Characteristics of Accounting Fraud and Improper Manipulation

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Accounting fraud is defined as a "deliberate and improper manipulation of the recording of sales revenue and/or expenses in order to make a company's profit performance appear better than it actually is." [1] " According to the textbook Fraud Examination by Steve Albrecht, fraud are triggered by three elements, the first being rationalization, perceived pressure, and lastly perceived opportunities." [2] This essay will demonstrate the variety of ways accounting fraud can occur and how it is detected while illustrating its many outcomes through rival Enron and WorldCom experiencing the famous accounting fraud scandal.

Accounting fraud is not a process that occurs overnight. It is classified into a number of categories and types that require time, planning and accomplices. It is usually characterized by understating/overstating revenues, expenses and asset values. Also accounting fraud is demonstrated by the misuse or misdirection of funds and underreporting of liabilities. [3] 

Under-recording expenses could be expressed by not recording all the costs of goods sold during the specific time period. This way the gross margin would be higher, when the business would classify products that are delivered to customers as inventory asset. Another way is by not recording the depreciation expenses. [4] 

Asset losses that should be recognized might be disinclined by the business. Examples would include uncollectable accounts receivable, or not writing down inventory under market rule. Also, the business might record only a part of the amount of liabilities for different expenses, understating the liabilities in the company's balance sheet and therefore overstating the profit. [5] 

The most common technique of accounting fraud is over-recording sales revenue. The business may be involved in channel stuffing. The products are shipped to customers when they weren't ordered, however the business knows that the products will be returned after the end of the year. Until the returns are made, the shipments are recorded as actual sales. Also, the returned sales might not be recorded instantly in order to delay recognition of the offsets against sales revenue in the current year. [6] 

Enron Accounting Fraud:

An accounting fraud scandal rose to rival Enron and WorldCom recently. As a result of the mutual funds and insurance fiasco of 2004, AIG is still being investigated for accounting fraud. However, "recent investigations uncovered more than a billion dollars in accounting transaction errors." [7] 

"The accounting fraud was done by creating the Special Purpose Entity that covers the debt and failing investment in the company and turns it into sales revenue in the financial statement." [8] Basically the liabilities were turned into assets. This was accomplished by executives of Enron and by the assistance of Arthur Andersen, the chief auditor of Enron. [9]  

An extraordinary fraud like the Enron fraud could not be detected for a long time, if no one wants to see it. Audit procedure is not designed to precisely detect fraud, but to only confirm that financial statements are misstatements free. In the case of Enron, financial controls were not reported. [10] This action is considered as a crime in the point of law and organizational fraud that affects the organization's stakeholders.

Figure 1


When Scandal Went Public


Investigating Agencies

Latest Developments

Company Comment

Enron (otc: ENRNQ - news - people )

October 2001

Boosted profits and hid debts totaling over $1 billion by improperly using off-the-books partnerships; manipulated the Texas power market; bribed foreign governments to win contracts abroad; manipulated California energy market

DOJ; SEC; FERC; various congressional committees; Public Utility Commission of Texas

Ex-Enron executive Michael Kopper pled guilty to two felony charges; acting CEO Stephen Cooper said Enron may face $100 billion in claims and liabilities; company filed Chapter 11; its auditor Andersen was convicted of obstruction of justice for destroying Enron documents.

No comment

The analysis of Enron's financial statements held indications that could have been easily detected by anyone who took the time to check. "Hedge-fund manager James Chanos was just such an individual. He was looking for a stock to short and felt that Enron might be a good prospect when he spotted the fuzzy references in the Notes regarding "related party" transactions involving Enron's senior officers. " [11] He couldn't understand what the term related party was referred to. Other financial consultants couldn't explain it either. That is how he came to the conclusion that Enron executives were hiding something. "In 2000, a full year before Enron went broke, he shorted the stock and made a huge profit for himself and his clients. In February 2001, Chanos tipped off a reporter at Fortune magazine, Bethany McLean, who in March, published a story entitled "Is Enron Overpriced?" That story started a chain of events that eventually led to the company's demise and the Sarbanes-Oxley Act of 2002. " [12] 

Outcomes of Accounting Fraud:

Creative accounting tactics may be regarded as fraud in publicly listed companies. When these techniques are detected, the government oversight agency, such as Exchange Commission and Securities could launch an investigation.

These accounting firms were expected to identify and prevent the publication of false financial reports. Their negligence lead to the publication of misleading reports illustrating the company's financial status. In some cases, accounting fraud arrived at billions of dollars. The worst punishment is the loss of support for the accused company. AIG for instance has lost about fifty billion dollars in market capital after the scandal. [13] 

Effect of scandal on Enron

In the case of the Enron scandal, criminal conviction is taking place of the Big Five auditor Arthur Andersen, and the company is obliged to "divest itself of its non-US partners". [14] Enron was the seventh largest company in the US; however it filed for bankruptcy after only six months. [15] 

The Enron accounting fraud was called the greatest fraud of the twentieth century. Twelve thousand employees lost their jobs, life savings and retirements funds that were invested in the Enron Stocks. The rest of the Enron stock owners "including thousands of ordinary Americans whose pension was also invested in Enron's Stock lost a total of $70 billion when the value of their stocks collapsed to zero." [16] 

Detecting Accounting Fraud:


"The Public Company Accounting Reform and Investor Protection Act, also called the Sarbanes-Oxley Act (or Sarbox), was speedily passed in 2002 in response to the wave of accounting scandals that occurred in corporate America that year. It was in 2002 that the countries biggest accounting firms, like Arthur Andersen, Ernst & Young, Pricewaterhouse Coopers, etc., were charged in court or admitted negligence in their duties." [17] 

1.Public companies must assess and divulge the effectiveness of their internal financial reporting controls.

2. Independent auditors must vet these assessments and disclosures.

3. Financial reports must be certified by CEOs and CFOs.

4. Personal loans to any director or executive officer are banned in most cases.

5. A stock-exchange-listed company must have a 100% independent audit committee whose sole task is to oversee the relations between the company and auditor

6. More severe civil and criminal penalties for violating SEC rules and longer jail sentences plus bigger fines for execs who intentionally misstate their company's financial status

a. Reinstatement

b. Back pay

c. Benefits

d. Compensatory damages

e. Abatement orders

f. Attorney's fees and legal expenses within reason

Figure 2Sarbox contains provisions, such as the following [18] :

Usually companies who are accused of accounting fraud commit a series of prevalent actions like collapsing short/long term debt into a singular amount, not listing incidental assets/ prepaid expenses and finally hiding specific classifications of liabilities/current assets. [19] Unethical activities like accounting fraud lead to negative effects on the stakeholders of the company, marketplace and the economy as a whole. Consequentially, it is impartial for regulatory authorities to implement indissoluble rules and regulations preventing the occurrence of this unethical behavior and protecting stakeholders from its destructive outcomes.