Famous Accounting Frauds and What They Teach

Why this matters

Rules about revenue, depreciation, and reserves can feel abstract. These six cases show what happens when they're abused, and how much money was lost when the truth came out. Each summary below relies on what the SEC stated in its own enforcement documents. Most of those documents are complaints, which set out allegations. Where a case ended in a settlement, companies and individuals often neither admitted nor denied them.

Six cases, six methods

Sunbeam: borrowing from next quarter

Sunbeam made household appliances. In its order, the SEC found that at least $62 million of the $189 million of income the company reported for 1997 came from accounting fraud. Sunbeam offered customers discounts and other incentives to order earlier than they otherwise would have, and recorded bill-and-hold sales for goods that stayed in its own warehouses.¹

The trace. Sales pulled forward leave receivables that grow faster than revenue and customers sitting on stock they don't need. The following period then starts short of sales, so the company has to pull forward even more. The method runs out by its own arithmetic.

Waste Management: trucks that never wore out

Waste Management ran a very large fleet of garbage trucks. The SEC alleged that between 1992 and 1997 the company's former top officers misstated its pre-tax earnings by about $1.7 billion. One method was to avoid depreciation on the trucks by giving them unsupported, inflated salvage values and by extending their useful lives. The restatement that followed in 1998 was the largest in corporate history at that time, and the SEC said shareholders who kept their stock lost more than $6 billion in market value.²

The trace. Depreciation that's low against the size of the asset base, and assumed lives longer than competitors use for the same equipment. Both are disclosed. The notes state the lives a company assumes, and the same notes at its competitors are a ready comparison.

WorldCom: turning costs into assets

WorldCom was a large US telephone and internet company. The SEC's 2002 complaint said the company capitalized, and so deferred, about $3.8 billion of its costs instead of recording them as expenses, which overstated its income by about $3.055 billion in 2001 and $797 million in the first quarter of 2002.³

The trace. This method is dangerous because it also defeats the simplest cash check. A cost recorded as an expense reduces profit and operating cash flow. The same payment recorded as an asset leaves both untouched and appears as capital spending instead. Profit and operating cash flow look healthy together. What gives it away is capital spending rising against revenue while expenses fall as a share of revenue, and free cash flow that's much weaker than operating cash flow suggests.

Enron: what wasn't on the balance sheet

Enron was an energy trading company. The SEC alleged that its chief financial officer hid his interest in, and control of, certain entities so that they could be kept off Enron's balance sheet, in a scheme meant to enrich himself and to mislead analysts, rating agencies, and others about Enron's true financial condition.⁴

The trace. Less in the numbers than in the notes: dealings with entities run by the company's own executives. When a company's results depend on transactions with entities its insiders control, the reported figures can't be taken at face value.

HealthSouth: numbers to match the forecast

HealthSouth was a US healthcare company. The SEC alleged that from 1999 the company systematically overstated its earnings by at least $1.4 billion in order to meet or exceed Wall Street's expectations. The false earnings were matched by false increases in assets, and by the third quarter of 2002 its assets were overstated by at least $800 million, about 10%.⁵

The trace. The second sentence is the general lesson. Accounts have to balance, so every dollar of invented profit needs a dollar of invented assets, or a dollar of liabilities left out. Earnings that meet expectations quarter after quarter, alongside asset balances growing faster than the business, is the combination to notice.

Luckin Coffee: invented customers

Luckin Coffee is a Chinese coffee chain whose shares traded in the United States. The SEC alleged that from at least April 2019 to January 2020 the company fabricated more than $300 million of retail sales, using related parties to create false transactions. Revenue was overstated by about 28% for the period ending in June 2019 and about 45% for the period ending in September 2019. To hide it, expenses were inflated by more than $190 million, a fake operations database was created, and accounting and bank records were altered. Luckin agreed to pay a $180 million penalty without admitting or denying the allegations.⁶

The trace. Very little in the statements themselves, which is the point. With false sales, matching false costs, and altered bank records, the accounts were consistent with each other. What stood out was outside the accounts: growth far beyond what comparable businesses achieve, and transactions with related parties.

What the cases have in common

• They began with a target. The aim was to report the numbers investors expected. HealthSouth's case says so directly.
• They used judgment areas. Revenue timing, asset lives, and the line between a cost and an asset are all places where accounting needs estimates. Fraud often starts as an aggressive estimate and grows.
• They had to escalate. A gap filled this year is a gap to fill again next year, on top of the new one.
• The balance sheet kept the evidence. False profit ends up as receivables, inventory, equipment, or "other assets" that grow out of proportion.
• Cash flow wasn't a complete defence. WorldCom's method moved costs out of operating cash flow, and Luckin's records were falsified to match.

What an investor can and can't do

The checks in Accounting Red Flags are aimed at exactly these methods: estimates that drift, balances that grow out of proportion, and dealings with insiders. The realistic goal is to notice that something doesn't add up and to decline to rely on it.

Certainty isn't available. When records are forged and several senior people cooperate, an outsider reading filings can be fooled, and so can analysts and auditors. Since 2002, the chief executive and chief financial officer of a US public company must personally certify that its annual report is accurate and complete,⁷ which raises the personal cost of lying. It doesn't make lying impossible.

So the last line of defence isn't analysis. It's the size of the position. An investor who holds many companies, with no single one large enough to do serious damage, survives being deceived by one of them. Diversification and Position Sizing explained how. And a company whose results look too smooth, too fast-growing, or too hard to understand can simply be left alone.

Key takeaways

• The major accounting frauds abused ordinary judgment areas: revenue timing, asset lives, and what counts as an asset.
• False profit has to sit on the balance sheet, so assets growing out of proportion to the business are a trace.
• Recording costs as assets inflates profit and operating cash flow together, so check capital spending and free cash flow too.
• Dealings with entities controlled by insiders make reported figures hard to trust.
• Forged records can defeat analysis. Diversification and position size are what limit the damage.

Check your understanding

A company starts recording a large recurring cost as an asset instead of an expense. Which combination would you expect to see?

1. Lower profit, lower operating cash flow, and lower capital spending than before.
2. Higher profit, lower operating cash flow, and unchanged capital spending.
3. Higher profit, higher operating cash flow, and higher capital spending.

An investor has studied a company closely and found no warning signs at all. What's the best reason to still limit the size of the position?

1. Falsified records can pass every check, so no analysis removes the risk completely.
2. Companies with no warning signs are usually the ones most likely to be hiding fraud.
3. Regulators forbid individual investors from holding large positions in one company.

What's next

That completes the module on judging the numbers. The final module looks at industries whose statements don't fit the usual pattern, beginning with Reading a Bank's Financial Statements.