Further Reading
  • Financial Shenanigans: How to Detect Accounting Gimmicks & Fraud in Financial Reports, Third Edition
    Financial Shenanigans: How to Detect Accounting Gimmicks & Fraud in Financial Reports, Third Edition
    by Howard Schilit, Jeremy Perler
  • Stolen Without A Gun: Confessions from inside history's biggest accounting fraud - the collapse of MCI Worldcom
    Stolen Without A Gun: Confessions from inside history's biggest accounting fraud - the collapse of MCI Worldcom
    by Walter Pavlo Jr., Neil Weinberg
  • Final Accounting: Ambition, Greed and the Fall of Arthur Andersen
    Final Accounting: Ambition, Greed and the Fall of Arthur Andersen
    by Barbara Ley Toffler, Jennifer Reingold
  • Power Failure: The Inside Story of the Collapse of Enron
    Power Failure: The Inside Story of the Collapse of Enron
    by Mimi Swartz, Sherron Watkins
  • WorldCom: The Accounting Scandal (Congressional Research Service)
    WorldCom: The Accounting Scandal (Congressional Research Service)
    by Bob Lyke Congressional Research Service, Mark Jickling Congressional Research Service

Accounting Fraud


A New Push for Auditor Independence?

A key recommendation of reformers back in the early 2000s, after the Enron and WorldCom frauds, was that public companies should have to rotate their auditors every few years, so that overly cozy ties didn't undermine the independence of auditors.

That never happened. Congress decided the issue needed to be "studied" further, and the matter soon disappeared. (Although Sarbanes-Oxley does require that specific partners rotate off a company's account every seven years.) But now, in the wake of the financial crisis, some powerful regulators are asking whether it's time to revisit the issue of auditor independence and mandate rotation of firms.

Last week, James Doty, chair of the Public Company Accounting Oversight Board (PCAOB), raised this issue in a speech in Pasadena. Among other things, Doty said that PCAOB has, in fact, now studied the issue of auditor independence by reviewing several thousand cases of how auditors have engaged with firms. Along the way, inspectors have identified hundreds of cases of "audit failures."

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Auditor Independence: Documents on Firm Rotation

With the debate on auditor independence resurfacing, it is useful to have a few documents on hand, especially about firm rotation. One document is the recent speech that James Doty, chair of the PCAOB, gave calling for a new look at mandator rotation.

You can read that speech here.

Another document is the extensive 2003 GAO report that explored this topic. That investigation was based on numerous interviews. You can read it below.

GAO Report on Auditor Independence, 2003


Where Was Deloitte While Kabul Bank Was Looted?

The troubling story of Kabul Bank -- looted of some $850 million by corrupt insiders connected at the highest levels of the Afghan government -- has just gotten even more troubling. It turns out that the U.S. paid a top accounting firm, Deloitte, a small fortune to keep an eye on things at the bank, only to have Deloitte be asleep on the job when the fraud went down.

This latest twist emerged earlier this week when the U.S. Agency for International Development suspended the contract with Deloitte after its AID's Inspector General issued a damning report on Deloitte's negligence during the Kabul Bank heist. According to the report, "Deloitte advisers did not follow up aggressively on fraud indicators." Apparently Deloitte advisers were told clearly and on different occasions that there was a high risk of fraud at Kabul Bank. And even when the fraud was being investigated, the report said, "the Deloitte advisers remained detached, providing only theoretical advice instead of lending hands-on assistance to find evidence of the fraud that seemingly everyone believed exists."

One has to wonder: If a top accounting firm could miss a $900 million fraud, just what exactly was Deloitte doing for the $92 million that the U.S. paid it to provide provide technical assistance" to the Afghanistan Central Bank "in bank supervision and examination?" Long lunches at Kabul's luxury Serena Hotel, perhaps? 

This would not be first time that a major U.S. contractor failed to fulfill its obligations in Afghanistan. In fact, contractors operating in both Afghanistan and Iraq have been accused of a wide range of failures and abuses that have cost taxpayers a fortune. While some patriotic Americans have voluntarily chosen to fight and die in these battle zones, major corporations have seen an opportunity to line their own pockets while doing the least amount of work possible.

The difference here is that this profiteer is a respected accounting firm. Surprised? I'm not. Nearly every major accounting firm, including Deloitte, has been implicated in some of the worst financial scandals of our time. Greed, it would seem, is an alarmingly powerful current in an industry that is entrusted with ensuring the integrity of crucial corporate and financial institutions -- not just at home, but also abroad.

Report on Deloitte Negligence in Kabul Bank Fraud


Study: Many Executives Escape Punishment for Accounting Fraud 

There have been so many corporate accounting frauds since the 1990s that it can be hard to keep track of what the outcomes were from the frauds. In particular, keeping tabs on drawn out criminal and civil cases against the executives implicated in accounting frauds can be tough.

One of the best studies so far on accounting fraud was published last year by the Committee of Sponsoring Organizations of the Treadway Committee, a group backed by various accounting associations. The study is entitled “Fraudulent Financial Reporting: 1998-2007," and -- for some of us, anyway -- it makes for fascinating reading.The study looked at nearly 350 cases of accounting fraud. Among its findings:

  • Financial fraud affects companies of all sizes, with the median company having assets and revenues just under $100 million.
  • The median fraud was $12.1 million. More than 30 of the fraud cases each involved misstatements/misappropriations of $500 million or more.
  • The SEC named the CEO and/or CFO for involvement in 89 percent of the fraud cases. 
  • Initial news in the press of an alleged fraud resulted in an average 16.7 percent abnormal stock price decline for the fraud company in the two days surrounding the announcement.
  • News of an SEC or Department of Justice investigation resulted in an average 7.3 percent abnormal stock price decline.
  • Companies engaged in fraud often experienced bankruptcy, delisting from a stock exchange, or material asset sales at rates much higher than those experienced by no-fraud firms.

Those are so some pretty negative consequences for companies where executives fudged the books -- particularly for shareholders who had no responsibility whatsoever for perpetrating such frauds but took a bath anyway.

But what happened to the executives accused of accounting fraud? Well, here's the finding that really caught my attention: "Within two years of the completion of the SEC investigation, about 20 percent of CEOs/CFOs had been indicted. Over 60 percent of those indicted were convicted."

In other words, only 1 in 5 executives involved in these frauds faced any criminal charges, and of those, nearly half got off. So basically the historic record suggests that executives had only about a ten percent chance of doing jail time for major financial crimes that cost shareholders millions of dollars. Well, no wonder so many CEOs and CFOs were ready to cook the books.

The odds surely changed with the passage of Sarbanes-Oxley after the Enron collapse. But the ongoing stream of accounting fraud cases suggest that plenty of executives are still willing to roll the dice.

Fraud Study Overview


Will the Accounting Industry Ever be Reformed?

The history of accounting is filled with sorry stories of accountants helping to cover up frauds by corporations and banks. Long before Arthur Andersen famously collapsed in 2002 after being indicted on federal charges related to the Enron scandal, the accounting industry faced big ethical problems.

Accounting firms were implicated in some of the frauds that preceded the stock market's collapse in 1929 and helped facilitate some of the corporate frauds of the late 1960s and early 1970s. In fact, the ethics problems in accounting were seen as so serious that Congress undertook hearings on this issue in the mid-1970s and debated tougher oversight of the profession. A major report released by a key subcommittee chaired by Senator Lee Metcalf in 1976 stated:

Doubts as to the accuracy and reliability of information reported by corporations have resulted from continual revelations of corporate misconduct which was not found or not reported by independent auditors. Congress and the public have little assurance that corporate financial statements accurately portray the results of business activities because of flexible, alternative accounting standards. Public confidence in independent auditors, which is essential to the success of the federal securities, has been seriously eroded.

No new legislation was enacted at that time and major accounting firms went on to be deeply implicated in the Savings and Loan scandals of the 1980s. "Accountants didn't cause the S&L crisis," said Senator Ron Wyden in 1992. "But they could have saved taxpayers a lot of money if they did their jobs properly and set off enough warning alarms for regulators."

More hearings were held, but not much was done. Then came the frauds and earnings scandals at Enron, WorldCom, and many other companies. The combination of Arthur Andersen's collapse and the passage of Sarbanes-Oxley changed the calculus and put the accounting industry on notice that regulators would take a tougher approach.

Yet here we are just a few years later with the revelation that Ernst & Young may have covered up massive financial missreporting by Lehman Brothers. That missreporting helped ensure Lehman's rapid collapse and the financial crisis that followed.

The allegations were made in late December in suit filed against Ernst & Young by New York State Attorney General Andrew Cuomo. You can read the text of the suit below. A press release by Cuomo's office summarized their case this way:

The Attorney General’s lawsuit claims that for more than seven years leading up to Lehman’s bankruptcy filing in September 2008, Lehman had engaged in so-called “Repo 105” transactions, explicitly approved by E&Y. The transactions purpose was to temporarily park highly liquid, fixed-income securities with European banks for the sole purpose of reducing Lehman’s financial statement leverage, an important financial metric for investors, stock analysts, lenders, and others interested in Lehman.

“This practice was a house-of-cards business model designed to hide billions in liabilities in the years before Lehman collapsed,” said Attorney General Cuomo. “Just as troubling, a global accounting firm, tasked with auditing Lehman’s financial statements, helped hide this crucial information from the investing public. Our lawsuit seeks to recover the fees collected by Ernst & Young while it was supposed to be using accountable, honest measures to protect the public.”

The complaint, filed in New York Supreme Court, alleges that E&Y was fully aware of Lehman’s fraudulent Repo 105 transactions, specifically approved of Lehman’s use of them, and gave Lehman an unqualified audit opinion every year from 2001 to 2007, despite knowing that they concealed the Repo 105 transactions. Further, the lawsuit alleges that in 2007 and early 2008, when Lehman was facing demands to reduce its leverage, Lehman rapidly accelerated its use of Repo 105 transactions, removing up to $50 billion from its balance sheet on a quarterly basis without disclosing the use of the Repo 105 transactions.

The complaint also alleges that E&Y failed to object when Lehman misled analysts on its quarterly earnings calls regarding its leverage ratios, and that E&Y did not inform Lehman’s Audit Committee about a highly-placed whistleblower’s concerns about Lehman’s use of Repo 105 transactions.

The Attorney General seeks the return of the entirety of fees E&Y collected for work performed for Lehman between 2001 and 2008, exceeding $150 million, plus investor damages and equitable relief.

Boy, all that sounds familiar, doesn't it? Sounds a lot like the kind of stuff that Arthur Andersen did for Enron in helping it mask high levels of debt in various subsidiaries.

(Ernst & Young responded to Cuomo's charges by stating: There is no factual or legal basis for a claim to be brought in this context against an auditor where the accounting for the underlying transaction is in accordance with the Generally Accepted Accounting Principles (GAAP). Lehman’s audited financial statements clearly portrayed Lehman as a highly leveraged entity operating in a risky and volatile industry.)

If Ernst & Young did do something wrong, why does this kind of thing keep happening? Well the answer can be found in that last paragraph, about the huge fees that Ernst & Young collected during its work for Lehman. When a client like Lehman is worth millions and millions, there is a natural reflex to make them happy -- even if that is fundamentally unethical.

Accountants are in a famously tough spot: They were as supposed to serve as watchdogs of the financial system and ensure that companies are being honest about their finances. But they are also being paid to serve those same companies. The new regulations put in place after Enron were supposed to make it easier for accountants to do the right thing. Clearly those laws aren't tough enough.

Cuomo Lawsuit Against Ernst & Young