Well thank you for that… we appreciate it… asshole.

Jeff Skilling, CEO of Enron, on being asked why his company could not produce a balance sheet

There exist various motives for maintaining dishonest financial records—such as portraying financial stability to long firm victims or concealing embezzled funds as legitimate expenses. However, the predominant reason is often to showcase these deceitful accounts to investors, aiming to secure financial backing. Hence, any discourse on accounting fraud necessitates examining it within the context of stock-market deception, given their interrelation. Considering this, let’s delve into how deception within the stock market leads to financial theft.

A public financial market serves both honest businesses and deceivers alike—it essentially transforms narratives into monetary gains. In a functional stock market economy, owning a profitable enterprise equates to holding what fund manager and author George Goodman termed “Supermoney.” Why is it ‘super’? Well, besides generating a steady income, the stock market offers a mechanism to access and spend projected future profits well in advance.

The initial step involves selling a share in the company. Let’s illustrate this with a simple calculation: Imagine owning a sandwich business generating $1 million in annual profit. Suppose you desire a $5 million yacht without saving or incurring debt. Consulting an investment banker reveals that present stock-market investors are willing to buy and sell shares in sandwich businesses at fifteen times their annual earnings. As the sole owner of all business shares, your assets could be valued at $15 million. By selling a third of your shares, you could afford the yacht. Admittedly, this diminishes your annual profit share to $660,000, but if that doesn’t suffice, perhaps reconsidering the yacht purchase is prudent.

This process, in its simplistic form, appears mundanely straightforward, akin to using a building producing $1 million in rent as collateral for a loan. Transitioning to more intricate cases, such as valuing a company based on potential future market dominance despite lacking current earnings, isn’t substantially more challenging. Fundamentally, the stock market capitalizes on anticipated future profits—it serves as the platform where claims on these potential profits exchange for capital, effectively converting stories into monetary assets.

Consequently, stock markets can transform a lie into a fraudulent act. If companies trade at fifteen times earnings, each dollar of accounting overstatement could potentially translate into fifteen dollars of cash.

In theory, this ratio of lies to profit stands as the maximum threshold. Yet, selling all shares of a fraudulent enterprise rapidly enough to sustain the deceit is arduous, though not impossible. Your capacity to turn accounting misstatements into profit relies on the quantity of shares sold to the public. Conversely, generating fraudulent accounts is cost-effective—achieving a three-dollar return on one dollar of deception signifies a remarkable yield.

In essence, the institution of trading shares in companies converts narratives into cash, rather than solely the stock market itself. Conducting the aforementioned transaction with the sandwich shop by selling a business stake to a single investor is feasible, just as deceiving the private equity industry mirrors deceiving the stock market. Currently, if transforming an egregiously false internet story into sufficient capital to purchase a yacht is the goal, private venture capital seems the viable route. Nonetheless, public markets offer distinct advantages.

Primarily, scrutiny is decentralized across the market rather than reliant on a singular entity. Moreover, this scrutiny involves numerous individuals, most holding a minor stake in your narrative. Comparable to other counterfeiting fraud domains, stock markets typically function on a certification basis—extensive validation (“due diligence”) occurs upon market entry, yet once in, continuous monitoring of quoted companies is surprisingly limited. Numbers presented by a company are largely accepted as facts, challenging external rebuttals.

This facet of public stock markets introduces a critical time element into investment fraud. If initial due diligence is compromised to introduce a fraudulent company that persists in disseminating deceptive statements before collapsing, connecting the initial fraud to the perpetrator becomes significantly challenging. This form of securities fraud marked Jordan Belfort’s career trajectory.

The individual behind Stratton Oakmont penned an autobiography titled “The Wolf of Wall Street,” likely opting against a less marketable title like “Tales of a Parasite.” This memoir, while memorable, evokes discomfort, comprising excessive self-praise, smugness, and disingenuous remorse. Its opening chapters dwell extensively on incidents of drug-induced unconsciousness sprawled across the front lawn. Yet, amidst these, there’s a single paragraph that somewhat salvages the book, succinctly encapsulating the business approach of “boiler room” stockbroking:

And what secret formula had Stratton discovered that allowed all these obscenely young kids to make such obscene amounts of money? For the most part it was based on two simple truths: first, that a majority of the richest 1 percent of Americans are closet degenerate gamblers, who can’t withstand the temptation to keep rolling the dice again and again, even if they know the dice are loaded against them; and second, that contrary to previous assumptions, young men and women who possess the collective social graces of a herd of sex-crazed water buffalo and have an intelligence quotient in the range of Forrest Gump on three hits of acid can be taught to sound like Wall Street wizards, as long as you write every last word down for them and then keep drilling it into their heads again and again—every day, twice a day—for a year straight.

The quintessential Stratton Oakmont stock typically involved launching a new company, often in a trendy sector like defense or high tech. This company would either boast greatly exaggerated and deceitful financial records or, in some cases, exhibit no profits at all, relying solely on a compelling “narrative” about an imminent product launch. Stratton Oakmont would contract to sell shares of this company to the public, pocketing a considerable portion for their services. The shares held by Stratton were usually obscured to sidestep stock exchange regulations mandating disclosure of significant ownership, employing intermediaries whimsically termed “ratholes” as nominal owners.

Following the company’s debut on the stock market, the second phase of the deception unfolded. Specialists skilled in market manipulation would artificially inflate the stock’s value, drawing external investors’ interest and enabling Stratton to offload the shares they had concealed in the ratholes. Meanwhile, Belfort’s young brokers, during the “pump” phase, would urge victims to purchase more shares as their prices skyrocketed. Eventually, the fraudulent brokers would abandon the company and its investors, leaving them to discover later that the financial records were fabricated and the business held no actual value.

While the stock manipulations constituted the bulk of the charges leading to Belfort’s imprisonment, these were essentially “market crimes” violating stock exchange rules deemed crucial to the functioning of the broader economy, thus warranting intervention by state and law enforcement authorities. However, the genuine fraud perpetrated by Stratton Oakmont lay in facilitating numerous companies to go public by soliciting investments based on falsified accounts. Essentially, it amounted to another form of counterfeiting: a deceitful certification against those who trusted a seemingly reputable brokerage not to engage with bogus enterprises.

One essential aspect to grasp about how stock markets evaluate future earnings is their occasional inefficiency. Ideally, the focus should rest solely on cash, projected over a long-term horizon. Yet, the practical challenges prompt those involved in share trading to seek shortcuts. One common shortcut involves concentrating solely on short-term earnings, assuming they adequately represent long-term cash flow. This means manipulating earnings for a single year, even at the expense of future years, can often yield a fraudulent cash boost in share prices. Additionally, for swiftly expanding companies, individuals tend to emphasize revenues rather than earnings, presuming they offer a better indication of long-term prospects, making them a prime target for accounting manipulation. Manipulating assets is also a tactic, occasionally involving the discussion of gold reserve figures not even reflected in the accounts, as seen in cases like Bre-X. To truly understand the mechanics of accounting fraud, delving into some technical details becomes necessary.

Techniques of accounting fraud

There exist two types of misleading accounting practices. While they might be dubbed “accounting fraud” versus “accounting manipulation,” fundamentally, they both fall under the umbrella of fraud. Think of them as “aspects necessitating deception before auditors” and “aspects where auditors lend a hand.”

It’s important to note that the second category isn’t intended as a jest and only slightly disparages the auditing profession. Since the inception of capital markets, audit firms, even the most esteemed ones, have assisted deceitful managers in presenting egregiously deceptive financial records. There have been numerous instances where these firms have stretched the limits so far that it’s implausible to assert the auditors believed they were adhering strictly to accounting regulations, which are problematic in themselves. This occurs despite auditing being a professional field crucial for maintaining checks and balances. We’ll explore later in this chapter why these occurrences persist. For now, remember that aside from deceiving auditors, it’s feasible to fabricate financial records with the aid of these very auditors. While an exhaustive list of accounting improprieties would warrant a dedicated book, here are seven commonly encountered techniques that provide a glimpse into the potential malpractices. Our examples will primarily draw from the recent era marked by widespread accounting irregularities—the dot-com and telecom bubble of the late 1990s/early 2000s.

Completely fake sales

Similar to sales that never transpired but are documented in a ledger as if they occurred, presenting this fabricated ledger to the auditor can be part of the strategy. It’s often preferable to fabricate these false sales overseas, preferably in an emerging market or any location with a substantial time-zone difference, language barriers, and opaque company registration. This setup allows for a confirmation bias: if the auditor investigates, they might reach one of your collaborators, who will confirm the existence of the fictitious order. When the expected cash doesn’t materialize, claim it has been locally banked and rely on the auditor’s time constraints preventing a thorough inquiry into your false declarations. A case in point is the computer software company Lernout & Hauspie, which recorded millions of dollars in sales to South Korea from their offices in Belgium through this fraudulent method.

Another instance involved Gowex (also known as Let’s Gowex), a Madrid-based company that purported to supply approximately nine times more free municipal Wi-Fi installations across Europe and the Americas than it actually provided. This fraud was, in some respects, bolder than Lernout & Hauspie’s, as it involved wholly fabricated sales that would have necessitated the purchase and installation of counterfeit capital equipment, theoretically more traceable than software licenses. The auditors could have potentially verified this by physically inspecting the locations where Gowex claimed to have deployed free Wi-Fi and confirming the discrepancy. Remarkably, Gowex’s auditor was a small local practice and faced legal consequences alongside the company’s directors. Conversely, Lernout & Hauspie underwent audits by KPMG, showcasing that such occurrences can transpire even within esteemed auditing firms.

Fake sales by economically meaningless transactions

Let’s imagine I’m a US long-distance telecommunications company (let’s say Qwest Communications in 2001), and imagine you’re also a US telecom company (let’s use Global Crossing, also in 2001). Both of us own extensive telephone cable networks and charge other companies for using these cables. Now, what if we engage in a “capacity swap,” allowing each other to utilize our cables without any charges, but within a reasonable limit? It seems logical that both of us should register some form of revenue and an equivalent expense—this swap is somewhat akin to a pair of mutually offsetting sales. Typically, determining that figure involves estimating the market price for selling such telecom capacity and adding it to both the revenue and cost lines in the accounts. However, if we’re aware that the stock market is paying attention to our revenues rather than our earnings, we might opt for a much higher number and justify it to auditors as a “strategic” deal or under some other pretext where open-market pricing isn’t considered relevant.

During the dot-com boom of the 1990s, this tactic was excessively utilized as websites exchanged advertising inventory among themselves and treated it as if it had been sold. No actual money changed hands, allowing both companies to feign higher ad space sales than reality, while there was no limitation on exaggerating the market price of their adverts. This aspect of swap sales is quite advantageous in other contexts too, as it sets a “market” price serving as the basis for valuing assets. For instance, two property developers might sell portions of their projects to each other at an inflated valuation to establish a “recent transaction,” thus increasing their overall business valuation and convincing banks to continue lending against what they perceive as valuable collateral.

An even broader and more generalized extension of the sham sales tactic no longer involves two offsetting transactions but appears to be an open-market sale for cash. You locate another company unbeknownst to the auditors, either directly owned by a related party or an apparently independent company acting as a “front” for this transaction. Then, you lend this company money (either through a regular loan or by purchasing newly issued shares in it) on the condition that it uses the borrowed funds to buy goods from you. Through this process, you effectively buy from yourself, recycling investor-raised funds to simulate profits. This strategy was part of the numerous restatements made by the telecom giant WorldCom shortly before its CEO and CFO faced legal consequences.

Up-front recognition of revenues

Myron and Mordy over at OPM Leasing coined their version of this accounting maneuver as the “Kutz Method,” named after the accountant who convinced their auditors to approve it. In the realm of long-term contracts, like leases, the typical accounting practice involves reporting customer payments as revenue, spread out over the lease’s duration.5 The “Kutz Method,” however, involved recording all payments as revenue on the contract’s signing day. This visibly enhanced the short-term appearance of the accounts. However, when clients utilized the early break clauses that Mordy Weissman had negotiated, it led to accounting disasters: not only was there a cessation of new revenue, but a substantial portion of the revenue reported under the Kutz Method had to be reversed.

This technique was popular among telecom companies of the 2000s, notably associated with Jeff Skilling’s Enron and its internet ventures. Skilling’s adaptation of the Kutz Method was even more extreme—rather than confining itself to contractual revenues, Enron accounted upfront for anticipated revenues. In a memorable episode in 2000, they inked a joint-venture deal with Blockbuster Video for on-demand film delivery over their internet cables and recorded all projected profits for the next two decades as immediate revenue. Yet, the subsequent year, Blockbuster backed out of the joint venture. Enron then reported another chunk of revenue, reflecting their new belief that they wouldn’t need to share the internet film profits with Blockbuster anymore! Ultimately, very little revenue materialized, and the internet video concept joined the list of footnotes in the colossal accounting restatement signaling Enron’s descent into bankruptcy.

Delayed recognition of costs

The direct counterpart to recognizing substantial upfront revenue is the strategy of deferring costs into the future. This tactic led WorldCom to overstate profits by $3.8 billion, mirroring Enron’s approach of booking revenue as soon as they conceptualized an idea. WorldCom used to make payments for line-rental fees to regional telecom firms to link their long-distance cables with customers’ actual telephones. These were legitimate costs that needed proper accounting—no long-term contracts existed, and telecom capacity couldn’t be stockpiled. But… what if you convinced yourself that paying substantial line fees to a local telecom operator, say in Wisconsin, was a brilliant strategic move? What if you considered it an investment in future market dominance, with short-term expenses leading to a far more lucrative position a decade later? Wouldn’t it seem more logical to spread out these expenses over the ten-year period of your strategic plan rather than recording them all in the year the cash was disbursed?

In reality, it wouldn’t make sense at all. However, Scott Sullivan, WorldCom’s chief financial officer at the time, managed to convince himself and Arthur Andersen LLC that it did—for a brief period. Yet, failing to report a cost doesn’t erase it. Consequently, WorldCom found itself significantly less financially robust than it had portrayed to investors, a factor contributing to its eventual bankruptcy.

Completely fake assets

Although it’s more common for an accounting manipulator to overvalue an existing asset, fabricating a complete fiction is not unheard of. Take Gowex’s network of European municipal Wi-Fi hotspots, for instance, although the most significant false-asset frauds often revolve around offshore bank accounts. Legitimate reasons might exist for a company to hold a substantial amount of cash in an offshore account—such as proceeds from a large asset sale requiring reinvestment or funds raised through a loan or bond issue from an offshore bank. However, offshore accounts tend to lack transparency inherently. Occasionally, these accounts get drained by embezzlers, or the ownership might belong to a corporate entity other than the one reporting it in its financial statements. There have even been instances of simply depositing money into one’s own bank account and fabricating documentation. Parmalat, the Italian milk company, briefly held the world record for the largest fraud-driven bankruptcy scandal between Enron and WorldCom. This was mainly due to auditors discovering abruptly that a $4.9 billion bank account, pivotal for solvency, didn’t actually exist. Demonstrating that lessons often go unlearned, at the time of writing, the chief operating officer of the German credit card processing company Wirecard is on the run following the revelation of a similarly fictitious bank account in the Philippines.

Unreported debt

You’d prefer not to display excessive debt on your balance sheet, but you still want to borrow a significant amount—utilizing corporate borrowing is a fundamental step in siphoning cash out of a fraudulent scheme. So, what’s the solution? Engage a separate company to take the loan, assuring the bank that you guarantee the debt. Since the separate company is under your control, redirect the loan for your corporate needs. Accounting regulations aim to prevent this—consolidation in financial statements should reflect all assets and liabilities controlled by your company, regardless of the loan’s documentation under a different company name. However, the concept of control and the precise definition of a guarantee can spark lengthy semantic debates, akin to college days’ discussions over beer and pot. Detailed rules exist, leaving room for endless disputes on when one company’s debt should appear as another’s liability. Exploiting these ambiguities, you can often influence auditors, guiding them to exclude debts from the balance sheet by seeking loopholes or using persuasive tactics.

Enron’s strategy involved creating numerous “off-balance-sheet vehicles”—essentially, shell companies registered offshore, devoid of independent operations but empowered to borrow from global markets and purchase substantial assets desired by Enron. These companies, though essentially reliant on Enron’s guarantee for borrowing, should have logically seen their debts reported as part of Enron’s own liabilities. At least, that was the conclusion of the eventual bankruptcy examiner. If there’s a compelling counterargument, it’s probably buried in a shredder within Arthur Andersen’s Houston offices.

Overvalued or undervalued assets

In a well-known interview, Donald Trump mentioned that “[m]y net worth fluctuates, and it goes up and down with markets and with attitudes and with feelings, even my own feelings.” Despite widespread ridicule, this statement holds truth. Presently, the primary endeavor of the Trump Organization involves affixing the owner’s surname to various ventures. Consequently, the chief asset of this company is its name (or strictly speaking, the right to use it as a trademark; unrelated individuals sharing the same surname likely wouldn’t receive authorization). The value of this asset fluctuates daily, influenced by various factors—including President Trump’s personal sentiments—that are likely to impact it.

Life would be simpler if a balance sheet only listed cash, readily marketable goods, cars with Blue Book listings, and real estate in fast-paced markets—assets whose values can be reasonably gauged by comparing them to recent sales in an open market. However, companies often possess specialized machinery, factories without versatile applications, patents, brands, and long-term service agreements.

These assets are subjective in value, reliant on estimations by accountants based on potential future cash flows and profits. Since these valuations typically begin with discussions with management, and auditors can be influenced (as discussed below), there’s ample room for assets to be significantly overvalued, inflating the company’s worth to investors and lenders. Conversely, assets might be undervalued, reducing objections when sold to a party connected to management. In the past, these practices were prevalent in former Communist states of Central and Eastern Europe, leading Western investors to believe they were striking remarkable deals, only to discover a harsh reality best summarized by the old accountant’s adage: “On the left side, nothing’s right, and on the right side, nothing’s left.”

Auditors, analysts, and other disappointments

All these fraudulent activities ought to have been thwarted by auditors, whose specific role is to impartially scrutinize every set of accounts and affirm their accuracy in portraying the business’s true state. However, they failed to do so. Why? The answer is simple: some auditors are dishonest, while others are easily misled by fraudsters. Regardless of the reforms implemented in accounting standards and professional regulations, these issues persistently resurface across different times and locations. This recurrence likely signifies an equilibrium tied to the fundamental economic structure.

Initially, the problem lies in the fact that the vast majority of auditors are both honest and proficient. While this is positive, the downside is that most individuals have never encountered a deceitful or incompetent auditor, lacking an understanding that such individuals exist. Uncovering a truly corrupt professional at a major accounting firm like the Big Four requires substantial misfortune (or, ironically, considerable luck if that’s what one seeks). Yet, as a fraudulent manager of a company, the strategy involves cycling through auditors until encountering a less scrupulous one, subsequently retaining them. Consequently, these unethical auditors tend to gravitate towards auditing shady companies, leading the profession at large to hold an unrepresentative view of this probability.

Moreover, even if an auditor is both honest and skilled, they require assertiveness; otherwise, their effectiveness diminishes. Fraudsters can be persistent and domineering, and not every individual who joined an accounting firm post-college—opting for auditing over a more glamorous specialization—possesses commanding, alpha-type personalities. Adding to this, fraudsters often attempt to bypass auditors and lodge complaints with their higher-ups at the accounting firm. They allege that the auditor is uncooperative and bureaucratic, hindering the CEO from exercising legitimate judgment in presenting the business’s outcomes. Due to auditors’ often conservative and defensive nature, and because audit, despite being vital, is an unprofitable and fiercely competitive sector typically used to market more lucrative consulting and IT services, there’s no certainty that the auditor’s superior will support their employee. This is despite the fact that the employee is the one who stamps their signature (and the entire practice’s reputation) on the set of accounts. Similar to other behavioral patterns generating fraud, the dynamic wherein a challenging audit partner gets overridden or replaced occurs so frequently and replicates itself so precisely that it reflects a deeply ingrained and widespread incentive issue that’s immensely challenging to rectify.

Wall Street Confidential

As an additional layer of defense, investors and brokerage firms employ their own “analysts” to meticulously scrutinize published sets of accounts. These analysts are expected to be industry experts with sufficient financial acumen to interpret company accounts and conduct valuations of assets and companies. While their primary role is to uncover lucrative opportunities in securities trading—identifying undervalued or overvalued shares or bonds—one would assume a part of their responsibility involves flagging companies that are overvalued due to fraudulent activities.

At times, this process succeeds. Fraudulent accounts often exhibit “tells”—fraudsters rushing or lacking the ability to manipulate the balance sheet to match fabricated profits. Consequently, inflated sales might appear without corresponding inventories or any trace of expected cash. Analysts also excel at detecting tactics like “channel stuffing,” where companies, particularly those with highly motivated sales teams, push substantial product sales to wholesalers and intermediaries toward the quarter’s end, inflating short-term growth but compromising future sales and brand integrity.

Occasionally, an honest auditor, succumbing to pressure, might include a cryptic legal passage buried in the accounts’ notes, hinting that the headline numbers are fabricated. Almost all of Enron’s fraudulent accounting policies could have been deduced from its public filings with precise scrutiny. Some analysts specialize in this detailed analysis, yet it remains a niche area and isn’t particularly profitable. Most “red flags” turn out to be misleading because the majority of companies operate honestly.

More common is the scenario preceding the Global Financial Crisis. Analysts occasionally observed discrepancies and raised concerns in their reports, which, if taken seriously, could have been seen as prescient warnings. However, during market highs, reports portrayed a positive outlook, while downturns led to negative assessments. Similar patterns occurred in previous bubbles. Independent market watchdogs exhibit the same flaws as those with statutory status and support.

Detecting fraud is challenging and often not worth the majority of investors’ efforts. Hence, most analysts do not prioritize this pursuit either. Fraudulent cases that are detectable via meticulous analysis are rare, and those sizable enough to yield substantial gains from betting against them occur roughly once per business cycle in waves.

Analysts face comparable pressures to auditors, discouraging them from publicly accusing a company of fraud due to significant risks of retaliation. It’s important to note that frauds typically resemble thriving companies for sound accounting reasons. Once committed to falsifying accounts, perpetrators tend to make them appear stellar rather than average. Additionally, they often engage in numerous financial transactions, paying substantial commissions to investment banks while projecting an image of prosperity to investors. Although the barriers against questioning a successful CEO aren’t as formidable as those against doubting a doctor or lawyer’s honesty, they are significant.

Lastly, most analysts’ opinions go unread. A fraudster doesn’t need to deceive everyone—just enough to secure their funding. A historical example, like the London Quarterly Review’s meticulous expose of the Poyais fraud in 1822, despite its accuracy, had minimal impact in deterring investors from pursuing the venture aboard the Kennersley Castle and Honduras Packet.

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Fraud: The Art of Stealing Wealth and Trust - Cooked Books (Ch. 6)

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