilities of regulators. A widely discussed 2023 study, “How Pervasive Is Corporate Fraud?” published in the Review of Accounting Studies, suggests that about two-thirds of corporate fraud cases in public companies go undetected. More startling is what they find looking at financial statements and other corporate financial indicators. “Accounting violations are widespread,” the authors argue. “In an average year, 41% of companies misrepresent their financial reports, even when we ignore simple clerical errors.” While this number could wildly overstate actual legal violations, which occur at a far lower rate than “violations,” there is still a significant cost to investors. The average cost of fraud, they estimate, in line with other studies, could be as high as 15.6% of firms’ market capitalization.
The effects of accounting fraud are not just on the stakeholders of particular firms. The indirect methods researchers use to estimate this purposely and professionally hidden practice involve examining the effects of known accounting fraud on other firms and attempting to detect it at other times. For example, a company might be overspending to catch up to a competitor firm that is, in fact, behind.
Accounting fraud thus has effects on the market and investors more broadly. One recent study posited that the impact is so widespread that it can be used as a predictor of recessions. The thinking is that companies are more likely to cook their books when facing financial pressures, and if we combine all firms doing this at a certain moment, it could be enough to push a weakening economy over the edge.
Let’s now cover the main ways it occurs.
Always be careful when alleging accounting fraud. Fraud requires intent, which can be difficult to prove.
A company can commit accounting fraud if it overstates its revenue. Suppose company ABC is operating at a loss and not generating enough revenue. To cover up this situation, the firm might claim to produce more income on financial statements than in reality. If the company overstates its revenues, it could drive up its share price and create a false image of financial health.
Here are some common ways of doing this:
- Bill and hold schemes: This involves billing customers for products that are being delayed by holding them in a company’s warehouse while recording the revenue.
- Channel stuffing: Shipping more products to distributors or retailers than they can sell and recording what’s shipped as sales, even though most will come back returned.
- Playing with the timing of recorded revenue: This involves moving up (and sometimes overpromising) future sales in the current period, artificially boosting revenue. Doing so before a sale is final disregards the accounting principle that revenue can only be recognized once earned and completed.
- Recording fictitious sales: Producing counterfeit invoices or recording sales that never occurred.
Another type of accounting fraud occurs when an expense or set of expenses isn’t recorded. This leads to overstating a company’s net income. Here are some common ways of doing this:
- Deferring expenses: Delaying the recording of costs to future accounting periods. This puts the current financial period in a better light.
- Failing to record depreciation and asset impairments: Under-recording or not recording these for equipment, vehicles, or buildings would inflate the company’s net income.
- Hiding operating expenses: Deliberately not recording operating expenses is another way to inflate the company’s net income.
- Lowballing the costs of production: This is intentionally recording lower costs of goods sold than incurred, which artificially boosts gross profit margins.
Misstating Assets and Liabilities
Accounting fraud occurs when a company overstates its assets or understates its liabilities. For example, a company might overstate its assets and not record accrued liabilities that have been incurred but not yet paid, like unpaid wages, taxes, or interest expenses. This can also include pensions and other kinds of retirement costs for retirees.
Suppose a company has assets of $1 million and its liabilities are $5 million. If the company overstates its assets and understates its liabilities, it is misrepresenting its liquidity. The company could state that it has $5 million in assets and $500,000 in liabilities. Then, potential investors would believe that the company has enough liquid assets to cover its liabilities.
Real World Examples of Accounting Fraud
The history of accounting fraud is perhaps as old as accounting itself. The Hammurabi Code, dating back almost 4,000 years, is the oldest complete law code available and records in great detail just how seriously it was taken. A common enough crime was that scribes, accountants, and other workers would record lower harvests to cut the percentage owed in tribute to the temples. Fines began at six times the amount believed stolen and went up to 30 times the amount if the king was defrauded. Defendants were sure to pay if they could; the alternative was death.
The Enron scandal remains one of the most famous examples of accounting fraud. Enron used off-balance-sheet entities to hide the company’s debts from investors and creditors. Although using such entities was not illegal, Enron’s failure to disclose the necessary details of its dealings constituted accounting fraud. As the true extent of Enron’s debts became known to the public, its share price collapsed. By the end of 2001, Enron declared bankruptcy.
The consequences of accounting fraud were severe in the Enron case. Criminal charges were brought against many of the company’s top executives, and some went to prison. The scandal also eventually destroyed accounting giant Arthur Andersen LLP, which handled Enron’s books.
Another prominent example of accounting fraud occurred in 1998, when Waste Management, a major publicly traded U.S. waste management company, hired a new CEO who, along with his management team, discovered the company had reported false earnings totaling more than $1.7 billion.
In 2002, the SEC charged Waste Management and its former executives with fraud. The company eventually restated its financial results for 1992 through 1997 and agreed to pay $457 million to shareholders affected by the inflated stock prices. The case, along with the Enron scandal, led to increased scrutiny of accounting practices and the development of the Sarbanes-Oxley Act of 2002, a law designed to protect investors from corporate accounting fraud.
Roadrunner Transportation Systems
The SEC charged Roadrunner for an accounting fraud scheme that ran from at least July 2013 to January 2017. Roadrunner, a shipping and logistics company based in Downers Grove, Illinois, eventually settled, without admitting wrongdoing, over SEC charges that included several types of accounting fraud:
- Manipulating financial statements: The company goosed its numbers, so earnings reports matched prior earnings guidance and analyst projections. This involved tactics such as deferring incurred expenses and spreading them over several quarters.
- Misrepresenting assets and receivables: Roadrunner failed to write down assets that were worthless and receivables that it couldn’t collect.
- Manipulating earnout liabilities: The company manipulated earnout liabilities related to its acquisitions. This created an income “cushion” that could be used in future quarters to offset expenses.
- Concealing the fraud from auditors: The fraudulent activities were concealed from Roadrunner’s independent auditor.
In 2021, Roadrunner’s longtime CFO was sentenced to two years in prison, and in early 2023, the company agreed to pay almost $10 million in fines.
Who Monitors Accounting Fraud?
Companies often hire independent auditors to validate their books and check for accounting fraud. Firms also typically have their own internal auditing programs. Those who monitor and investigate these crimes include many entities across state and federal levels in the U.S.:
- SEC: The SEC is the primary federal regulator responsible for enforcing securities laws and regulating the securities industry. It reviews and investigates companies for financial misconduct, including accounting fraud, and enforces compliance with financial disclosure and reporting requirements.
- Financial Industry Regulatory Authority (FINRA): Although it concentrates its energy on brokerage firms and securities professionals, FINRA also plays a role in monitoring and investigating accounting irregularities.
- Public Company Accounting Oversight Board (PCAOB): This board was established by the Sarbanes-Oxley Act in 2002. The PCAOB oversees the audits of public companies to confirm that financial statements accurately represent their finances.
- Internal Revenue Service (IRS): The IRS investigates tax fraud, which typically intersects with accounting fraud, particularly in cases of misreported earnings or assets.
- Federal Bureau of Investigation (FBI): The FBI and other law enforcement agencies at the state and federal level investigate accounting fraud, especially when it involves embezzlement or money laundering.
- State Securities Regulators: State-level agencies have the authority to investigate and act on accounting fraud.
How Does the SEC Uncover Fraud?
A common way for accounting fraud to be discovered is through the actions of a whistleblower. Under the SEC Whistleblower Program, the SEC offers protection and awards to eligible whistleblowers who report violations such as accounting fraud.
What Are the Penalties for Accounting Fraud?
Companies that commit accounting fraud are subject to financial penalties based on the impact of their fraud. These penalties can be significant, often reaching into the hundreds of millions. They may also have to make payments to those affected by the fraud. Individual executives and other employees involved could face fines, prison, probation, and being banned from future fiduciary roles in U.S. companies.
The Bottom Line
Accounting fraud is a serious problem that can shatter investor confidence in a market and result in costs for investors, employees, and other stakeholders. As seen in the Enron, Waste Management, and Roadrunner Transportation Systems cases, accounting fraud is a significant breach of ethical and legal standards in the corporate world. It does far more than rip off investors.
Recent studies and cases of financial accounting fraud underscore the need for stringent oversight, transparent financial reporting, and rigorous internal controls within companies. Accounting fraud damages the companies involved, shakes investor confidence, and can lead to substantial legal and economic repercussions. As such, maintaining the highest standards of accounting integrity is a key part of maintaining the health and stability of the financial system.