Accounting Fraud: A 'How-To' Guide

NEW YORK (TheStreet) -- When Anthony "Tino" De Angelis, a soybean-oil magnate based in Bayonne, New Jersey, wanted to fool his auditors, he filled his warehouse tanks almost to the brim with water, then floated a few yards of oil on top. Uncritical auditors took a peek into a handful of those tanks, saw what they'd come to see, and signed off on the De Angelis audit: all clear.

With his assets officially sanctified by his accounting firm, De Angelis used those Bayonne assets as collateral for loans from many banks, including Chase Manhattan. And he used the funds from those loans to attempt a bold ploy: the cornering of the soybean-oil market. The inevitable collapse of his scam brought American Express ( AXP) (one of his creditors) to its knees; its stock lost half its value. Two Wall Street brokerages went belly up. Fifty banks failed.

This was in 1962 and 1963. The scam cost investors, banks and their counter-parties nearly $220 million. In today's dollars, that's $1.6 billion.

"It was a textbook example of accounting fraud," says Louis Straney, an expert on high-level financial larceny and, as it happens, the author of the textbook Securities Fraud: Detection, Prevention and Control. And its lessons are the lessons of all corporate accounting deceit, from Enron to Lehman Brothers. "De Angelis presents the classic example of how a man can exploit a complicated situation and use the credulity of high financiers for tremendous gain," commented Time magazine when De Angelis was arraigned in federal court in 1965.

White-collar swindling on a possibly massive scale has yet again entered the minds of investors in recent months, this time caused by a burgeoning raft of fraud revelations and allegations directed at Chinese companies that have sold shares in the U.S. So many China-based companies -- such as China Media Express ( CCME) and Longtop Financial ( LTF) -- have blown up amid accusations of fictitious profits that some investors have come to doubt the financial reports of an entire nation.

Investigating Chinese Reverse Mergers

The types of fraud allegedly perpetrated by these Chinese companies aren't new. The hoaxes, cons and scams used by white-collar criminals inhabiting the world's C-suites haven't changed all that much since the days of De Angelis and earlier, when accounting standards were first codified.

It's true that some types of fraud have fallen out of favor. For instance, the off-balance-sheet, special-purpose entities famously used by the boys at Enron to falsify earnings, says Straney, "isn't as big of a problem now as then. That's been tightened up."

But other categories have remained durable. And although fraud, when executed at a high level, is extremely difficult to detect, there are ways for investors to identify signals that may point to potential abuse.

First things first: Investors need to adopt a stance of extreme skepticism, what Sam E. Antar likes to call "professional paranoia." He should know. As the CFO of the infamous electronics retail chain Crazy Eddie's in the 1980s, he helped "mastermind" an A-level fraud that eventually cost investors hundreds of millions of dollars.

"I pretty much did everything that everybody else is doing now," Antar likes to say. "Maybe on a smaller scale, but I did it all. That's why the Crazy Eddie case is taught at colleges and universities, even today, 20 years later. It became like the all-in-one textbook case."

To avoid being duped, Antar says, amateur investors need to recalibrate how they understand financial reports. For Antar, they're little more than "marketing brochures. They exist to sell a product, and that product is stock. OK? Forget about internal auditors, external auditors, compliance people, whatever. Financial reports are there to present the company in the best light possible."

Accounting fraud at publicly traded companies has an obvious motive. By falsely inflating their earnings as represented on financial filings and reports, C-suite crooks aim to raise money by selling shares to an unsuspecting public. Or, once the company is public, they want to drive their companies' share prices higher, an effort to increase their own personal wealth or preserve their jobs. Or they want to disguise the fact that they're skimming off the top.

One well-known method for falsifying earnings involves inventory accounting, sometimes known as "cookie jar reserves." It's the easiest form of fraud to perpetrate, says Antar, who now blogs about fraud and advises the likes of the FBI and the Securities and Exchange Commission.

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.

Another major category of accounting fraud: acquisitions. Indeed, any company that can be described as a "roll up" -- a business built almost entirely through a series of acquisitions -- should automatically draw the skepticism of investors, fraud experts say.

That's because the opportunity for theft is so ripe. Essentially, a company managed by fraudsters overpays for an acquisition, then pockets the difference or cycles it through the income statement in order to falsely boost earnings.

It should perhaps not be surprising that many Chinese companies listed in the U.S. are complicated roll-ups. One short-seller who focuses on Chinese stocks says that dubious acquisition-accounting "appears to be the modus operandi of the most common fraud in China."

Any executive engaged in acquisition-related fraud will attempt to cover his tracks through misdirection. But there are ways to smell the smoke coming from this type of fire. "You gotta watch the goodwill," says Antar. One way for an executive to overpay for an acquisition is to inflate goodwill -- the excess of the purchase price over the fair market value of a target's assets and liabilities. Once again, the skeptical investor must go to the filings. If it turns out that goodwill makes up a majority of a company's assets -- watch out.

Fraud strategies are, of course, inherently unsustainable. Built on air, they all must collapse eventually, whether law enforcement pursues them or not. Still, depending on the skill of the perpetrator, fraudulent companies can last for years, even decades. This raises a dangerous point.

Crazy Eddie, for example, lasted three years as a public company following its IPO in 1984. "Before we imploded, the stock kept on rising no matter what the skeptics said," Antar recalls. "So here's the problem: Were the longs right? Or were the longs wrong -- and they traded right? In many cases, even though they're being probed by the SEC, even though there are a lot of legitimate questions being raised about these companies, their stock prices still go up. With Wall Street, it's all about the trade. So if you're gonna be a short seller, not only do you have to be right, you have to be right on time."

-- Written by Scott Eden in New York

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Disclosure: TheStreet's editorial policy prohibits staff editors and reporters from holding positions in any individual stocks.

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