Companies within the SEC’s purview are required to report their earnings and basic accounting data to allow investors to make informed decisions about the company. Unfortunately, some companies manipulate this data through fraudulent accounting practices.
Companies may be tempted to do so for a variety of reasons—to hide losses, to overstate earnings, or to avoid investor or SEC inquiries. A big enough misstatement can lead to a wildly swinging stock price, causing havoc that reverberates throughout the market.
As the wide variety of recent SEC enforcement actions shows, accounting fraud takes many forms, including:
- Revenue overstatement
- Premature recognition of revenue
- Sham transactions
- Understatement of expenses or losses
The most straightforward version occurs when a company overstates revenue numbers. The SEC recently went after Monsanto for artificially inflating its earning numbers by failing to include in its earning statements numerous expenses related to a rebate program for its flagship weed-killer Roundup.
The SEC issued an $80 million award against the company for the fraud. Similarly, in April 2016, Logitech was assessed $7.5 million for artificially inflating its 2011 revenue to avoid missing earnings targets.
Other companies defraud investors by prematurely recognizing revenue. The SEC has specific criteria for when revenue may be booked—for example, an agreement to sell particular goods or services must exist, the price must be determinable, and the likelihood of payment must be high.
In 2014, AirTouch Communications Inc. was caught recognizing revenue for over a million dollars of goods that were sitting in a warehouse, without any purchase agreements.
Some companies enter sham transactions to create the illusion of revenue where it does not exist. In 2012, TheStreet Inc. was caught creating fake transactions with nonexistent counterparties. To bolster its fraud, the company also backdated contracts and prematurely recognized revenue before any actual work was completed.
On the flip side, companies improperly minimize or understate expenses. For example, a company may pretend that an expense or loss occurred in an earlier—or later—quarter than when it was actually incurred to avoid revenue fluctuations or the appearance of a bad quarter. In 2013, the SEC charged Capital One with understating millions of dollars of auto loan losses during the financial crisis by failing to publically realize losses when they were internally recognized.
Another strategy to understate losses is to understate reserve amounts. American Home Mortgage Investment Corporation was charged in 2009 based on a scheme in which it understated the company’s reserves despite internal analysis showing that the financial crisis would cause millions in losses.
And of course, some companies combine many forms of fraud. In 2009, GE settled charges that it committed four major accounting frauds—improperly avoiding a $200 million pre-tax charge to earnings, improperly accounting for certain interest-rate swaps, prematurely recognizing $370 million in revenue for end-of-year sales of locomotives that had not occurred, and improperly increasing net earnings on spare airline engine parts by $585 million through changes to accounting methods.
To find out more about whether a particular type of fraud is covered by the whistleblower provisions of Dodd-Frank, contact us today.