What is accounting fraud?

Accounting fraud is the deliberate manipulation of a company's books to manufacture profits that don't exist or to hide debts and losses, and so fool investors, banks and employees. The textbook case is Enron: the Houston energy company, the seventh-largest in the United States by revenue in 2001, inflated its results for years with its auditor's sign-off and filed, on December 2, 2001, what was then the biggest bankruptcy in US history. Unlike other scams, the company here is usually real: what's fake are the numbers.

What is accounting fraud, and how is it different from creative accounting?

Accounting rules leave room to choose how certain assets are valued or when revenue is recognized. Using that room in your favor, without hiding anything, is what's called creative accounting or “window dressing”: it can be aggressive and even misleading to the eye, but it isn't always a crime. It becomes fraud, cooking the books, when facts are invented or hidden: sales that never happened, debt kept off the balance sheet, losses that never get recorded, rigged audits.

In the US, executives of public companies who falsify their accounts are prosecuted for securities fraud, conspiracy and filing false reports with the SEC. In the UK, false accounting is a crime under section 17 of the Theft Act 1968.

How is accounting fraud done, step by step?

1. The pressure. A company promises Wall Street or its lenders growth it can't deliver. Missing a forecast would sink the stock or cut off its credit.
2. The first touch-up. Revenue booked early, a provision pushed back, an optimistic assumption. It looks small and reversible.
3. The snowball. The next quarter, the previous hole has to be covered and the new forecast met. The touch-ups grow.
4. The structures. Separate entities to move debt off the balance sheet, round-trip deals between companies in the same group, valuations done by the company itself.
5. The endorsements. The auditor signs, the analysts cheer, the directors don't ask. Reputation takes the place of checking.
6. The end. An awkward question, a short seller's report or a cash crunch forces the company to show the money. When there's no money, the stock collapses within days.

What are the red flags of accounting fraud?

You don't need to be an auditor to spot some signs that keep coming back:

• Results that are too smooth. The company never misses a forecast, either up or down.
• Profits without cash. The books say it's making a lot, but the money actually coming in (the cash flow) doesn't keep pace.
• Nobody can explain how it makes money. Not the analysts and, sometimes, not even its own executives.
• Opaque related entities. Large deals with companies controlled by executives.
• Changes of auditor, or a tiny auditor for a huge company.
• Executives who sell while urging everyone else to buy.
• Hostility toward questions. Attacks on the journalist or analyst who has doubts.

If you're being offered an investment in a company and want to run the offer through a checklist, use the scam checker.

What are the biggest accounting fraud cases?

Enron (United States, until 2001). Enron had pipelines, power plants and about 20,000 employees. What was fake were the numbers. It booked as that day's profit what it expected to earn from twenty-year contracts, using its own assumptions. It hid debt and losses in entities run by its chief financial officer, Andrew Fastow, who, according to the report commissioned by Enron's own board, made at least $30 million from them. In March 2001, the journalist Bethany McLean asked a simple question in Fortune: how exactly does Enron make its money? Nine months later the company went bankrupt. The hardest hit were its own employees, who had much of their retirement savings in Enron stock. We tell the story in the Enron scandal and Jeffrey Skilling, with its Law of Deception No. 14: “If the numbers always add up, someone is making them add up.”

WorldCom (United States, 1999–2002). Then the second-largest long-distance telephone company in the US, WorldCom inflated its earnings to prop up its stock price under its founder and CEO, Bernard Ebbers. It wasn't an outside auditor who found it, but the company's own internal audit team, led by Cynthia Cooper, which in June 2002 identified more than $3.8 billion in fraudulent entries. Later investigations showed the company had overstated its assets by more than $11 billion, the largest accounting fraud in US history at the time. WorldCom filed for bankruptcy in July 2002, and in 2005 Ebbers was convicted of fraud and conspiracy and sentenced to 25 years in prison.

Stanford International Bank (Antigua, until 2009). Allen Stanford's bank reported a return of 15.71% in 1995 and exactly the same figure in 1996. Its chief financial officer confessed that the figures were decided first and the accounting was manufactured afterward. It's accounting fraud in the service of a Ponzi scheme. See the case of Allen Stanford.

FTX (2022). It wasn't only a diversion of funds. At trial, the head of the Alameda Research fund, Caroline Ellison, testified that Sam Bankman-Fried asked her to prepare alternative ways of presenting the balance sheet to lenders, and that she made seven versions. FTX's new chief after the bankruptcy, John J. Ray III, who had wound down Enron, said he had never seen such a complete failure of controls. It's in the case of Sam Bankman-Fried.

If you want to see how much money these frauds involved compared with others, we compare them in the largest frauds by amount.

Why does accounting fraud work?

Because it leans on authority: a big audit firm, a prestigious board, a stock market listing. And on investors' fear of missing out: nobody wants to sell the stock that's rising fastest. The Laws of Deception sum it up: when everyone trusts someone else's signature, nobody looks at the cash.

What should you do if you suspect a company's books?

1. Look at the cash, not just the profit. Compare net income with operating cash flow in the financial statements the company has filed.
2. Check the official filings. In the US, public companies file their annual and quarterly reports with the SEC, in its EDGAR database; in the UK, companies file their accounts with Companies House.
3. Be wary of anyone selling you shares off-market in a company that's “about to go public”: in the US, look up the seller on FINRA BrokerCheck; in the UK, on the FCA Register and the FCA Warning List.
4. If you're an employee and see irregularities, there are official channels: in the US, the SEC's whistleblower program; in the UK, you can report to the FCA as a whistleblower.
5. If you've invested and lost money, keep all the documentation, talk to a licensed attorney of your own choosing and consider joining a class action by the people affected. Be wary of anyone who calls offering to get your money back for a fee: that's a recovery scam.