Fraudulent Financial Reporting
The term fraudulent financial reporting, came about in the wake of multiple financial statement fraud scandals at the start of the century.
Between 2000 and 2002, several large companies filed for bankruptcy because they had misreported their financial earnings.
In the late 1990s, many stocks were competing for investor dollars by surprising the markets with better financial results.
However, as pressure continued for companies to report better earnings, companies had to manufacture ways to make the earnings look better than they were in reality.
Much of this activity came about through using underutilized aspects of accounting procedures, known as Generally Accepted Accounting Principles (GAAP).
Executives would take debt from the company’s balance sheet and transfer it to small non-public businesses, which were set up solely to buy debt from larger corporations.
Another aspect of the financial manipulation was caused by over-inflating assets of the company when they would buy out a competing business.
Just from these few instances alone, you can see that there are many ways businesses manipulated financial reports and caused investors to buy stocks, which may not have been as valuable as the financial reports indicated.
To stem this fraudulent financial reporting, the Securities Exchange Commission developed new rules, which among other things, required CEOs and CFOs to personally sign for the validity of the financial reports.
Thus, no longer could a CEO suggest that the business would perform extremely well, unless there genuinely was a basis for that kind of optimism.
The following examples are some of the biggest scandals utilized on Wall Street prior to the new financial reporting requirements.
Example 1 - Enron
Enron was the most famous example of any company abusing its financial reporting requirements.
Right from the outset, the company seemed to utilize stock manipulation and reporting techniques in order to make itself bigger and better than it actually was.
In fact, once the scandal had broken, it became apparent that Enron had very little assets whatsoever. Indeed, much of the company’s $63 billion in assets were virtually nonexistent.
Enron used multiple techniques to improve its financial position.
One technique was to over utilize an accounting technique called marked to market. Under this method of accounting, a business was allowed to inflate its assets based upon what the asset would sell for at that moment on the market.
If the economy fell or the company hit bad times, those assets would be valued too high and would need to be written down. Therefore, the value of the asset was massively over-inflated. This was the key problem with Enron.
Additionally, the company utilized several techniques to strip debt from the company’s balance sheet by selling it to businesses owned by executives solely to get the debt off Enron’s books.
The balance sheet looked better and more valuable. In reality, the debt had never been repaid and ultimately would return to the Enron balance sheet in the future.
Example 2 - WorldCom
Following Enron filing bankruptcy back in 2001, most people thought it was the worst company on the stock market.
However, in 2002 everything changed once more and the world found out that there was a worse perpetrator of financial statement fraud, called WorldCom.
WorldCom filed the largest bankruptcy of any business in 2002, which stood at a staggering $107 billion. It used some of the same techniques as Enron in its financial accounting; however, the company executives utilized other techniques as well.
One technique that WorldCom used was to overvalue some of its new businesses ventures that the company bought out.
Because of its rapid expansion and acquisitions, investors were never fully able to understand the real value of assets that company was buying up in the marketplace.
The 1990s were notorious for the expansion of the Internet, as such assets associated with Internet and communications were given valuations that were unrealistic.
Thus, when WorldCom filed for bankruptcy, much of the assets that the company had claimed on its balance sheet were false values placed on the companies they had purchased in the 1990s.
Example 3 - Waste Management
Of the three examples in this article, Waste Management is the only company still operating.
Waste Management’s financial statement fraud scandal was what you would think of as a more standard reporting scandal.
Several executives at Waste Management merely inflated the company’s earnings in order to draw more attention to the company and gain more investments from investors.
What the manager simply did was over inflate the actual earnings for certain periods from the late 1990s until 2002.
Therefore, unlike WorldCom and Enron the company did not cease operations. Instead, the company merely had to restate its earnings and all executives who had perpetrated the fraud, were fired and subsequently sued by the SEC.
In this situation, the company did not have an overly-inflated balance sheet, so the company was able to withstand the fraudulent financial reporting scandal.