CHAPTER 7

The Future of Fraud and Scandals

Manipulation and scandals are well established and, despite the best efforts of standard setters, regulators, and auditors, expected to have a continuing future. Points one is motivation. When the incentives exist to cheat, a substantial percent of people are expected to cheat. Almost from the beginning, America was about capitalism and free markets,¹ relying on entrepreneurial innovations, but simultaneously with short-term corruption. Government action could be ambiguous, from generous support, to apathy, to seeming antipathy for economic progress. The roles of innovation, entrepreneurship, and corruption are complex. Corruption could be hard to resist even by wealthy and successful businesspeople—private gain provides opportunities for corruption and exploitation. As long as incentives exist, expect corruption to continue.

Key Points on Continuing Scandals

Types of fraud and corruption changed over time, from smuggling and bribery, to land speculation, political machines, and bank frauds, to massive corporations using conspiracies and monopoly power, to mass-market speculation, stock pyramiding, and price manipulation, to widespread earnings manipulation and growing accounting fraud, to manipulation and speculation with innovative financial innovations in derivatives and structured finance. Accounting seems to have played an increasing role over time, largely because of the importance of accounting standards, formal financial disclosures, and required audits. Accountants seemed necessary for the conspiracies to work and other accountants needed to uncover the fraud.

The Progressive Movement of the late 19th century, combined with muckraking journalists and activist politicians led to federal regulations, from the Sherman Act of 1890 though reforms under Woodrow Wilson. However, major changes to the perspective of federal responsibilities came with Franklin Roosevelt’s New Deal. Those regulations and enforcement (including the Securities and Exchange Commission (SEC) and substantial changes in banking) proved reasonably effective for half a century. Manipulation and fraud certainly occurred (as has bribery for the last 10,000 years), but enforcement seemed to work reasonably well.

Beginning in the 1970s increased inflation, global competition, energy problems, and so on created economic cracks. The banking system provided new services and got exponentially bigger, a deregulation mindset led to lax enforcement, combined with increased speculation and manipulation. Tax cuts, ironically, and other changes resulted in greater interest in compensation especially at the top of big organizations. The incentives were in place for new boom-bust cycles. The last two, the tech bubble and subprime collapse, have been particularly severe. The misaligned incentive structures are obvious and many recommendations have been made about needed institutional changes, from the Volcker Rule to “too-big-to-fail” solutions, political fixes, corporate governance, and executive compensation reforms.

Accounting and Auditing Issues

Various problematic accounting issues refuse to go away, dealing with complex instruments and contracts difficult to account for and allow for continued manipulation.

These include the major issues from Enron and the Subprime Meltdown: derivatives, mark-to-market, and special purpose entities. Other continuing issues include pension and other retirement benefits, acquisition accounting, taxes (including off-shore operations), and executive compensation. There involve long-term contracts, financial markets, and government regulations. The accounting role is how to properly book transactions and how complex information should be disclosed. The auditing role is discussed below. Generally, accounting procedures and disclosures have improved for these items. This should limit information asymmetries, potentially reducing but not eliminating the potential for manipulation and fraud.

Auditors have a major role in minimizing aggressive accounting. Although external auditors are paid by the companies being audited, they are on the front line of monitoring and have regulatory obligations to ensure that abuse and fraud are nonexistent. Accounting researchers have considerable evidence on what constitutes high-quality audits, using empirical surrogates to describe theoretical and professional relationships.

According to Christensen et al.,² “audit professionals most frequently define a high quality audit as one performed and documented in accordance with generally accepted auditing standards (GAAS) to provide reasonable assurance that financial statements are not materially misstated.” Some of the common measures of poor quality audits are the existence of earnings restatements (from previous years that almost always had unqualified opinions in those earlier years), SEC comment letters and enforcement actions, and reports of deficiencies by the Public Company Accounting Oversight Board. Other potential signals of poor audit quality include very low audit fees, small audit firms (rather than the Big Four and other “second tier” auditors such as Grant Thornton or BDO Seidman), and technical measures of discretionary accruals used by researchers (a greater magnitude of accruals suggest more manipulation).

Expected Outcomes: What Are the Incentives?

“Follow the money.” That was Deep Throat’s advice to journalist Bob Woodward uncovering the Watergate scandal in the 1970s. The same advice applies to finance and accounting scandals. Consequently, many of the same types of fraud from the past will recur because incentives are fundamentally unchanged, while regulations and enforcement to eliminate potential scandals remain questionable. Most of these are the same troublemakers from Enron and the various 1990s financial scandals: excessive and badly designed executive compensation contracts, mark-to-market, and that trifecta of financial abuse: structured finance, special purpose entities, and derivatives. Scandals emanating from the financial sector are particularly likely because of their substantial incentives and long history of manipulation. Add to that the likely “cognitive capture” of the Treasury Department and other regulators and the odds of continuing scandals seem high.

Accounting will likely play only a supporting role, given the continuing institutional framework. Auditors are still agent for (and paid by) corporations and have never shown a propensity to discover fraud. The previously mentioned trifecta of financial abuse are subject to greater disclosure requirements, but these accounting rules are not likely to deter future fraud. Major subprime player Citigroup disclosed their trifecta extremely well, for example, without setting off major alarm bells.³

Although the underlying incentives seem roughly the same, the institutional environment—especially regulatory reform—has been modified. Consequently, the when, where, and how of specific scandals are hard to determine. Just as hackers perpetually attack the Pentagon, the fraudsters probe for institutional weaknesses. The big players have high-powered talent and past experience demonstrates their effectiveness.

Businesses seriously promoting social responsibility (i.e., acting in the best interests of all stakeholders including the general public) are unlikely to promote illicit practices, but relatively few corporations seem particularly serious about social responsibility—remember the economics of bad behavior. Businesspeople, on the other hand, interested only in maximizing short-term stockholder wealth and executive compensation (and perhaps only interested in the executive compensation part) are certainly continuing candidates for manipulation and fraud.