Cooking the Book – How do they do it?

Enron, Worldcom, AOL, corporations who have committed financial fraud by “cooking their books” – presenting untrue information about the company’s financial operation in their financial statements. Since the book, a company’s financial statement, is what investors look at to decide whether they should invest in the company, its authenticity is vital to investment decisions,  and its fraudulence fatal.

We, as investors can not help but wonder, “How did they all happen?” and “Could they happen again?” This post will (1) explain some of the ways by which companies cook their books, and (2) cover regulatory changes ever since to see how likely that cooking the book can happen again.

How did they all happen?

Cooking the book is a staged act of both the company and its external auditing firm. Prior to the enactment of Sarbanes-Oxley Act in 2002, auditing is not as tightly regulated, hence there are many vulnerabilities that can be exploited . Here are the most popular few book-cooking strategies:

Mark-to-market Profits and Losses Calculation

Enron convinced federal regulators in 1992 to permit Enron to use an accounting method called “mark-to-market”. This was a technique that was previously only used by brokerage and trading companies. With mark to market accounting, the price or value of a security is recorded on a daily basis to calculate profits and losses. Since the value of security can be based upon projected income that takes years to materialise, Enron’s can manipulate such projection and its financial statement needed not to reflect the actual profit and losses at the time of performance releases.

Off-Balance Sheet Accounting

Assets that fulfils certain criteria need not to be “on” the balance sheet, hence they can be moved off  the balance sheet and not visible to the public. Using this accounting strategy, companies who want to appear to be financially sound by reducing the amount of debt it holds on the public balance sheet can move them off the balance sheet. This is done typically via transferring it to a Special Purpose Entity (SPE):

  1. Special Purpose Entity (SPE) and Debt Removal – this strategy is adopted by Enron. The operating company (e.g. Enron) could establish a new company called Special Purpose Entity (SPE) and moves its debts to that company. The operating company could own a total of 97% of its SPE and not be obliged to put these debts on their own balance sheet. Enron used this tactic to hide a huge amount of debt under its ownership.
  2. Synthetic Leases, Assets, and Tax Benefit – the operating company can also use SPE to reap tax benefit. The operating company can first transfer ownership of asset to the SPE and then lease it back to the itself. Since the U.S tax code specified that the leasee/operating company own the asset leased to it, the company is entitled to tax benefit as a result of depreciation of these asset.

Expense Manipulation

A company can book expenses in a way that it does not affect the operating profit, here is how:

  1. Putting Regular Expense as Capital Expense to boost operating profit– A company can manipulate its expense so that it appears to have a more profitable operation than it really does. One of the way is to categorise regular expenses as capital expenses. AOL, for example, has been accused of listing advertising expense as capital expense rather than regular expense. Since capital expense is not factored in in a company’s operating profit, AOL boosted its profit by millions by removing a substantial expense from its income statement. Worldcom used the same strategy to boost apparent profit in the scale of billions of dollars.
  2. Non-Recurring Expense, and operating profit- these are expenses that are suppose to occur only once so as to be kept out of calculation of regular expense. Because of the hard-to-define nature of this type of expense, company can recharacterise regular expense as non-recurrring expense so to boost operating profit, which does not include non-recurring expense.

Earning Manipulation

A company can calculate earning in a way that does not reflect its actual revenue at the current quarter, here is how.

  1. Revenue Manipulation – a company can inflate revenue by booking revenue from sales of items before the cash arrives in the company’s account. A company is also considered inflating revenue if it books in already cashed-in sales of items that are highly risky of being returned, such as electronics.
  2. Pension Plan Manipulation – a company is expected to have a fund that pays out to employees’ benefit in the event that the company goes out of business. The money in this fund, however, can be used for investment to generate profit. By accounting rules, the reported profit from investment using pension fund, however, need not be actual profit figure, but an “estimate” of the company. Many companies invested the money in the stock market and made estimated profit based on how the stock market perform in the 90s, which soon turned sour, and created a profit gap between the actual and estimated profit.

Could they happen again?

The Sarbanes-Oxley Act are legislation that amend the previous vulnerabilities of accounting rules. It has definitely become harder for companies to cook their book ever since.

The Sarbanes Oxley Act

The Sarbanes–Oxley Act of 2002  is a United States Federal Law that set new or enhanced standards for all U.S. public company boards, management and public accounting firms. Here are some of the key components which address vulnerabilities in the then existing accounting rules.

  1. The Establishment of PCAOB – For the first time in history, auditing firms are subject to independent, external oversight. The PCAOB is a nonprofit corporation established by Congress to oversee the audits of public companies in order to protect the interests of investors and further the public interest in the preparation of informative, accurate and independent audit reports. The PCAOB also oversees the audits of broker-dealers, including compliance reports filed pursuant to federal securities laws, to promote investor protection.
  2. Mandatory Disclosure of all Off-balanced Materials – Section 401(a) of the Sarbanes-Oxley Act requires that annual and quarterly financial reports disclose all material off-balance sheet transactions, arrangements, and obligations. The rules also require most companies to provide an overview of known contractual obligations in an “easy-to-read tabular format”
  3. Mandatory Report on Internal Control by External Auditing firms – Section 404 provides that company must adopt measures to conduct independent assessment of its internal control, and filed detailed report to the PCAOB for examination of the integrity and efficiency of their internal control. This scaled up checks and balance should play an important role in making sure that manipulation of revenue and expenses are under supervision.
  4. Personal Certification from CEO and CFO of Financial Statement – Section 906 made CEO/CFO personally responsible for financial statement that turn out to be fraudulent. Though difficult to prove, many would agree that financial frauds alike those of Enron or Worldcom could not have happened without the CEO/CFO knowing. The additional certification process makes the top management directly responsible for the company’s fraudulent behaviours, adding a  deterrent to fraud arising from leadership.

The Act has largely reduced that risks of book-cooking by establishing an independent body to oversees the auditing practice, and put in place obligation that acts both to enhance disclosure of financial status of a company and deter company management from taking the chance to forge their financial statements. As an outsider, however, it is difficult to know whether such the Act will stop all future creative accounting from cooking the books. But the record from the enactment of the Act to today has not been free of book-cooking. The old accounting magic is still going on (see the charges agains Dell which results in charges of $100m in 2010), and new accounting magic is being invented every day (see Lehman Brother’s Repo 105)

End Note

To effectively cook the book, cooperation across all types of firms in the financial sector must cooperate with the company. Take the example of Enron, Frank Partnoy, a law professor and former Wall Street derivatives specialist commented on the fraud, saying that ” a thorough inquiry into these dealings also should include the major financial market “gatekeepers” involved with Enron: accounting firms, banks, law firms, and credit rating agencies.” To really understand whether “cooking the book” can happen again, it is necessary to look at the relevant legislation and practice across the entire financial sector. Too often than not, the smartest and the keenest people are the greediest bunch, and ordinary investors like us must get smarter just to protect ourselves from a the possibility of a staged-fabulance by the financial sector.

Sources

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