Business Math in Action

Hold the Creativity

A company’s accounting records are as essential to its success and reputation as the products it makes or the people it employs. The balance sheet and income statement should be complete, straightforward, current, and transparent-that is, easily understood by someone unfamiliar with the company. Businesses everywhere know the rules of accounting, and most abide by them. Sometimes, however, a company slips over to the dark side. Its top management hides losses by overcomplicating the records or by moving or renaming assets and liabilities. One term for this is creative accounting. The legal term is fraud.

The most notorious cases of accounting fraud occurred during the first several years of the new millennium. By 2002, it was discovered that numerous corporations that appeared to be hugely successful were in fact basing their value on crooked accounting practices. Enron, WorldCom, and Global Crossing were among the most dishonest. How did these companies “cook the books?”

Enron set up offshore (outside the U.S.) partnerships designed to hide its losses. It engaged in dishonest energy trading-for example, the strategy Enron execs called Death Star. As an energy broker to the state of California, Enron made deals to receive payment for relieving “energy congestion” on the power grid. They claimed to move the energy to Oregon, then sold it back to California, billing the state twice. According to an Enron memo, Enron was paid “for moving energy to relieve congestion, without actually moving any energy or relieving any congestion.” Enron’s illegal dealings were exposed and it went bankrupt. Many of its 20,000 employees, who had been encouraged to buy Enron stock, lost their retirement savings.

Global Crossing, which developed fiber optic cable networks, falsely reported deals in which goods and services were supposedly traded, generating profit. The profits (which did not really exist) made the company appear more successful than it actually was, causing its stock to go up. Global Crossing’s criminal dealings were discovered, and it declared bankruptcy.

WorldCom, a telecommunications company, hid $3.8 billion in losses by recording daily costs as capital expenditures. This allowed the company to hide a large operating loss and make it appear to be profitable. Ultimately, WorldCom was found to have inflated its assets by $12 billion. It filed for Chapter 11 bankruptcy protection and changed its name to MCI. People who had bought WorldCom stock lost 100 percent of their investment; those who had bought WorldCom bonds were repaid 35.7 cents to the dollar-not in cash, but in MCI bonds and stocks.

Arthur Anderson, a large accounting firm that was supposed to be auditing many of these companies (making sure their recordkeeping was honest and accurate), was later convicted of obstruction of justice for shredding Enron-related papers. During this era accounting firms often caved in to pressure from their corporate clients to make the company appear profitable. When auditors saw an irregularity, instead of confronting the corporation (and possibly losing their business), they intentionally overlooked it and hoped no one would catch them. The massive wave of arrests for fraudulent bookkeeping, followed by bankruptcies and jail sentences for top executives, proved that someone was watching after all.