Accounting Fraud: Definition, Techniques, and Famous Cases

Accounting fraud is the deliberate manipulation of financial statements to create a false appearance of financial health. Managers, accountants, and other employees in an organization may overstate revenue, hide expenses, or misstate assets and liabilities to mislead investors and regulators. These actions carry serious legal consequences, as seen in major scandals like Enron.

In-Depth Look at Accounting Fraud

Accounting fraud involves misrepresenting a company’s financial statements and documents or deliberately hiding transactions, accounts, and important financial matters necessary for inclusion in financial statements. The American Institute of Certified Public Accountants notes that two kinds of fraud result in distorted financial statements: fraudulent financial reporting and theft of assets.

It’s helpful to begin by differentiating words and phrases that are often substituted for one another but that have different legal, regulatory, and financial consequences.

Aggressive Accounting

Aggressive accounting covers a host of phrases used in the U.S.—such as “earnings management” and “income smoothing." These phrases refer to legal practices used to smooth out earnings or present what management thinks is a more accurate or better picture of a firm’s financial health. Practices might include

• Moving up or delaying investments
• Transferring expenses, income, and invoices between divisions in a company
• Selling assets and then repurchasing them
• Selling properties to produce outsized results in a given accounting period.

When taken to an extreme—if the intent is simply to mislead outsiders—a firm could be looking at investigations from the Securities and Exchange Commission (SEC), federal, and state agencies, as well as shareholder lawsuits. Until then, these are legal activities.

Corporate Fraud

Corporate fraud is the broad category of illegal activities carried out by a company or individuals within it. Accounting fraud falls under this umbrella. Corporate fraud also includes insider trading, bribery, money laundering, tax evasion, and other forms of financial and nonfinancial misconduct.

Occupational Fraud

Occupational fraud is done by employees for personal gain at the expense of their employers. These actions include stealing assets, payroll fraud, and reimbursing for fake or limited expenses. This type of fraud could cross with accounting fraud if financial records are manipulated, but many acts of occupational fraud don’t involve financial reporting.

Accounting Fraud

Accounting fraud specifically refers to the act of intentionally manipulating a company’s financial records to present a false picture of its financial health, performance, or profitability. Examples include overstating revenue, understating expenses, hiding debts and material financial events, and falsifying financial documents.

For accounting fraud to occur, a firm must deliberately falsify financial records. For example, if a company reports earnings in a given quarter and then revises them, no accounting fraud has occurred since, in most cases, the errors were not deliberate. Now, suppose the CEO of a publicly traded company knowingly makes false statements about the firm’s prospects to investors. The SEC may well charge that CEO with fraud. However, it wouldn’t necessarily be accounting fraud unless financial records were falsified.

For accounting fraud, the costs are hard to estimate, given the professionals involved and the limited auditing abilities of regulators. A widely discussed 2023 study, “How Pervasive Is Corporate Fraud?” published in the Review of Accounting Studies, suggests that about two-thirds of corporate fraud cases in public companies go undetected. More startling is what they find looking at financial statements and other corporate financial indicators. “Accounting violations are widespread,” the authors argue. “In an average year, 41% of companies misrepresent their financial reports, even when we ignore simple clerical errors.” While this number could wildly overstate actual legal violations, which occur at a far lower rate than “violations,” there is still a significant cost to investors. The average cost of fraud, they estimate, in line with other studies, could be as high as 15.6% of firms’ market capitalization.

The effects of accounting fraud are not just on the stakeholders of particular firms. The indirect methods researchers use to estimate this purposely and professionally hidden practice involve examining the effects of known accounting fraud on other firms and attempting to detect it at other times. For example, a company might be overspending to catch up to a competitor firm that is, in fact, behind.

Accounting fraud thus has effects on the market and investors more broadly. One recent study posited that the impact is so widespread that it can be used as a predictor of recessions. The thinking is that companies are more likely to cook their books when facing financial pressures, and if we combine all firms doing this at a certain moment, it could be enough to push a weakening economy over the edge.

Let's now cover the main ways it occurs.

Tactics for Overstating Revenue

A company can commit accounting fraud if it overstates its revenue. Suppose company ABC is operating at a loss and not generating enough revenue. To cover up this situation, the firm might claim to produce more income on financial statements than in reality. If the company overstates its revenues, it could drive up its share price and create a false image of financial health.

Here are some common ways of doing this:

• Bill and hold schemes: This involves billing customers for products that are being delayed by holding them in a company's warehouse while recording the revenue.
• Channel stuffing: Shipping more products to distributors or retailers than they can sell and recording what's shipped as sales, even though most will come back returned.
• Playing with the timing of recorded revenue: This involves moving up (and sometimes overpromising) future sales in the current period, artificially boosting revenue. Doing so before a sale is final disregards the accounting principle that revenue can only be recognized once earned and completed.
• Recording fictitious sales: Producing counterfeit invoices or recording sales that never occurred.

Common Methods of Underreporting Expenses

Another type of accounting fraud occurs when an expense or set of expenses isn't recorded. This leads to overstating a company's net income. Here are some common ways of doing this:

• Deferring expenses: Delaying the recording of costs to future accounting periods. This puts the current financial period in a better light.
• Failing to record depreciation and asset impairments: Under-recording or not recording these for equipment, vehicles, or buildings would inflate the company's net income.
• Hiding operating expenses: Deliberately not recording operating expenses is another way to inflate the company's net income.
  
• Lowballing the costs of production: This is intentionally recording lower costs of goods sold than incurred, which artificially boosts gross profit margins.

How Companies Misstate Assets and Liabilities

Accounting fraud occurs when a company overstates its assets or understates its liabilities. For example, a company might overstate its assets and not record accrued liabilities that have been incurred but not yet paid, like unpaid wages, taxes, or interest expenses. This can also include pensions and other kinds of retirement costs for retirees.

Suppose a company has assets of $1 million and its liabilities are $5 million. If the company overstates its assets and understates its liabilities, it is misrepresenting its liquidity. The company could state that it has $5 million in assets and $500,000 in liabilities. Then, potential investors would believe that the company has enough liquid assets to cover its liabilities.

Case Studies of Notorious Accounting Fraud

The history of accounting fraud is perhaps as old as accounting itself. The Hammurabi Code, dating back almost 4,000 years, is the oldest complete law code available and records in great detail just how seriously it was taken. A common enough crime was that scribes, accountants, and other workers would record lower harvests to cut the percentage owed in tribute to the temples. Fines began at six times the amount believed stolen and went up to 30 times the amount if the king was defrauded. Defendants were sure to pay if they could; the alternative was death.

The Enron Scandal: A Definitive Case of Fraud

The Enron scandal remains one of the most famous examples of accounting fraud. Enron used off-balance-sheet entities to hide the company's debts from investors and creditors. Although using such entities was not illegal, Enron's failure to disclose the necessary details of its dealings constituted accounting fraud. As the true extent of Enron's debts became known to the public, its share price collapsed. By the end of 2001, Enron declared bankruptcy.

The consequences of accounting fraud were severe in the Enron case. Criminal charges were brought against many of the company's top executives, and some went to prison. The scandal also eventually destroyed accounting giant Arthur Andersen LLP, which handled Enron's books.

Unmasking the Waste Management Fraud

Another prominent example of accounting fraud occurred in 1998, when Waste Management, a major publicly traded U.S. waste management company, hired a new CEO who, along with his management team, discovered the company had reported false earnings totaling more than $1.7 billion.

In 2002, the SEC charged Waste Management and its former executives with fraud. The company eventually restated its financial results for 1992 through 1997 and agreed to pay $457 million to shareholders affected by the inflated stock prices. The case, along with the Enron scandal, led to increased scrutiny of accounting practices and the development of the Sarbanes-Oxley Act of 2002, a law designed to protect investors from corporate accounting fraud.

Roadrunner Transportation’s Fraudulent Practices

The SEC charged Roadrunner for an accounting fraud scheme that ran from at least July 2013 to January 2017. Roadrunner, a shipping and logistics company based in Downers Grove, Illinois, eventually settled, without admitting wrongdoing, over SEC charges that included several types of accounting fraud:

1. Manipulating financial statements: The company goosed its numbers, so earnings reports matched prior earnings guidance and analyst projections. This involved tactics such as deferring incurred expenses and spreading them over several quarters.
2. Misrepresenting assets and receivables: Roadrunner failed to write down assets that were worthless and receivables that it couldn't collect.
3. Manipulating earnout liabilities: The company manipulated earnout liabilities related to its acquisitions. This created an income "cushion" that could be used in future quarters to offset expenses.
4. Concealing the fraud from auditors: The fraudulent activities were concealed from Roadrunner’s independent auditor.

In 2021, Roadrunner's longtime CFO was sentenced to two years in prison, and in early 2023, the company agreed to pay almost $10 million in fines.

The Bottom Line

Accounting fraud is a serious violation that can destabilize markets, as seen in cases like Enron and Waste Management.

Measures such as the Sarbanes-Oxley Act aim to prevent these schemes by improving oversight, transparency, and internal controls. When fraud occurs, it damages companies, undermines investor confidence, and carries major legal and economic consequences. Maintaining strong accounting integrity is necessary for a stable financial system.