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Module: 16

Avoiding illegal accounting

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This module looks into how you avoid illegal accounting. Over the past modules we have covered all of

the right ways to do things. Now we take the time to highlight the common pitfalls, rookie mistakes, and

the gargantuan fraudulent activities of some of the most high-powered execs in the land. Understanding

how illegal accounting can happen is the first step in avoiding it. While being able to identify the

fraudulent behavior when you see it is the next step. Only then can you avoid illegal accounting.

What you’ll learn in this module:

16.1 Improper Accounting Procedures

16.2 Consequences of Poor Accounting Practices

16.3 Avoiding Shortcuts

16.4 Famous Accounting Scandals

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16.1 Improper accounting procedures

The previous modules have laid out in detail the acceptable way to run your finances. Adhering to a

well-structured accounting system and budget will serve you well in the sometimes complicated and

grey areas of the world of corporate finances.

This is not to say that sometimes you will make mistakes and inadvertently do something illegal or

unethical in your financial journey. It is important to be educated on some of the pitfalls and ways

that you can trip up. They can be small or big. When trying to decide if you are the right side of the

line, listen to your intuition. Chances are if you are feeling uneasy about something it isn’t on the up

and up. Whether it is something you have done, a colleague or a superior it is important to do your

best to correct it, report it, and learn from your mistake. In this section we will highlight a few ways

that you can mistakenly use improper accounting procedures.

For our purposes here we have sorted the sometimes nefarious aspects of accounting in to two sub-

groups. They are honest accounting mistakes and genuinely unethical & dishonest accounting

practices.

Honest accounting mistakes usually happen because a business doesn’t have their finances in order.

They may not have the required knowledge to do their finances or organize their accounts in a way that

will help the business manage and understand its financial health.

Dishonest accounting is instigated and perpetuated with a specific goal in mind. The instigators know

what they are doing is unethical and generally have a complete disregard for the damage and heartache

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they may cause with their actions. Their goals are ultimately greed driven and can cost their victims

greatly.

Either of these accounting faux pas can land you in hot water with the authorities, your colleagues,

and your business stake holders.

16.1.1 Honest Accounting Mistakes

We will cover honest mistakes first. This list is of improper accounting procedures that generally

happen out of ignorance and sometimes just laziness. Neither of these reasons are acceptable. If

you don’t know the rules and regulations, don’t understand how they work or just don’t want to do

your finances, find someone who does understand accounting, who cares that it is done right and

hire them, immediately. This will make all the difference.

Not having an accounting system at all – let’s face it this is probably the biggest mistake a business

can make would be to not have a financial plan or accounting system in place. It will undoubtedly lead to

a myriad of mistakes that will be hard to recover from. This maneuver can be classified as gross

negligence on the part of the business owner.

Poorly planned cash flow – if a business does not plan for cash poor times in the business cycle, when

those times come they will not be able to survive. These cash times can happen during the Christmas

season when many companies are shut down or running at half steam. Good cash flow planning will

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allow your business to stay open and anticipate any cash flow shortfalls before the problem fully

develops.

Improper financial reporting – not filing the proper financial reports with shareholders, governments,

banks and other entities that need the information is a big taboo and can land you in some serious

trouble. Purchasing financial reporting software will minimize these occurrences and ensure that you

have the correct reports that need to be filed with each requesting entity. These rules and regulations

can change from one reporting period to the next so it is important to always stay abreast of what is

going on.

Poor or non-existent record keeping – An audit review could happen at any time, so you should be

ready with all of your business documents. You must keep all relevant documentation for your business

– bank statements, balance sheets, profit and loss statements, accounting records, deposit books etc.

There are guidelines for how long each document should be kept. Those should be referenced in your

business’s country of origin to ensure you are within their regulations. Of course, not having these up-to-

date anyway will mean your accountancy practices are inadequate, so the risk of an audit shouldn’t be

the primary reason to maintain this information.

Budgeting - Common mistakes with budgets are underestimating expenditures in the business cycle

and overcomplicating them making the chances of a mistake happening higher. Plan to use a spread

sheet that includes business income and expenditure sections – and keep them simple. You can also

purchase accounting software that will have a budget template for you to customize. The data can be

populated throughout the year so you will have a very good idea of your expenses will be for the next

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year. Try to use exact costs based on the costs of the past year, not estimates – and plan 12 months in

advance.

Mistakes that can be made in the accounting cycle:

Treating sales as revenue before the product or service is delivered – Doing this can give you a false

sense of security. If you think that you have made a large profit then you may try to expand and grow

your business. Even though you sold say $10,000 of product in December but it be delivered until

January, it can’t be counted as revenue until January. If that same amount is booked as revenue in

December it will falsely inflate the profitability of the company for that year. So when you make a sale,

you don’t book it as income or revenue until you have delivered the service or product to the customer.

Not considering the financial ramifications of a large purchase, such as equipment – Understanding how

depreciation works, knowing what your tax liability will be at tax time and how much you have in the

way of cash reserves are all things that need to be considered and accounted for before making a large

capital expenditure. When you pay cash for a capital expenditure you are able to depreciate the expense

over time. However depleting your cash reserves can put you at risk. If you gradually write the expense

off then you can’t take it as a one-time expense on your taxes, which will potentially cause your tax

liability to be higher. You may want to consider a small loan or using a credit card instead to keep your

cash reserves in place. The tax liability may still be there, but you will have the cash reserves to cover it.

Confusing profits for cash flow – This presents itself by showing a profit at month end on paper but not

having any cash left. This happens when you spend money faster than you are making it. Generally you

are tapping into credit cards and other temporary solutions. This mistake is avoidable by tracking your

expenses and revenue all month long instead of at the end of the month.

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Why do businesses think they can ignore their finances? Often-times businesses say they just didn’t have

the time or planned to do it later. Many people think they will handle it tomorrow, only tomorrow never

comes and eventually they go out of business or are in debt up to their necks. Other businesses don’t

think they need to hire a dedicated finance person and try to manage everything themselves. This may

work up to a point but if the owner doesn’t have a grasp on how accounting works, then the business

will suffer. Businesses need to make it a priority to educate themselves on how finances operate or they

need to hire someone who already has the knowledge.

16.1.2 Unethical or Dishonest Accounting Practices

This section covers accounting practices that are questionable at best and absolutely fraudulent and

illegal at the worst. Some of these occur in grey areas and

One -Time Charges – A charge against earnings that is expected to be an isolated one and not likely to

occur again. A one-time charge can be a cash charge - for example, severance expenses associated with

workforce reduction and early retirement. It can also be a non-cash charge, such as an asset write-down

(like inventory). One-time charges are routinely excluded by analysts and auditors when evaluating a

company's financial heath continued earnings potential.

While some charges are easily identifiable as one-time in nature, many companies will wrongly book

charges that are incurred in the normal course of business as one-time charges - a tendency that

investors need to watch out for. For example, a technology company may be justified if it writes off

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restructuring charges as a one-time charge. But if the company also records inventory every other

quarter and tries to pass it off as one-time charges, then it is possible these inventory write-down

charges are not truly one-time in nature. It is imperative that all levels of the company are aware of the

generally accepted accounting principles this will cut down on simple mistakes that turn in to grave

consequences.

Investment Gains – Investment gains usually occur when the market is doing really well. If a company

has bought assets that have done well then their total asset value will be higher than normal and then

change can take place in very short order. For instance, at the peak of the dotcom boom, when

companies were throwing money at anything and everything, a lot of investment gains were showing up

on financial statements. An investment gain is definitely better than a loss, but these gains are typically

unsteady. To illustrate the point, Intel's investment and interest gains during the second quarter of 2000

were just over $2.3 billion. Just one year later, specifically in the second quarter of 2001, their

investments and interest gains dropped to a paltry $115 million. Intel's investment income had declined

at a faster rate than the Nasdahanks to bad investments.

A company's aims for investment gains can also pose another problem. When the company is having

trouble meeting earnings expectations, the business management team can become consumed with

boosting investment income to meet the total income predictions. This can mean that the core

operations and regular day-to-day business of the company are left behind. The moral of the story is to

not put too much faith into investment gains. Although they may reflect the company's ability to

diversify revenue streams, watch out because these investments can fluctuate widely. These gains

flourish when the future looks bright, but shrink when the financial markets head south.

Misappropriation of Assets – misappropriations can occur in number of different ways but even the

smallest infraction, for instance taking a stapler home from the office, is a misappropriation. This

seemingly small act could just as easily be the owner taking business bought paper or other materials

home. Let’s say an employee sees this and then thinks well he can do it, why can’t I? The owner probably

sees it at his/her own assets they are taking but in reality they are the business’s assets. This kind of

mind set is a dangerous road that can quickly become a slippery slope.

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Creative Accounting - Creative accounting refers to any accounting practice performed by a business

that is technically correct but deviates from how the accounting policies were intended to be used. In

general, the creative accounting methods employed by businesses capitalize on loopholes in generally

accepted accounting principles. These methods are used in order to disguise financial performance. For

example they could hide as by keeping debt off a balance sheet.

Ponzi Schemes – A Ponzi scheme is an investment operation that is fraudulent. The operator of the

scheme who is usually an individual or organization pays its investors returns from new capital received

by the operator from new investors instead of profits earned by the operator in the course of business.

These are a just a few examples of things that can be done on purpose to affect the appearance of a

company’s financial health. Many small businesses will go into business and then forget about the

actual business part, the numbers and money that make the world go round. When they don’t take

the time to develop a good solid base with their accounting system, they are doomed to fail from the

start.

16.2 Consequences of Poor Accounting Practices

If you choose to endorse, practice or ignore illegal or unethical accounting practices, you need to be

prepared to accept and deal with the subsequent consequences.

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Civil and Criminal Penalties – There are a myriad of penalties awaiting those who choose to engage in

unethical practices perpetrating financial fraud. These can include both civil and criminal penalties.

Knowingly falsifying financial information can lead to prison time and fines. The investors of a company

may be able to sue for civil damages from the company and the owners. Keep in mind that claiming to

not know the generally accepted accounting practices is not a valid defense for fraudulent reporting. The

best rule to keep in mind is that if a reasonable person would believe that a manager or owner should

have known about any the fraud in the business then that could be enough for a jury to convict.

Loss of Reputation – If you choose to cut corners, take the easy way, and otherwise run your business

in an unethical manner, you will lose people’s respect. You may lose your reputation not only if you

operate in a big city but also and sometimes more painfully in a small communication. Small businesses

that run their operations unethically could find themselves closing their doors. Given enough time, this

could destroy your business. Customers may be unwilling to patronize the business and suppliers may

not want to conduct business with you. Large metropolis areas will have organizations that link like

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businesses together. Those organizations are like being in a small community. The integrity of your

business represents your integrity and vice versa. Arthur Andersen LLP effectively perished as a

business because of its poor conduct in the Enron scandal.

Loss of Human Capital – Many good employees do not want to work for a company that is unethical.

They may feel that is better to be without a job than to be working for a dishonest company or boss.

Accounting professional standards require that accounting work is performed ethically and with

integrity. Applying any kind of pressure to company accountants to behave unethically will not go over

well. These accountants can't uphold the standards of their profession much like doctors, and they

might risk loss of their license or credentials. Any reputable accountant would not work for an

employer who expects any kind of unethical behavior.

Personal Consequences – The individuals that participated in, perpetuated and otherwise assisted in

unethical financial practices will eventually be caught.

o They will then be tried and most likely fined, jailed or otherwise punished for their deplorable

behavior. Depending on the specific circumstances of the case, this can result in long term prison

time, huge financial costs and other legal punishments to the accountants and business owners

found guilty.

o Not only can this be devastating for the individuals directly involved, it is also devastating for both

friends and family, but most especially the family.

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Usefulness of Financial Statements – Your financial statements are your business’s report card. They

let the world know how your business is doing and whether or not you are viable as an investment

opportunity.

o With this is mind, every time the rule and regulations are broken to manipulate the otherwise

accurate information on the financial statements makes them less and less useful. To break the rules

and regulations to manipulate the financial statements to create an illusion of financial health is

illegal and unethical.

o Misrepresented financial statements derail any decisions based on them that are made for the

business. Financial statements must remain truthful and accurate to ensure the end users are making

the best financial decisions. Just one figure that is found to be inaccurate or wrong will cast the entire

report into question.

16.3 Avoiding Shortcuts

So how do you avoid those easy looking shortcuts? They would save time, maybe some money, and your

sanity right? Wrong, oh so wrong. That “little” shortcut can cause you big problems.

Take the time to set up your financial processes. Having policies and expectations outlined in the

beginning will let your company know where you stand and where you would like them to be.

Set aside time each month to go over your monthly financials and touch base with each department. This

will help keep everyone on the same page and moving in the same direction. If you show an interest in

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what is going on in the business your employees will most likely do the right thing if they are ever faced

with an ethical decision.

Know the rules and regulations of your local governments to make sure you are in compliance with

everything. It is not required to know every in and out of tax law however, you should consult a

professional who specializes in business taxes and finances to ensure that you have everything in order.

They may also be a good person to do your taxes at tax time. There is no shame in asking for help and

delegating tasks that you may not be the best at. Finances are always a good example of a time when you

should seek someone out who knows more than you do.

16.4 Famous accounting scandals

Over the centuries countless numbers of unethical business decisions have gone unnoticed and

unchecked. Unfortunately this is most often the case. The little things that fall into the grey area slide

through and no one really gets “hurt” at least not in a big way. The unethical business practices that we

know about were massive in nature, each victimized scores of people and stole millions and millions.

Here we will highlight just a few of the notable ones.

Enron Scandal (2001)

Enron was a Houston, TX based corporation the dealt in commodities, energy and services.

In 2001 the scandal broke wide open due to a whistleblower named Sherron Watkins and the fact that

their stock prices were abnormally high. This coupled with Watkins helped catch the perpetrators.

They routinely kept huge debts off of the balance sheets.

The main figure heads of the fraud were CEO Jeff Skilling and former CEO Ken Lay.

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All told shareholders last $74 billion, thousands of investors and employees lost their retirement

accounts and many employees lost their jobs.

Skilling received 24 years in prison and Lay unfortunately died before he could serve his time. The

company ultimately filed for bankruptcy. Arthur Andersen was found guilty of doing creative accounting

with Enron's accounts.

WorldCom Scandal (2002)

A telecommunications company that is now known as MCI, Inc. They inflated assets by as much as $11

billion.

This lead to 30,000 lost jobs and $180 billion in losses for the company’s investors.

The main figure head was CEO Bernie Ebbers. He underreported line costs by capitalizing rather than

expensing. He also inflated revenues with fake entries.

He was finally caught because WorldCom's internal auditing department uncovered $3.8 billion in

fraudulent accounting.

Bernie Ebbers was fired and sentenced to 25 years in prison for fraud, conspiracy and filing false

financial documents with regulators. The account controller resigned and the company ultimately filed

for bankruptcy.

Bernie Madoff Scandal (2008)

Bernard L. Madoff Investment Securities LLC was a Wall Street investment firm founded by Madoff.

He managed to trick investors out of $64.8 billion by carrying out the largest Ponzi scheme in history.

The main figure heads were Bernie Madoff, his accountant, David Friehling, and Frank DiPascalli.

They paid their investors returns out of their own (the investors’) money or that of other investors

rather than from profits.

They were caught because Madoff told his sons about the Ponzi scheme. The brothers subsequently

reported him to the SEC and he was arrested the next day.

Madoff was sentenced to 150 years in prison. He also was required to make $170 billion in restitutions.

Prison time for Friehling and DiPascalli both received prison time for their involvement.

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Satyam Scandal (2009)

An Indian IT services and apparent back-office accounting firm.

They falsely boosted revenue by $1.5 billion.

The main figurehead of the fraud was the Founder/Chairman Ramalinga Raju.

He falsified revenues, margins and cash balances to the tune of 50 billion rupees.

Raju was eventually because he confessed the fraud in a letter to the company's board of directors.

Raju and his brother charged with breach of trust, conspiracy, cheating and falsification of records. They

were both released after the Central Bureau of Investigation failed to file the charges on time.