How could many of the security frauds of the late 1990s and early 200s have been prevented?

Organizations worldwide watch 5% of their annual revenue go right out the window due to a single cause:  fraud. That is one of the findings reported in the Association of Certified Fraud Examiners (ACFE) 2020 Report to the Nations, a global study on occupational fraud and abuse. Accounting fraud is defined as fraud that involves theft and other crimes committed by accountants or related to an organization’s accounting methods and practices.

• The ACFE report estimates that each case of accounting costs the affected organization an average of $1.5  .
• The total amount of losses in the 2,504 fraud cases that the ACFE analyzed in its biennial report was $3.6 billion.
• The International Federation of Accountants (IFAC) forecasts that the economic damage from the COVID-19 pandemic will increase occurrences of accounting fraud, due in part to companies’ increased reliance on remote and virtual work environment

The damage from accounting scandals extends beyond shareholders and employees, affecting local and global economies as well as investors,   and the accounting industry. The financial well-being of companies and individuals depends on preventing accounting crimes, detecting them quickly when they occur and responding effectively to contain the damage they inflict.

This article explores seven of the worst corporate accounting scandals in recent U.S. history.

• Enron
• General Electric Co. (GE)
• Tyco
• WorldCom
• Bernie Madoff
• American International Group Inc. (AIG)
• Lehman Brothers

What Is an Accounting Scandal

An accounting scandal is a case of accounting fraud that’s so damaging to a company, an industry or the economy that it reverberates far beyond the principal players.

• The damage may have a negligible impact on large numbers of people; for example, the Wells Fargo scandal involved millions of false , each of which led to small monetary losses for each of the millions of Wells Fargo customers affected.
• Conversely, the crime could devastate the lives of hundreds or thousands of victims, some of whom may lose millions of dollars, as in the Bernie Madoff scandal.

From a corporate perspective, accounting fraud is defined as the intentional manipulation of financial statements in a way that’s intended to falsify the appearance of the company’s finances. It’s typically motivated either by personal gain (theft) or by a desire to mislead investors and shareholders.

Federal and State Laws Relating to Accounting Crime

Accounting fraud is a crime in the U.S. under both federal and state laws. The legal information site HG.org explains the federal statutes pertaining to accounting fraud:

• Section 1520 of Title 18 of the U.S. Code makes it a violation of federal law to destroy or discard any material pertaining to a financial audit or review until at least five years after the review is completed.
• Section 78j of Title 15 of the U.S. Code makes it a violation of federal law to use fraud or deceit in the purchase or sale of securities, including use of confidential information that isn’t available to the public, or “insider trading.”
• Sections 1956 and 1957 of Title 18 of the U.S. Code make it a violation of federal law to engage in a monetary transaction that involves any unlawful activity or “money laundering.”

While most prosecutions for accounting crime originate in the U.S. Department of Justice (DOJ) and the U.S. Securities and Exchange Commission (SEC), state laws also prohibit accounting fraud by allowing individuals to file civil suits against firms to recover monetary damages resulting from fraudulent activity. In particular, states apply their own financial reporting requirements in addition to those required by federal law.

How Forensic Accountants and External Auditors Combat Accounting Fraud

For many years, internal and external auditors detected and reported accounting fraud, but as the Institute of Certified Forensic Accountants (ICFA) reports, those audits only verified compliance with generally accepted accounting principles (GAAP) and the company’s own policies. Forensic accounting goes further, focusing on identifying fraudulent financial transactions.

The ways that forensic accountants and auditors detect and respond to incidents of accounting fraud include the following:

• Participating in criminal and civil investigations of suspicious financial practices
• Preparing and reviewing evidence used to prosecute cases
• Writing expert reports and affidavits explaining an accounting crime’s details
• Appearing as witnesses in court cases prosecuting accounting crimes
• Engaging in dispute resolution, arbitration and mediation
• Implementing fraud prevention and awareness programs

Challenges in Detecting and Prosecuting Accounting Fraud

The regulations of most State Boards of Accountancy prohibit Certified Public Accountants (CPAs) from reporting clients whose financial practices violate the law unless the client grants them permission to do so. This has led to efforts by the American Institute of CPAs (AICPA) and the National Association of State Boards of Accountancy (NASBA) to create whistleblower protections for CPAs to report accounting crimes committed by their clients without receiving the client’s consent beforehand.

The CPA Journal notes that financial criminals are increasingly using artificial intelligence (AI), robotic process automation (RPA) and other advanced technologies to perpetrate fraud. Most of these crimes occur not in the accounting department but in the corner offices of CEOs and chief financial officers (CFOs), rendering internal audit controls ineffective. The same technologies intended to detect and prevent accounting fraud can circumvent built-in protections against financial crimes.

Challenges in Detecting and Prosecuting Accounting Fraud

The regulations of most State Boards of Accountancy prohibit Certified Public Accountants (CPAs) from reporting clients whose financial practices violate the law unless the client grants them permission to do so. This has led to efforts by the American Institute of CPAs (AICPA) and the National Association of State Boards of Accountancy (NASBA) to create whistleblower protections for CPAs to report accounting crimes committed by their clients without receiving the client’s consent beforehand.

The CPA Journal notes that financial criminals are increasingly using artificial intelligence (AI), robotic process automation (RPA) and other advanced technologies to perpetrate fraud. Most of these crimes occur not in the accounting department but in the corner offices of CEOs and chief financial officers (CFOs), rendering internal audit controls ineffective. The same technologies intended to detect and prevent accounting fraud can circumvent built-in protections against financial crimes.

The Association of Certified Fraud Examiners’ 2020 Global Study on Occupational Fraud and Abuse identifies the three most common forms of accounting fraud: asset misappropriation (theft) makes up 86% of all corporate fraud cases, with a median loss of $100,000; corruption (misuse of authority) makes up 43% of all corporate fraud cases, with a median loss of $200,000; and financial statement fraud (incorrect or omitted material information) makes up 10% of all corporate fraud cases, with a median loss of $954,000.

Worst Corporate Accounting Scandals in U.S. History

The worst accounting scandals in terms of monetary loss have occurred in recent decades, but there is nothing new about fraudulent accounting practices. Accounting crimes perpetrated by U.S. companies date back to the early 19th century. For example, in the 1860s, the railroad firm Crédit Mobilier defrauded the U.S. government of millions of dollars by grossly inflating the price of its work. A number of politicians profited from the scheme.

The damage that the following modern corporate accounting scandals have inflicted continues to be felt by their victims, by the accounting profession and by industries around the world.

1. Enron Accounting Scandal

Few financial crimes have had the impact of the Enron accounting scandals of the early 2000s. The scandals led directly to far-reaching reform of business financial practices via the  . They also led to the demise of one of the Big Five public accounting firms, Arthur Andersen.

• Enron was a publicly traded company, headquartered in Houston, Texas, that was active in a range of energy-related enterprises, including oil and gas futures, oil refineries, and power plants. Before its forced bankruptcy in 2001, the company was one of the largest pulp and paper, electricity, gas and communications companies in the world.
• Enron’s officers and employees engaged in many fraudulent accounting activities and other crimes. They misrepresented the company’s earnings in financial reports to shareholders, embezzled corporate funds and illegally manipulated energy markets, creating fake power shortages to drive up the price of electricity, for example. The company hid financial losses and claimed profits on assets that in fact lost money.
• Former Enron CEO Jeffrey Skilling received the longest sentence of the many company executives sentenced for their crimes related to the scandal, earning his release from a federal prison in 2018. Other executives involved in the crimes include former Enron Chairman Kenneth Lay, who died in 2006 after being convicted of multiple crimes, and former Enron CFO Andrew Fastow, who was released from federal prison in 2011 after serving six years of his 10-year sentence.
• The dot-com bubble burst in early 2000, which exposed Enron’s fraudulent accounting practices. The Houston office of the Arthur Andersen, which had approved Enron’s sham financial reports, was found complicit in the company’s crimes, which led to the firm losing most of its clients. Once Enron could no longer hide its debt, its stock price plummeted in the summer of 2001; it filed for bankruptcy soon thereafter.

2. General Electric Co. Accounting Scandal

A multiyear investigation by the SEC determined that General Electric Co. (GE) misled investors in 2016 and 2017 by failing to disclose that the true source of much of its reported profits was a reduction of earlier cost estimates. This was one of several GE accounting scandals in recent years.

• GE is a multinational conglomerate with many large operations. One of the units that the SEC investigated was GE Capital, which was heavily invested in insurance and reported a $6.2 billion loss in early 2018, as CNN reports.
• The SEC’s investigation determined that GE failed to disclose to investors that 25% of its GE Power profits in 2016 and almost 50% of the division’s profits in the first three quarters of 2017 were due primarily to internal receivable transactions between GE Capital and GE Power.
• Then-CEO Jeff Immelt certified GE’s 2016 annual report. The company’s longtime CFO, Jeffrey Bornstein, exited the company unexpectedly in the same year. Lawsuits from GE shareholders named both Immelt and Bornstein, and the SEC is considering civil action against the company related to its accounting practices, but to date no criminal charges have been filed against the former executives.
• GE’s settlement with the SEC includes a $200 million penalty for violation of securities laws related to anti-fraud, reporting, disclosure controls and accounting controls. In addition, the disclosure of the fraud led GE’s stock price to drop by nearly 75%.

3. Tyco Accounting Scandal

In the years before the Tyco accounting scandal of 2003, the company had grown via acquisitions into one of the largest security firms in the U.S. Unethical behavior by former CEO L. Dennis Kozlowski and other top Tyco International executives nearly brought down the organization.

• Tyco consisted of that made such products as surgical equipment, undersea fiber-optic cable, electronics and security systems. It employed more than 270,000 people.
• Kozlowski’s crimes included tax evasion involving the purchase of millions of dollars in art. His unethical behavior ultimately involved several other Tyco officials, who participated in the activities or shielded them from detection. Tyco’s accounting firm, PricewaterhouseCoopers, failed in its obligation to identify the fraudulent transactions included in Tyco’s financial reports.
• Soon after the scandal broke, CNN reported a tip from “banking sources” about questionable transactions at the company that uncovered fraudulent activities by Tyco executives. Kozlowski and CFO Mark Swartz were charged with stealing $170 million in company funds and gaining more than $430 million from fraudulent stock sales.
• Both Kozlowski and Swartz were convicted and sentenced to prison terms of up to 25 years. They also had to pay $134 million in restitution in addition to fines of $70 million and $35 million, respectively. Kozlowski and Swartz were imprisoned in 2005 and released on parole in 2013.

4. WorldCom Accounting Scandal

The WorldCom accounting scandal was one of the most financially costly in corporate history, ultimately involving nearly $4 billion in accounting fraud.

• The leading telecommunications firm WorldCom in the 1990s.
• In 2001, WorldCom began to fraudulently inflate the earnings reported on its profit and loss statements. It did so by manipulating financial data in its income statements, balance sheets, Form 10-K filings and annual reports.
• Scott Sullivan, WorldCom’s CFO at the time of the scandal, used illegal methods to spread billions of dollars in operating expenses across several property accounts, which are a kind of capital expense account. This extended expenses for years, allowing the company to inflate revenue by almost $3 billion in 2001 and report a $1.4 billion profit rather than a loss.
• Internal audits initially brought the WorldCom fraud to light. Cynthia Cooper and her team of internal auditors at the company discovered unusual entries by WorldCom’s wireless division. The company eventually declared bankruptcy, costing its shareholders billions.

5. Bernie Madoff Accounting Scandal

The Bernie Madoff accounting scandal remains one of the most shameful events in the history of the financial industry. For at least 17 years, Bernard Lawrence “Bernie” Madoff operated a Ponzi scheme that bilked 37,011 investors out of tens of billions of dollars.

• Madoff founded his first investment company in 1960 at the age of 22. He was instrumental in promoting electronic trading systems, and by the late 1980s, he was earning about $100 million a year. Madoff served as chairman of the Nasdaq stock market in 1990, 1991 and 1993.
• The Ponzi scheme Madoff perpetrated paid early investors “profits” that were actually sums that more recent investors had given him to invest. Like all Ponzi schemes, the incoming investments eventually failed to cover the fake profits that previous investors came to expect. Rather than investing the money he received from clients, Madoff deposited it in banks and pocketed as much as $483 million in interest.
• Investors Carl Shapiro, Jeffry Picower, Stanley Chais and Norm Levy were longtime associates of Madoff’s who each received hundreds of millions of dollars as a result of Madoff’s crimes; several other investment-fund managers whose greed was greater than their ethics were also longtime associates of Madoff’s.
• The SEC first began investigating Madoff in 1999. In 2000, financial analyst Harry Markopolos filed a whistleblower complaint with the SEC that was ignored. It wasn’t until 2005 that Markopolos was able to convince the SEC of Madoff’s crimes. In 2009, Madoff was sentenced to 150 years in prison and required to forfeit $170 billion. By December 2008, $2.7 billion had been repaid to the victims of Madoff’s . In 2020, Madoff requested compassionate release due to failing health but was denied; he passed away in prison on April 14, 2021.

6. American International Group Inc. (AIG) Accounting Scandal

The AIG accounting scandal is centered on the mortgage meltdown that began in 2008 and eventually caused the Great Recession that persisted for several years. The company had placed huge bets on risky mortgages in the form of a financial instrument called collateralized debt obligations (CDOs).

• AIG was one of the largest insurance companies in the world through the 1990s, but beginning late that decade, the firm came to rely on CDOs, which had become favorites of investment banks and large financial institutions. Many CDO assets were subprime mortgages issued to people who lacked the resources to repay them.
• When the housing market crashed in 2008 and foreclosures multiplied, AIG’s Financial Products division incurred losses of $25 billion. The company’s questionable accounting practices exacerbated the losses. AIG’s lowered credit rating forced the company to post collateral for its bondholders, worsening its financial situation.
• Officials at the Federal Reserve and the U.S. Department of the Treasury decided that AIG was “too big to fail” because of the many mutual funds, pension funds and hedge funds that had invested heavily in the company or that were insured by AIG (or both). Federal agencies poured an estimated $150 billion into the company.
• AIG continues to operate, and its potential failure is no longer considered a threat to the U.S. economy. By 2013, the company had repaid its debt, which reportedly earned $22.7 billion in interest from the bailout, to the government. Critics continue to question why AIG was bailed out when other firms that fell victim to risky financial instruments were allowed to fail.

7. Lehman Brothers Accounting Scandal

The Lehman Brothers accounting scandal demonstrates the devastation that can result from a seemingly minor change to an accounting standard. In 2001, Statement of Financial Accounting Standard (SFAS) No. 140 created an accounting loophole referred to as Repo 105. The loophole allowed Lehman Brothers to conceal just how highly leveraged its investments were.

• When Lehman Brothers collapsed in 2008, it was the fourth-largest investment bank in the U.S. The company had 25,000 employees worldwide, $639 billion in assets and $613 billion in liabilities. During the housing boom of 2003 and 2004, the bank invested heavily in CDOs and mortgage-backed securities. In 2007, Lehman Brothers recorded net income of $4.2 billion on $19.3 billion in revenue.
• When the credit crisis struck in August 2007, Lehman Brothers had a portfolio of mortgage-backed securities valued at $85 billion, which was more than any other company and four times its shareholders’ equity. Despite its efforts to reduce its risk, the company faced a $3.8 billion loss in 2008, including a write-down of $5.6 billion.
• On September 15, 2008, Lehman Brothers declared bankruptcy, causing its stock price to fall by 93% in three days. Former CEO of Lehman Brothers Richard Fuld acknowledged the bank’s accounting mistakes but complained about the government’s decision not to offer it a bailout, which AIG and other failing financial giants received.
• After Lehman Brothers’ collapse, the focus fell on its auditors, EY, for failing to detect the bank’s misuse of the Repo 105 loophole to disguise how much its finances were leveraged. In 2013, EY agreed to pay $99 million to Lehman Brothers’ investors but denied any responsibility for the resulting bankruptcy and investor losses. No one was ever prosecuted or jailed for misuse of Repo 105.

How Does Accounting Fraud Happen

Considering the tremendous damage to investors and economies that results from accounting scandals, as well as the fiduciary responsibility that accounting professionals pledge to their clients that subjects them to a higher standard of conduct than other people, it’s natural to  how accounting fraud happens despite the financial safeguards in place. The results of a recent study reported in Forbes indicate how business managers react when faced with earnings that fall short of expectations. The managers are more likely to hide the shortfall by failing to report expenses they already made rather than by prematurely reporting revenue they expect to make in the future.

The reason managers give for choosing the passive approach to hiding losses is that it’s easier to explain the omission to auditors as an accident rather than an intentional act. The researchers highlight the dangers of managers “strategically committing fraud” that auditors, regulators and other investigators can label as errors. The result is that “seemingly harmless” acts of fraud grow into full-fledged fraudulent schemes that persist and involve large sums of money, some of which the perpetrators pocket.

Methods Used to Commit Accounting Crimes

Since it’s impossible to prevent all accounting fraud, early detection of fraudulent activities is key to reducing the risk to companies. However, gaps in financial oversight allow the crimes to go undetected for years, as the Madoff Ponzi scheme demonstrates. These are the most common methods that perpetrators of accounting fraud use to conceal their crimes:

• Creating fraudulent physical documents: 40% of cases
• Altering physical documents: 36%
• Altering electronic files and documents: 27%
• Creating fraudulent electronic files and documents: 26%
• Not attempting to conceal accounting crimes: 12%

Common Forms of Accounting Fraud

Along with failing to record expenses, the most common forms of corporate accounting fraud are  in the company’s financial statements and misrepresenting assets and liabilities. Other forms of accounting fraud include the following:

• Manipulating payroll
• Creating fake invoices
• Misreporting tax liabilities to the IRS
• Filing false insurance claims or banking applications

CFO Dive reports that 60% of actions that the SEC takes as a result of its whistleblower program for reporting suspected accounting fraud relate to improper timing of revenue recognition. Companies will accelerate revenue recognition if they’re falling behind their revenue targets and will delay reporting revenue if they’re ahead of their targets for a specific reporting period.

Resources for Preventing Accounting Fraud

• Moss Adams, “Take a Solutions-Based Approach to Fraud Prevention” — Tips help companies identify how they may be vulnerable to accounting fraud and address the conditions that are most likely to precipitate fraudulent accounting practices.
• California Society of CPAs, Fraud Prevention Steps for Small Businesses — Eight actions that small businesses can take to prevent themselves from becoming victims of fraud, include vetting potential new hires and separating accounting duties from other business .

New technologies make the task of finding and addressing instances of corporate accounting fraud more difficult. These are the 10 most common ways that occupational fraud is uncovered: tip, 43%; internal audit, 15%; management review, 12%; by accident, 5%; account reconciliation, 4%; external audit, 4%; document examination, 3%; surveillance/monitoring, 3%; notified by law enforcement, 2%; IT controls, 2%.

How to Detect Accounting Fraud

Knowing how to detect accounting fraud becomes more important as the risks of accounting-related crimes become more numerous and potentially more damaging. For example, the same advanced technologies on which companies rely to gain a competitive edge can be used to commit financial crimes that are nearly impossible to identify and quickly address.

Financial Oversight Provided by Auditors and Forensic Accountants

CFOs and other corporate financial managers play principal roles and have primary responsibility for policing their companies’ accounting operations. The most important tools in their fraud detection arsenal are internal and external audits, some of which are performed by forensic accountants who specialize in discovering accounting fraud.

Accounting firm Eide Bailly  explains the difference between standard financial audits vs. forensic audits:

• A financial audit, or financial statement audit, is an independent examination by a third party of the company’s financial statement and accompanying disclosure. The audit is intended to confirm the “fairness of presentation” and ensure that the report presents an accurate picture of the company’s financial health. The SEC requires that all public companies conduct such an audit annually.
• A forensic audit, or forensic examination, is intended specifically to identify any illegal activity related to a company’s financial records. The results are intended to be suitable for use in civil and criminal court cases and other legal matters.

Impact of the Sarbanes-Oxley Act on Accounting Fraud

The Enron debacle and other multibillion-dollar accounting scandals involving U.S. firms in the early 21st century prompted Congress to take action. In particular, the Sarbanes-Oxley Act attempts to prevent and more easily detect accounting fraud.

The Sarbanes-Oxley Act is intended to protect investors by requiring that corporate financial statements be accurate and reliable. These are among the major provisions of the act:

• Section 302 requires that senior corporate officers certify in writing that the company’s financial statements comply with the SEC’s disclosure requirements and accurately represent the company’s operations and financial status.
• Section 404 mandates the internal accounting controls that must be in place and makes managers and auditors personally responsible for ensuring that they’re effective.
• Section 802 stipulates three record-keeping rules relating to the destruction and falsification of documents; the retention period for financial records; and the specific business records that companies must retain, including electronic documents and communications.

While the Sarbanes-Oxley Act defines rules for information technology (IT) departments to follow in ensuring that records are securely stored, the law doesn’t specify storage methods or other business practices to ensure compliance with the law’s provisions.

Resources for Detecting Accounting Fraud

• Cornerstone Research, Accounting and Auditing Enforcement Activity — 2019 Review and Analysis — Details the enforcement actions the SEC and the Public Company Accounting Oversight Board took between 2014 and 2019 in chronological order.
• Fortune, “Only 4% of Fraud Is Caught by Outside Auditors. It’s Time for Accounting to Change Its Approach” — Calls for new approaches to training auditors to emphasize the need to prioritize fraud detection and end self-regulation of corporate accounting practices.

Protecting the Integrity of Corporate Financial Statements

Accounting scandals that went undetected for years, even decades, and that led to hundreds of billions of dollars in losses for investors have shaken consumer and investor confidence in corporations to the core. Efforts to regain that lost trust begin with the important roles that forensic accountants and auditors play in ensuring the accuracy of a company’s financial reports and the reliability and integrity of its accounting operations. Accounting professionals are critical in supplying the close scrutiny of corporate financial disclosures that governments and the public demand.

Infographic Sources:

Association of Certified Fraud Examiners, Report to the Nations: 2020 Global Study on Occupational Fraud and Abuse

Prager Metis CPAs, “The Anatomy of Fraud — Insights from the 2020 AFCE Global Study on Occupational Fraud”

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