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Accounting Fraud: A 'How-To' Guide

Stocks in this article: CCME LFT

On its balance sheet, a company is supposed to adjust the value of its inventory based on fair-market value of the products, or to account for estimated future sales returns, or the obsolescence of the products in its inventory, or an inability to sell products at the price the company initially thought it could. The amount of the adjustment is often a kind of guess, a judgment call. But it also reduces the value of the company's assets, as represented on its books. A fraudster in the finance office may decide to be overly aggressive by writing down its inventory to an unnecessary degree in one quarter -- reducing earnings. By doing so, he creates a "cookie jar reserve," with which he can boost earnings in a future quarter.

The fraudster covers his tracks by calling the previous, overly aggressive inventory writedown a "mistake." He hides behind the judgment call.

How to tell if a company is engaging in this sort of deception? If over a long period of time -- more than a year, say -- a company's top line is growing but its sales-return reserves remain flat or even decline -- that's a red flag indicating something could be amiss, says Antar.

A related and more-serious scam is simply to fake inventory outright, like De Angelis with his oil and water. Antar did the same thing at Crazy Eddie's, with his famous wall of empty television boxes, which auditors mistook for a huge warehouse chock-a-block with real TVs.

Audit firms will always attempt to verify inventory. But, says Jim Ratley, president of the Association of Certified Fraud Examiners, in Austin, Texas, audit firms almost always send their youngest, least-experienced employees to do that kind of in-the-field grunt work, a neophyte ill-equipped for "hand-to-hand combat with skilled businessmen."

Adds Ratley: "So the auditor is at a disadvantage already."

Ruses like the cookie-jar reserve pale in comparison to other swindles. One of the most egregious accounting frauds is sometimes called "round-tripping." In effect, a company that round-trips creates fictitious sales. It sells a product or quantity of products to a buyer, booking the sale and reporting the revenue in its quarterly statement to regulators. But the company and its "customer" have a secret agreement: in return for something (most likely a bribe or payoff of some kind), the "customer" sells the product back to the company after the quarter ends. Thus, the money from the "sale" of the product makes a round trip through the company's financial statement.

Perhaps the most famous perpetrator of the round trip was Sunbeam, the appliance maker, which, under CEO "Chainsaw" Al Dunlap in the 1990s, falsified nearly half of its earnings with such round-trip schemes, according to prosecutors.

Without subpoena power or the ability to inject an executive with truth serum, detecting the round trip is difficult. It requires a goodly amount of time spent poring over SEC filings, comparing numerical disclosures from quarter to quarter. But certain inconsistencies do serve as warnings that a company may be a serial round-tripper, according to experts. For instance: if a company has quarter after quarter of negative cash flow, but somehow it's also able to report positive net income, investors should take notice.

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