There has been great many discussions about introducing new legislature concerning the overhaul of the financial industry. There has been calls for Glass-Stegall to be re-introduced. The Dodd-Frank overhaul act of 2010 is a massive 800 page juggernaut aimed against the “egregious” acts committed by Wall Street during the latest recession. But, do laws really help against fraudulent behavior or are there deeper roots regarding this problem?
During the boom faze of the credit cycle, prices of factors of production and capital goods rise in value, the stock market rises and there is a sense of general euphoria. Companies are willing to go into debt to finance and expand entrepreneurial projects. They are romanced by the banking sector and the cheap funds that are all of a sudden granted to businessmen almost at no cost. Profits soar, and the balance sheets of companies have never looked stronger.
Assets are inflated in value, along with revenues. Projections based on current sales and expenses are prolonged into the future with expected double digit YOY growth. Companies in this period don’t really run high capital buffers to protect them in case of a sudden fall in ongoing revenue. They rarely engage in any accounting for reserve losses on their accounts receivables and a hectic schedule of ever increasing demand reduces their inventory amounts. The demand can be so excessive, that companies frequently neglect the qualitative value of there assets, as the only goal is to satisfy the voracious appetite of the consumers at large.
However, the fairytale economy built on money creation is an illusion, and soon companies will find themselves in trouble. The first thing that comes about is a cry for more liquidity; that is, the business community starts holding a grudge against the government due a “note shortage”, a situation where there isn’t enough funds in the economy for completing there projects of longer durations. Businesses are frightened due to rising interest rates and higher costs of going into debt or rolling over their current debts. Funding becomes an issue.
The only way for businesses to appear in good health is to engage in deceptive accounting or sometimes go so far and engage in embezzlement and fraud. Companies, which are first effected try to get rid of poor performing assets. But, instead of selling them, they usually engage in complicated repo transactions, where they try to ”window dress” their current financial mess.
(This closely resembles the situation and fraud perpetrated by Olympus in Japan. They tried to hide losses for over a decade in an ingenious scheme that finally unraveled a couple months back. For an accounting description of what happened read this post by an independent CPA from San Francisco located on retheauditors.com.)
But the window dressing and repo shams can last only for so long. The company will eventually run into problems paying back their vendors. They again decide to engage in aggressive accounting techniques using vendor financing. The troubled firm will sell their account payables for note payables. The cash injection will be recorded on the cash flow from operations (under IFRS) and when the note comes due, they may resort to booking it on the financing portion of the cash flow to make it appear that the firm is on steady grounds when its core business is concerned.
Fraud, in this context was generated not by an evil ambition of the businessman, but by a desperate attempt to stay afloat. That is usually what happens in a boom period. I am not vindicating this behavior, just stating the catalyst that brought such dubious behavior.
In a “normal” economy, these things happen as well, but are more profound during the end of the boom faze. Some other ways to manipulate earnings or financial statements is to: book revenue without shipping the product (bill and hold), booking a revenue when accrual accounting doesn’t allow it, lowering contra accounts to artificially prop up assets, capitalizing an expense when conditions are not made for it to be capitalized, engaging in aggressive securitizations, manipulating the life cycle of an asset, booking future profits, lowering the carry of defined pension benefit plans, using an asset as an operating lease instead of properly booking it as a finance lease etc.
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