BAD ACCOUNTING

SHABIH KAZMI

I dedicate this work to the innocent accountants who

have, unknowlingly or unintentionally, been a part
of worst accounting scandals of world history. So, a
heartfelt thanks to Mr. Jeff Skilling, for giving us the
Enron Scandal (2001), Mr. Hank Greenberg, for his
contribution in AIG Scandal (2005) and our own
Indian inspiration Mr. Ramalinga Raju, for his best
practices in Satyam Scandal (2009).
Without the likes of these gentlemen the world
would have never got the privilege of knowing the
dubious terminologies in accounting.

BAD ACCOUNTING

SHABIH KAZMI

Table of Contents
Preface..04
Introduction.05
Top Scandals
Waste Management Scandal (1998).....06
Enron Scandal (2001)07
WorldCom Scandal (2002)..08
Tyco Scandal (2002).09
HealthSouth Scandal (2003)10
Freddie Mac (2003)11
American International Group (AIG) Scandal (2005)..12
Lehman Brothers Scandal (2008)...13
Bernie Madoff Scandal (2008)....14
Satyam Scandal (2009).15
The 7 Gimmicks......16
New Born Terminologies
Accounting Noise..18
Aggressive Accounting19
Backdating..20
Big Bath21
Black Box Accounting...23
Cook the Book....23
Cookie Jar Accounting.....24
Voodoo Accounting..26
How to Figure Out Scandals27
Your Own Methodology30
About The Author...31

BAD ACCOUNTING

SHABIH KAZMI

Preface
In the recent past we have witnessed at least a dozen scandals involving the corporates, big
and small both, which has changed our thought processes. Here, in this book we will study
and discuss these corporates. Ever since these incidents took place the accounting pundits
have given birth to some new terminologies in accounting. What are these terminologies and
how they could be detected? What are the signs of bad accounting?
The purpose of this book is to make you aware of the bad practices which were adopted in
past, the result of their bad practices and its effect on a common man. As a manager or
accounts person you must know about these practices.
There is no particular reason for writing on such a subject. The simplest reason is that I was
reading some facts for myself, asked a few questions to people around me, realised that they
do not have a clue about what happened and I felt people around me must also know. After
an hour I wanted the all interested people to know what had happened in these scandals. I
can only say that this subject is very close to my heart, right now.
Most of the material in this book has been inspired by Wikipedia and Google searches,
however I have tried my best not to copy paste except for a few tables and facts which I did
not wanted to be changed.
Honestly, while writing this book, I as a common man must admit that running a business is
not an easy job. But then, playing with investors/shareholders money is even worse crime to
commit. At the end of this book I would require inputs from you, write to me and suggest
your experiences as well.

BAD ACCOUNTING

SHABIH KAZMI

Introduction
Until now, much of your academics revolved around the best of accounting practices in which
you simply follow what has been written or taught by the author or the professor. But in
practice you might find some situation where you are requested to change a few facts and
present the balance sheet as expected by the company. This may or may not be an instance
of bad accounting technique but how would you know. How would you know whether if you
conceal a particular fact how bad it is going to hit the stakeholders?
The way corporates have been hit by bad accounting in the recent past gives us a clear
understanding of existence of malpractices in big corporates. Enron, AIG, Satyam, there are
almost a dozen scandals starting from the year 1998 till date. After so many scandals the
account pundits have come up with new terminologies with in the process of accounting. The
concept of these terminologies are not new and you as an accountant must have thought of
it many times. It is only these concepts are being christened now.
Before starting I would like you to list down some expectations from this book. And at the end
of this book give you feedback. I really want to listen from you.

....

....

....

....

BAD ACCOUNTING

SHABIH KAZMI

Top Scandals That Shook the World

I just wanted to start with some examples of companies which were found involved in bad
accounting techniques. Although there could be many companies involved but I choose the
below 10 companies which were really shocking and literally took the world by storm.
1. Waste Management Scandal (1998)

In 1987, the US government accused Waste Management of violating antitrust laws by

colluding with other waste haulers to allocate customers in two Florida counties.
Revelations of irregular accounting led to a major drop in stock price and to the replacement
of top executives after a new CEO ordered a review of the company's accounting practices in
1998. The company had augmented the depreciation time length for their property, plant, and
equipment, artificially inflating the company's after-tax profits by US$1.7 billion. On July 8,
1999, a class action lawsuit was filed against WMI and its certains officers for issuing false
statements. Waste Management paid US$457 million to settle a shareholder class-action suit
in 2003. The SEC fined Waste Management's independent auditor, Arthur Andersen, US$7
million for its role.
6

BAD ACCOUNTING

SHABIH KAZMI

2. Enron Scandal (2001)

Enron's complex financial statements were confusing to shareholders and analysts. In

addition, its complex business model and unethical practices required that the company use
accounting limitations to misrepresent earnings and modify the balance sheet to indicate
favorable performance.
The combination of these issues later resulted in the bankruptcy of the company, and the
majority of them were perpetuated by the indirect knowledge or direct actions of Lay, Jeffrey
Skilling, Andrew Fastow, and other executives. Lay served as the chairman of the company
in its last few years, and approved of the actions of Skilling and Fastow although he did not
always inquire about the details. Skilling constantly focused on meeting Wall Street
expectations, advocated the use of mark-to-market accounting (accounting based on market
value, which was then inflated) and pressured Enron executives to find new ways to hide its
debt. Fastow and other executives "created off-balance-sheet vehicles, complex financing
structures, and deals so bewildering that few people could understand them.

BAD ACCOUNTING

SHABIH KAZMI

3. WorldCom Scandal (2002)

On November 4, 1997, WorldCom and MCI Communications announced their US$37 billion
merger to form MCI WorldCom, making it the largest corporate merger in U.S. history. On
September 15, 1998, the new company, MCI WorldCom, opened for business, after MCI
divested itself of its successful "internet MCI" business to gain approval from the U.S.
Department of Justice.
On July 21, 2002, WorldCom filed for Chapter 11 bankruptcy protection in the largest such
filing in United States history at the time (since overtaken by the bankruptcies of both Lehman
Brothers and Washington Mutual in a span of eleven days during September 2008). The
WorldCom bankruptcy proceedings were held before U.S. Federal Bankruptcy Judge Arthur
J. Gonzalez, who simultaneously heard the Enron bankruptcy proceedings, which were the
second largest bankruptcy case resulting from one of the largest corporate fraud scandals.
None of the criminal proceedings against WorldCom and its officers and agents was
originated by referral from Gonzalez or the Department of Justice lawyers. By the bankruptcy
reorganization agreement, the company paid $750 million to the SEC in cash and stock in the
new MCI, which was intended to be paid to wronged investors.
8

BAD ACCOUNTING

SHABIH KAZMI

4. Tyco Scandal (2002)

Former chairman and chief executive Dennis Kozlowski and former chief financial officer Mark
H. Swartz were accused of the theft of more than $150 million from the company. During their
trial in March 2004, they contended the board of directors authorized it as compensation.
On June 17, 2005, after a retrial, Kozlowski and Swartz were convicted on all but one of the
more than 30 counts against them. The verdicts carry potential jail terms of up to 25 years in
state prison. Kozlowski himself was sentenced to no less than eight years and four months
and no more than 25 years in prison. Swartz received the same sentence. Then in May 2007,
New Hampshire Federal District Court Judge Paul Barbadoro approved a class action
settlement whereby Tyco agreed to pay $2.92 billion (in conjunction with $225 million by
Pricewaterhouse Coopers, their auditors) to a class of defrauded shareholders represented by
Grant & Eisenhofer P.A., Schiffrin, Barroway, Topaz & Kessler, and Milberg Weiss & Bershad.

BAD ACCOUNTING

SHABIH KAZMI

5. HealthSouth Scandal (2003)

HealthSouth, the largest U.S. operator of rehabilitation-hospitals, is under investigation by the

Securities and Exchange Commission and the Justice Department for allegedly overstating
earnings by $2.5 billion since 1999.
Fifteen HealthSouth employees, including all five former chief financial officers, have pleaded
guilty to criminal charges. Former CEO Richard M. Scrushy has denied wrongdoing. He will
appear before the House Energy and Commerce Committee on Oct. 16, but is expected to
invoke his Fifth Amendment right against self-incrimination.
Former HealthSouth CEO Richard Scrushy, 50, was a self-made son of the new South, a
former teenage parent who hauled himself up from a menial job to become an emperor of
the new economy. (Steve Barnette - AP)
Scrushy has refused the company's request for his resignation and remains a non-active
board member of HealthSouth.

10

BAD ACCOUNTING

SHABIH KAZMI

6. Freddie Mac (2003)

This case is fascinating for another reason. The SEC continues to give miscreants a slap on
the wrist while hitting the innocents with a massive fine. The SEC continues to dote on the
bad guys by only slapping their wrist. The largest fine plus disgorgement is only $400,000.
For the salaries and stock options and perquisites that these guys got while working at Freddie
Mac, the fines plus disgorgement amounts to a speeding ticket for those mortals with at most
six-digit incomes. The fines are trivial. If the SEC wants to dissuade managers from
committing accounting frauds, then they must impose meaningful and enormous fines and
prison sentences. Petty and insubstantial fines imply that the SEC no longer cares for investors
and creditors. And managers at other entities surely take notice.

11

BAD ACCOUNTING

SHABIH KAZMI

7. American International Group (AIG) Scandal (2005)

What began as an investigation into two reinsurance transactions has mushroomed into a
growing scandal that has tarnished the reputation of one of America's premier corporations.
On Mar. 30, AIG acknowledged that it had improperly accounted for the reinsurance
transaction to bolster reserves, and detailed numerous other examples of problematic
accounting. It also announced the delay of its annual 10-K filing, and said the moves may have
inflated its net worth by up to $1.7 billion. While AIG says it does not yet know if the review
will force a restatement of prior results, its stock dropped 2.1% on the news; all together, AIG
shares have dropped 22%, to $57 apiece, since the company was served with subpoenas by
state and federal regulators six weeks ago.
But AIG remains a powerhouse in the industry. It has a diverse mix of industry-leading
insurance and financial-services businesses. Moreover, it's a global force with a particularly
strong foothold in fast-growing Asian markets, especially China.

12

BAD ACCOUNTING

SHABIH KAZMI

8. Lehman Brothers Scandal (2008)

In 2003 and 2004, with the U.S. housing boom (read, bubble) well under way, Lehman
acquired five mortgage lenders, including subprime lender BNC Mortgage and Aurora Loan
Services, which specialized in Alt-A loans (made to borrowers without full documentation).
Lehman's acquisitions at first seemed prescient; record revenues from Lehman's real estate
businesses enabled revenues in the capital markets unit to surge 56% from 2004 to 2006, a
faster rate of growth than other businesses in investment banking or asset management. The
firm securitized $146 billion of mortgages in 2006, a 10% increase from 2005. Lehman
reported record profits every year from 2005 to 2007. In 2007, the firm reported net income
of a record $4.2 billion on revenue of $19.3 billion.
Lehman's collapse roiled global financial markets for weeks, given the size of the company
and its status as a major player in the U.S. and internationally. Many questioned the U.S.
government's decision to let Lehman fail, as compared to its tacit support for Bear Stearns,
which was acquired by JPMorgan Chase & Co.
13

BAD ACCOUNTING

SHABIH KAZMI

9. Bernie Madoff Scandal (2008)

In 1992, Bernard Madoff explained his purported strategy to The Wall Street Journal. He said
the returns were really nothing special, given that the Standard & Poors 500-stock index
generated an average annual return of 16.3% between November 1982 and November 1992.
"I would be surprised if anybody thought that matching the S&P over 10 years was anything
outstanding." The majority of money managers actually trailed the S&P 500 during the 1980s.
The Journal concluded Madoff's use of futures and options helped cushion the returns against
the market's ups and downs. Madoff said he made up for the cost of the hedges, which could
have caused him to trail the stock market's returns, with stock-picking and market timing.
The scheme began to unravel in December 2008, when the general market downturn
accelerated. However, Markopolos later wrote Madoff was on the brink of insolvency as early
as June 2005, when his team learned he was seeking loans from banks. At least two major
banks were no longer willing to lend money to their customers to invest it with Madoff. In
June 2008six months before the scheme implodedMarkopolos' team uncovered evidence
that Madoff was accepting leveraged money. To Markopolos' mind, Madoff was running out
of cash and needed to increase his promised returns to keep the scheme going.

14

BAD ACCOUNTING

SHABIH KAZMI

10. Satyam Scandal (2009)

The case, which is also called the Enron of India, dates back to 2009. Six years ago, Raju wrote
a letter to the Securities and Exchange Board of India (SEBI) and his companys shareholders,
admitting that he had manipulated the companys earnings, and fooled investors. Nearly $1
billionor 94% of the cashon the books was fictitious. In an immediate reaction to the
confession, investors lost as much as Rs14,000 Crore ($2.2 billion) as Satyams shares tanked.
Raju explained his reasons for inflating earning in the letter thus: As the promoters held a
small percentage of equity, the concern was that poor performance would result in a takeover,
thereby exposing the gap.
What started as a marginal gap between actual operating profit and the one reflected in the
books of accounts continued to grow over the years, Raju said in the letter. It has attained
unmanageable proportions as the size of the company operations grew significantly.
Raju was once the poster boy of Indias IT revolutionrubbing shoulders with top CEOs and
politicians across the world, including Bill Clinton.

15

BAD ACCOUNTING

SHABIH KAZMI

The 7 Gimmicks
The pundits has identified thirty techniques, grouped in to 7, that companies use to trick
investors and other stakeholders. They are:
Gimmic#1. Recording Revenue Too Soon or of Questionable Quality
There are six tricks commonly used under this category. They are:

Recording revenue when future services remain to be provided.

Recording revenue before shipment or before the customer's unconditional

acceptance.

Recording revenue even though the customer is not obligated to pay.

Selling to an affiliated party.

Giving the customer something of value as a quid pro quo.

Grossing up revenue.

Gimmic#2. Recording Bogus Revenue

There are five techniques commonly used under this category. They are:

Recording sales that lack economic substance

Recording cash received in lending transactions as revenue

Recording investment income as revenue

Recording as revenue supplier rebates tied to future required purchases

Releasing revenue that was improperly held back before a merger

Gimmick#3. Boosting Income with One-Time Gains

There are four techniques commonly used under this category. They are:

Boosting profits by selling undervalued assets

Including investment income or gains as part of revenue

Reporting investment income or gains as a reduction in operating expenses

Creating income by reclassification of balance sheets accounts

16

BAD ACCOUNTING

SHABIH KAZMI

Gimmick#4. Shifting Current Expenses to a Later or Earlier Period

There are five techniques commonly used under this category. They are:

Capitalizing normal operating costs, particularly if recently changed from expensing

Changing accounting policies and shifting current expenses to an earlier period

Amortizing costs too slowly

Failing to write down or write off impaired assets

Reducing asset reserves

Gimmick#5. Failing to Record or Improperly Reducing Liabilities

There are five gimmicks commonly used under this category. They are:

Failing to record expenses and related liabilities when future obligations remain

Reducing liabilities by changing accounting assumptions

Releasing questionable reserves into income

Creating sham rebates

Recording revenue when cash is received, even though future obligations remain

Gimmick#6. Shifting Current Revenue to a Later Period

There are two tactics commonly used under this category. They are:

Creating reserves and releasing them into income in later period

Improperly holding back revenue just before an acquisition closes

Gimmick#7. Shifting Future Expenses to the current Period as a special Charge

There are three tactics commonly used under this category. They are:

Improperly inflating amount included in a special charge

Improperly writing off in-process R&D costs from an acquisition

Accelerating discretionary expenses into current period

17

BAD ACCOUNTING

SHABIH KAZMI

New Born Terminologies

1. Accounting Noise
The distortion that is caused in a company's financial statements due to accounting
rules and regulations that must be followed. Accounting noise makes it difficult for
investors to easily ascertain a company's true financial condition. Accounting noise
can make a company's financial reports look better or worse.
Accounting noise can be the result of the implementation of the necessary accounting
principles that come under the Generally Accepted Accounting Principles and must be
implemented in order to make accurate and legal financial statements of a company.
On the other hand it can be an attempt from the management of the company to put
a brighter and the rosier picture of the company's financial statements in front of
investors and credit companies. Investors can scrutinize the foot notes of the financial
statements to identify the accounting noise and to get a clear and transparent picture
of the financial condition of a company.
Breaking down - Accounting Noise
Accounting noise can be seen as either a consequence of necessary rules regarding
generally accepted accounting principles (GAAP) or a result of management's attempts
to massage the numbers to present a rosier financial picture of the firm. Paying
attention to the footnotes can help an investor cut through the accounting noise and
get the real story.
For example, a company that has recently undergone a significant merger may look
very unprofitable on the income statement because the merger may cause serious
one-time charges for the company; it may be useful for investors to cut through the
accounting noise to get a more accurate picture of the company's prospects.
Conversely, an underperforming company could engage in earnings manipulation,
creating accounting noise to hide its poor performance.

18

BAD ACCOUNTING

SHABIH KAZMI

2. Aggressive Accounting
The practice of misreporting income statement and balance sheet items to make a
company appear more attractive to investors. Although some forms of aggressive
accounting are illegal, others are not. Regardless of the legality, however, aggressive
accounting practices are universally frowned upon, as they are clearly designed to
deceive. Aggressive accounting is also known as "creative" or "innovative" accounting
and in the worst, most fraudulent cases, is referred to as "cooking the books."
For a private company, one of its goals is to pay less tax. This equates to lowering
revenue by taking deductions and expensing items in order to qualify for a lower tax
bracket.
A public company on the other hand, is more inclined to use aggressive accounting
policies in order to over report earnings in order to meet analysts' expectations, meet
debt covenants or meet stock option performance bonuses based on stock price.
This has led to numerous accounting scandals and blowups in corporate America as
well as the rest of the world. In order to better understand what aggressive revenue
recognition is.
Breaking down - Aggressive Accounting
Though aggressive accounting has been an issue for a long time, the problem didn't
come to a head until the dotcom era in the late 1990s and early 2000s. Following the
bankruptcy of Enron Corporation (formerly traded as "ENE" on the New York Stock
Exchange) in 2001, Congress and the Senate passed the Sarbanes-Oxley Act. Sarbox,
or SOX, set new or enhanced standards for all U.S. public companies, as well as public
accounting firms, and was named after the bill's sponsors, U.S. Senator Paul Sarbanes
(D-MD) and U.S. Representative Michael G. Oxley (R-OH).

19

BAD ACCOUNTING

SHABIH KAZMI

3. Backdating
Backdating is dating any document by a date earlier than the one on which the
document was originally drawn up. Under most circumstances, backdating is seen as
fraudulent and illegal, although there are some situations in which backdating can be
used in a legal and beneficial way, such as backdating a claim for a past period.
For example, let's assume that Anthony Gonzales is the CEO of Company XYZ. When
he was hired, the Company XYZ board of directors offered Anthony an attractive salary
as well as an annual grant of 1,000 Company XYZ stock options. Those options give
Anthony the right but not the obligation to purchase 1,000 shares of Company XYZ
stock at the market price on the date of the grant. The board formally grants the stock
options to John every year at its January board meeting.
Typically, the grant date of the stock options is the same as the date of the board
meeting. This is important to note, because the grant date is what determines the
exercise price on the options. For instance, if the board meeting is on January 3, 2012,
and Company XYZ stock closes at 45 per share that day, then the exercise price of
Anthony's 2012 stock option grant is 45 per share. That is, he has the right but not the
obligation to purchase 1,000 shares of Company XYZ stock for 45 per share.
If, however, Company XYZ decides to backdate the options, it could change the
paperwork to state that it actually granted those stock options to John on, say, June
15, 2008, when the stock was only trading at 15 per share. This would mean that
Anthony's 2012 stock option grant would have an exercise price of 15 per share
instead of 45 per share.
Let's say that Anthony now decides to exercise his stock options. On the day he
decides to exercise his options, Company XYZ shares are trading at 50. Under normal
circumstances, he pays the 45 per share exercise price and can turn around and sell
those shares on the exchange for 50 each, netting a profit of 5 per share, or 5,000
total.

20

BAD ACCOUNTING

SHABIH KAZMI

But if John's options are backdated, then his exercise price is only 15 per share. He
pays the 15 per share exercise price and can turn around and sell those shares on the
exchange for 50 each, netting a profit of 35 per share, or 35,000.
Breaking down Backdating
Sometimes certain claims (such as insurance claims) can be backdated if they could
not be completed at an earlier date, although there must be good reason for neglecting
to claim in advance. If your backdated claim is approved, you will be able to receive
benefits from a certain date in the past.
4. Big Bath
A big bath is the strategy of manipulating a company's income statement to make poor
results look even worse. The big bath is often implemented in a bad year to enhance
artificially next year's earnings. The big rise in earnings might result in a larger bonus
for executives. New CEOs sometimes use the big bath so they can blame the
company's poor performance on the previous CEO and take credit for the next year's
improvements.
One of the hardest accounting frauds to spot is big bath accounting. When a company
is doing really bad and has no chance of meeting earning expectations, unscrupulous
management would begin writing-off every expense and asset they could imagine. As
a result, future expenses are reduced significantly and naturally earnings increase. In
other words, the company is taking a big bath in the worst year so it can wipe its slate
clean. This almost always guarantees record-breaking earnings in subsequent years,
likewise performance bonuses.
The reasoning behind taking a big bath is quite simple: We already look bad, so let's
make ourselves look as bad as we can. Needless to say, management wouldn't take
the blame for the fall. They would either blame it on previous management or the
challenging economic conditions. The sweet-talking CEO never fails to wrap up with a

21

BAD ACCOUNTING

SHABIH KAZMI

personal assurance that the company is well poised to seize the opportunities when
the market returns to more favorable conditions.
Breaking down - Big Bath
For example, if a CEO concludes that the minimum earnings targets can't be made in
a given year, he/she will have an incentive to move earnings from the present to the
future since the CEO's compensation doesn't change regardless if he/she misses the
targets by a little or a lot. By shifting profits forward - by prepaying expenses, taking
write-offs and/or delaying the realization of revenues - the CEO increases the chances
of getting a large bonus the following year.
In a big bath, management would write-down substantial assets, that don't occur under
normal operating conditions, in order to maximize future benefits. So, pay close
attention to special one-time charges. Sale of discontinued operations, accelerated
depreciation of inventory, plant and equipment, write-off of an investment gone south
and restructuring charges are some of the most common one-time charges.
Because one-time charges could very well be valid, sniffing out the smell of big bath
accounting is not easy. One thing to look out for is the frequency of big baths. If onetime charges begin to show up every other year, this becomes a worrisome pattern. It
is, therefore, crucial for an investor to not just look at the current year financial reports.
Unfortunately, apart from spotting patterns of one-time charges, without adequate
disclosure voluntarily offered by management, there is no sure way to determine
whether or not management has taken a big bath.

22

BAD ACCOUNTING

SHABIH KAZMI

5. Black Box Accounting

The use of complex bookkeeping methodology in order to make interpreting financial
statements time-consuming or difficult. Black box accounting is more likely to be used
by companies seeking to hide information that they do not want investors to readily
see, such as large amounts of debt, as the information would negatively affect the
company's shares or ability to gain access to funding. Accounting showing income
and expenses in a not normal way. This is done to bury financial issues.
Breaking down - Black Box Accounting
Black box accounting is not illegal, as long as it adheres to GAAP or IAS guidelines,
depending on the location. But is generally considered unethical, as it is designed to
obscure a simple and accurate picture of a company's financial health. The use of
complex formulas also creates skepticism about the accuracy of the numbers
displayed in financial statements.
6. Cook the Books
Cook the books is an idiom describing fraudulent activities performed by corporations
in order to falsify their financial statements. Typically, cooking the books involves
augmenting financial data to yield previously nonexistent earnings. Examples of
techniques used to cook the books involve accelerating revenues, delaying expenses,
manipulating pension plans and implementing synthetic leases.
A company might use credit sales to cook the books. Sales made on credit are booked
as sales even if the company allows the customer to postpone payments for six
months. In addition to in-house financing, companies can extend credit terms on
current financing programs.
Channel stuffing is a method some manufacturers use to cook the books.
Manufacturers engaged in channel stuffing ship unordered products to distributors at
the end of the quarter. These transactions are recorded as sales, even though the
company fully expects the distributors to send back the products, especially those that
23

BAD ACCOUNTING

SHABIH KAZMI

did not sell. To avoid confusion, manufacturers should book products sent to
distributors as inventory until the distributors record sales, otherwise, the amount of
sales reported is inflated.
One of the most common issues is with nonrecurring expenses. Nonrecurring
expenses are meant to be one-time charges classified as extraordinary events, which
artificially increase net income. These items are excluded from net income. The issue
is that some companies have the same nonrecurring event happen every year, which
means it is not extraordinary.
Another way that companies can manipulate earnings is with stock buybacks.
Breaking down - Cook the Books
During the first years of the new millennium, Fortune 500 companies such as Enron
and WorldCom were found to have cooked the books to improve their financial figures.
The resulting scandals gave investors and regulators a rude awakening concerning the
reality that companies were capable of hiding the truth between lines of financial data.
To rally investor confidence, the Sarbanes-Oxley Act of 2002 was created. The act of
Congress created policies to protect investors against future incidents of corporate
fraud. Even with Sarbanes-Oxley in place, there are still numerous ways companies
cook the books.
7. Cookie Jar Accounting
A disingenuous accounting practice in which periods of good financial results are used
to create reserves that shore up profits in lean years. "Cookie jar accounting" is used
by a company to smooth out volatility in its financial results, thus giving investors the
misleading impression that it is consistently meeting earnings targets. This reliable
earnings performance is generally rewarded by investors, who assign the company a
premium valuation. Regulators frown on the practice since it misrepresents a
company's performance, which may be very different in reality from what it purports
to be.
24

BAD ACCOUNTING

SHABIH KAZMI

The term may be derived from the fact that a company which employs this practice
dips into the "cookie jar" of reserves whenever it feels like it. But the company may
have to pay a steep price if it is caught with its hand in the proverbial cookie jar.
Breaking down - Cookie Jar Accounting
One-time charges and special items are a couple of areas where a company can
manipulate numbers to create cookie jar reserves. Potential investors should therefore
scrutinize these numbers carefully before committing investment capital to the stock.
One of the best-known cases of cookie jar accounting in recent years was that of
computer giant Dell, which in July 2010 agreed to pay a $100 million penalty to the
Securities and Exchange Commission (SEC) to settle SEC allegations that it used
cookie jar reserves. The SEC maintained that Dell would have missed analysts'
earnings estimates in every quarter between 2002 and 2006 had it not dipped into
these reserves to cover shortfalls in its operating results. The cookie jar reserves were
created through undisclosed payments that Dell received from chip giant Intel in return
for agreeing to use Intel's CPU chips exclusively in its computers. (Intel made these
payments to Dell to lock out rival chipmaker Advanced Micro Devices from Dell
computers.)
The SEC also said that Dell did not disclose to investors that it was drawing on these
reserves. The Intel payments made up a huge chunk of Dell's profits, accounting for as
much as 72% of its quarterly operating income at the peak. Dell's quarterly profits fell
significantly in 2007 after it ended the arrangement with Intel. The SEC alleged that
while Dell said the decline in profitability was due to an aggressive product-pricing
strategy and higher component prices, the real reason was that it was no longer
receiving the payments from Intel.

25

BAD ACCOUNTING

SHABIH KAZMI

8. Voodoo Accounting
Voodoo accounting refers to any accounting practices that artificially inflate the profits
reported on a company's financial statements.
Creative rather than conservative accounting practices. Voodoo accounting employs
numerous accounting gimmicks to artificially boost the bottom line by inflating
revenue or concealing expenses or both. The origin of the term "voodoo accounting"
probably lies in the fact that once the accounting gimmicks come to light, the
purported profits disappear like magic. Investor reaction to news that a company has
been engaged in voodoo accounting depends on the magnitude of the offense. While
minor, one-time accounting gimmicks may be ignored by investors, substantial repeat
offenses would affect the company's market value and reputation.
Breaking down - Voodoo Accounting
Some of the voodoo accounting practices identified by former SEC chairman Arthur
Levitt at the height of the dot-com bubble in September 1998 include:

"Big bath charges," in which a company improperly reports a one-time loss by

taking a huge charge to mask lower-than-expected earnings.

"Cookie jar reserves" used by a company for income smoothing.

Recognizing revenue before it is actually collected.

"Merger magic," whereby a company writes off all or most of an acquisition's

price as "in process" research and development.

26

BAD ACCOUNTING

SHABIH KAZMI

How to Figure Out Scandals

This sounds very interesting to figure out scandals in big corporates. But actually this starts
at lower level and then rises to the top. If there is something fishy about accounting or fraud
going on in an organisation the roots are with the people who do these things for the
corporates. I shall give you some of the traits for people and the practices. So here they are
as below:
1. Unusual Behavior - The perpetrator will often display unusual behavior, that when
taken as a whole is a strong indicator of fraud. The fraudster may not ever take a
vacation or call in sick in fear of being caught. He or she may not assign out work even
when overloaded. Other symptoms may be changes in behavior such as increased
drinking, smoking, defensiveness, and unusual irritability and suspiciousness.
2. Complaints - Frequently tips or complaints will be received which indicate that a
fraudulent action is going on. Complaints have been known to be some of the best
sources of fraud and should be taken seriously. Although all too often, the motives of
the complainant may be suspect, the allegations usually have merit that warrant further
investigation.
3. Stale Items in Reconciliations - In bank reconciliations, deposits or checks not included
in the reconciliation could be indicative of theft. Missing deposits could mean the
perpetrator absconded with the funds; missing checks could indicate one made out to
a bogus payee.
4. Excessive Voids - Voided sales slips could mean that the sale was rung up, the
payment diverted to the use of the perpetrator, and the sales slip subsequently voided
to cover the theft.
5. Missing Documents - Documents which are unable to be located can be a red flag for
fraud. Although it is expected that some documents will be misplaced, the auditor
should look for explanations as to why the documents are missing, and what steps
were taken to locate the requested items. All too often, the auditors will select an
alternate item or allow the auditee to select an alternate without determining whether
or not a problem exists.

27

BAD ACCOUNTING

SHABIH KAZMI

6. Excessive Credit Memos - Similar to excessive voids, this technique can be used to
cover the theft of cash. A credit memo to a phony customer is written out, and the
cash is taken to make total cash balance.
7. Common Names and Addresses for Refunds - Sales employees frequently make
bogus refunds to customers for merchandise. The address shown for the refund is
then made to the employee's address, or to the address of a friend or co-worker.
8. Increasing Reconciling Items - Stolen deposits, or bogus checks written, are frequently
not removed, or covered, from the reconciliation. Hence, over a period of time, the
reconciling items tend to increase.
9. General Ledger Out-of-Balance - When funds, merchandise, or assets are stolen and
not covered by a fictitious entry, the general ledger will be out of balance. An inventory
of the merchandise or cash is needed to confirm the existence of the missing assets.
10. Adjustments to Receivables or Payables - In cases where customer payments are
misappropriated, adjustments to receivables can be made to cover the shortage.
Where payables are adjusted, the perpetrator can use a phony billing scheme to
convert cash to his or her own use.
11. Excess Purchases - Excess purchases can be used to cover fraud in two ways:

Fictitious payees are used to convert funds.

Excessive purchases may indicate a possible payoff of purchasing agent.

12. Duplicate Payments - Duplicate payments are sometimes converted to the use of an
employee. The employee may notice the duplicate payment, then he or she may
prepare a phony endorsement of the check.
13. Ghost Employees - Ghost employee schemes are frequently uncovered when an
auditor, fraud examiner, or other individual distributes paychecks to employees.
Missing or otherwise unaccounted for employees could indicate the existence of a
ghost employee scheme.
14. Employee Expense Accounts - Employees frequently conceal fraud in their individual
expense account reimbursements. These reimbursements should be scrutinized for
reasonableness and trends, especially in the area of cash transactions on the expense
account.

28

BAD ACCOUNTING

SHABIH KAZMI

15. Inventory Shortages - Normal shrinkage over a period of time can be computed
through historical analysis. Excessive shrinkage could explain a host of fraudulent
activity, from embezzlement to theft of inventory.
16. Increased Scrap - In the manufacturing process, an increased amount of scrap could
indicate a scheme to steal and resell this material. Scrap is a favorite target of
embezzlers because it is usually subject to less scrutiny than regular inventory.
17. Large Payments to Individuals - Excessively large payments to individuals may indicate
instances of fraudulent disbursements.
18. Employee Overtime - Employees being paid for overtime hours not worked by altering
time sheets before or after management approval.
19. Write-off of Accounts Receivable - Comparing the write-off of receivables by
customers may lead to information indicating that the employee has absconded with
customer payments.
20. Post Office Boxes as Shipping Addresses - In instances where merchandise is shipped
to a post office box, this may indicate that an employee is shipping to a bogus
purchaser.
Let me also make this very clear that these traits are only indicative and if any of these situation
is encountered, it is to be probed before the accusations begin. We have seen some of the
above points in real life also, like the ghost employees of Municipal Corporation of Delhi or
like the case of a Member of Parliament from Rajasthan laundering money through fictitious
firm and so on.

29

BAD ACCOUNTING

SHABIH KAZMI

Your Own Methodology

As a man who keeps his commitments I would like to know about your views and
methodologies on bad accounting. You may write your notes below or share with me through
e-mail. Here you go:
Your views on Corporate Scandals:.
.
.
.
Your views on Accounting Gimmicks: ..

Your views on Bad Accounting Terminologies:..

Your Suggestions or new Terminology:

30

BAD ACCOUNTING

SHABIH KAZMI

31