THE NATURE OF MANAGEMENT FRAUD (STUDY OBJECTIVE 3)
Management fraud, conducted by one or more top-level managers within the company, is usually in the form of fraudulent financial reporting. Oftentimes, the chief executive officer (CEO) or chief financial officer (CFO) conducts fraud by misstating the financial statements through elaborate schemes or complex transactions. Managers misstate financial statements in order to receive such indirect benefits as the following:
- Increased stock price. Management usually owns stock in the company, and it benefits from increased stock price.
- Improved financial statements, which enhance the potential for a merger or initial public offering (IPO), or prevent negative consequences due to noncompliance with debt covenants or decreased bond ratings.
- Enhanced chances of promotion, or avoidance of firing or demotion.
- Increased incentive-based compensation such as salary, bonus, or stock options.
- Delayed cash flow problems or bankruptcy.
Management fraud may involve overstating revenues and assets, understating expenses and liabilities, misapplying accounting principles, or any combination of these. While there are numerous examples of management fraud, two examples follow.
THE REAL WORLD
Enron was forced to restate (reduce) earnings by approximately $600 million because of improper financial reporting. Enron's top management had been hiding debt and losses by using a complex set of special purpose entities (SPEs). These SPEs were partnerships controlled by members of Enron's top management, such as the CEO and CFO. The SPEs were treated as unrelated entities and, therefore, were not included in the Enron financial statements.
Shortly after the restatement of financial statements, Enron filed the biggest bankruptcy in history. The company had previously been considered by many to be one of the largest and most successful companies ever. The unraveling of Enron caused the stock price to fall from $90 in 2000 to less than $1 by the end of 2001. Many investors and employees were devastated by their losses. This fraudulent misstatement led not only to the demise of Enron, but also to the dissolution of Arthur Andersen, one of the oldest and most prestigious audit firms in the world.
In 2002, the SEC filed a civil fraud suit against Xerox Corporation,5 alleging that top managers at Xerox approved and encouraged accounting practices that violated GAAP and accelerated revenue recognition. These bad accounting practices included the following:
- Incorrectly counting service and financing lease revenue at the beginning of the contract rather than over the life of the lease
- Shifting revenue from financing to equipment sale, which increased gross margin
- Improperly recognizing a gain from a one-time event, usually called establishing “cookie jar” reserves
The effect of these frauds on the financial statements was to artificially increase pre-tax earnings by $1.5 billion over the four-year period of 1997 to 2000. Top management encouraged these practices so that the company could meet expected earnings targets. As a result of the SEC action, Xerox agreed to pay a $10 million fine and restate earnings.
These two examples illustrate that management fraud typically
- Is intended to enhance financial statements
- Is conducted or encouraged by the top managers
- Involves complex transactions, manipulations, or business structures
- Involves top management's circumvention of the systems or internal controls that are in place—known as management override
Management fraud, like the examples at Enron and Xerox, is conducted by top-level managers and usually involves manipulation of the financial statements so that the manager can benefit by such things as increases in compensation or stock price. Many management frauds include complex transactions or entities, such as Enron's use of SPEs. Moreover, managers operate above the level of internal controls—that is, internal controls can be overridden or circumvented by managers. Therefore, a good set of internal controls may not be as effective in reducing the chance of management fraud as it would be in reducing the chance of fraud committed by an employee, vendor, or customer. The most effective measure to prevent or detect management fraud is to establish a professional internal audit staff that periodically checks up on management activities and reports to the audit committee of the board of directors.
THE REAL WORLD
(JW: RW Example) An example of management override of internal controls was discovered in 2010 at the Koss Corporation, a headphone manufacturer. Sue Sachdeva, the vice president of finance, pleaded guilty to embezzling $34 million from Koss over a period of about five years. This is a very large dollar amount of fraud in a company of this size, since Koss's average net income over those years was about $6 million. Ms. Sachdeva's wrongdoings included fraudulent wire transfers to pay her personal credit card bills, fraudulent checks, and fraudulent petty cash disbursements. In addition, she overstated assets and expenses to hide the theft. Since she was the VP of finance, she could override the normal internal control processes that should prevent this type of fraud.