What is accounting fraud?

Picture of Mark Jolley
Posted by Mark Jolley

(Updated Nov. 13, 2023 to add role of subsidiaries in "What is equity accounting" section)

Almost everyone has a fair idea what is meant by accounting fraud. It occurs when accounting records, financial statements or tax returns are manipulated to make a company's financial condition appear better than it actually is. It’s pretty simple. 

Or is it?

Upon deeper inspection, accounting fraud is difficult to pin down because different agents have different interpretations of what it actually means.

Table of contents

  1. Part 1: Defining accounting fraud
  2. What accounting practices are illegal?
  3. Misappropriation of assets
  4. History: Enron collapse
  5. Legal definition of accounting fraud
  6. Part 2: Accounting fraud in the finance industry
  7. Why we lie
  8. How much account manipulation is excessive?
  9. What is account manipulation
  10. What is equity accounting
  11. Case study: Alibaba
  12. What is account misstatement
  13. Conclusion: Legal or illegal?

Part 1: Defining accounting fraud

Since fraud is a criminal activity, some like to focus on a narrow legal definition of accounting fraud. Others, notably investors and creditors, take a wider view because all types of account manipulation, whether legal or not, are typically detrimental to a company’s future performance. 

Most financial market participants, therefore, interpret excessive manipulation as fraudulent, regardless of its legality.

For those taking a wider interpretation, accounting fraud is difficult to put neatly in a box because accounting is part science and part art

Every company has considerable discretion in the way it reports its numbers. Just as everybody lies, even if only a little bit, all companies massage their numbers to a certain extent. Some massage their numbers more than others. 

This is accepted practice but there is general understanding that a distinction exists between aggressive accounting and accounting fraud. There is a line that signifies the boundary between the two. 

That line, however, varies considerably among investors and creditors. Some are more tolerant of account manipulation than others. As a consequence, there is no precise taxonomy of accounting fraud once we move beyond a strict legal interpretation. It becomes a judgement call.

Even those who adopt a strict legal interpretation will find that the line between aggressive accounting and accounting fraud is blurred because the law itself is nuanced. Although most companies charged with accounting violations agree to pay fines, very few are ever indicted, put on trial, and jailed. 

Relative to the reported prevalence of accounting fraud, in which one in 10 public companies are thought to commit securities fraud each year, admission of guilt is rare and criminal charges even rarer. 

This pattern applies to all areas of white-collar crime. According to the US Department of Justice, the annual losses from white-collar crimes are estimated at between US$426 billion and US$1.7 trillion per year. 

Meanwhile, the FBI estimates that property crime, otherwise known as street crime, costs a mere US$16 billion per year. In a nation with a prison population of more than 1.2 million, there were only 4,180 white-collar prosecutions in 2022. The vast majority of these were for employee theft, money laundering or embezzlement, not for accounting manipulation. 

In the whole of 2022, the US Department of Justice tried just 72 individuals for fraud and convicted 56 at trial. On our best efforts, we could find only one case of accounting fraud leading to incarceration, that being Frank Okanuk, the former CFO of the PR firm Weber Shandwick. However, this case was more about embezzlement than account manipulation. 

Of course, the FTX saga was major news in 2022 and Sam Bankman-Fried was indicted. But once again, this case looks to be more about embezzlement than account manipulation.    

The point we are trying to make is simply this: if one sticks to a strict legal interpretation of accounting fraud, meaning a criminal act that leads to prosecution and incarceration, one is drawn to the conclusion that criminal accounting fraud virtually never happens. Only the direst cases leading to corporate collapse typically result in criminal charges.

Once we move away from a strict legal interpretation, it matters little whether or not a company is breaking the law because only in exceptional cases will we ever know for certain. What really matters is the extent to which a company’s accounts distort its true financial condition. 

Coming to terms with financial fraud is a journey of discovery. The assessment of accounting fraud is never black and white. It is a matter of degree, a probabilistic investigation requiring the exercise of considerable judgment. This is what makes the field so fascinating to those engaged in it.

Back to top

What accounting practices are illegal?

If asked, most people would probably say that a company commits accounting fraud when it begins to engage in illegal accounting practices. 

Most would likely want to change this definition upon learning that up to 40% of public companies commit accounting violations each and every year. 

Illegal accounting practices consist of either misstatement arising from fraudulent financial reporting or misstatement arising from misappropriation of assets. In serious cases of fraud, the two will co-exist.

According to the Public Company Accounting Oversight Board (PCAOB), the arbiter of correct international accounting practice, misstatements arising from fraudulent financial reporting are:

Intentional misstatements or omissions of amounts or disclosures in financial statements designed to deceive financial statement users where the effect causes the financial statements not to be presented, in all material respects, in conformity with generally accepted accounting principles (GAAP).

Misstatements would include:

  • Manipulation, falsification, or alteration of accounting records or supporting documents from which financial statements are prepared;
  • Misrepresentation in or intentional omission from the financial statements of events, transactions, or other significant information; or
  • Intentional misapplication of accounting principles relating to amounts, classification, manner of presentation, or disclosure.

Once again deferring to the PCAOB, misstatements arising from misappropriation of assets, “involve the theft of an entity's assets where the effect of the theft causes the financial statements not to be presented, in all material respects, in conformity with GAAP.

Misappropriation of assets

Misappropriation of assets can include:

  • Embezzling receipts;
  • Stealing assets; or 
  • Causing an entity to pay for goods or services that have not been received.

Misappropriation of assets is essentially theft and is far easier to prosecute than fraudulent financial reporting, where a material misstatement might be rationalized as an aggressive rather than indefensible interpretation of complex accounting rules, or as an error. 

Thus, for example, in the ongoing Wirecard and FTX cases, prosecutors will likely pursue evidence of  misappropriation of assets with greater vigour than fraudulent accounting. 

In the eyes of the law, the mere fact that accounts have been “indefensibly misstated” does not mean that criminal accounting fraud has taken place.  

To be subject to criminal prosecution, prosecutors must demonstrate that the manipulation was a) deliberate, and b) undertaken for personal or corporate financial gain. In other words, a successful prosecution needs to demonstrate reasonable evidence of intent and this usually requires motive and hence evidence of material gain.

The standard defence in a fraud case isn’t that fraud didn’t happen; it’s that the perpetrator didn’t know they were breaking the law.

Given the complexity of accounting rules, it is exceptionally difficult to prove intent. Thus, even in the case of Marvell Technology, the Department of Justice did not press criminal charges even though the company admitted fault in the matter of the backdating of options and restated earnings by more than US$300 million.

Unless it leads to collapse, proving fraudulent financial reporting in a strict legal sense is equivalent to proving the existence of ghosts

Unless fraud leads to collapse, proving fraudulent financial reporting in a strict legal sense is equivalent to proving the existence of ghosts. 

Back to top

History: Enron collapse

Enron, FTX and Wirecard all resulted in criminal charges because these companies collapsed. Once a company collapses, liquidating auditors can dissect a company’s books, uncovering evidence that financial statement auditors can only dream of.  

When offenders are indicted, they are not charged on the basis that they breached a particular accounting rule, they are charged on a breach of the criminal code, which varies from country to country. 

In the US for example, prosecutors rely on securities law, and the wire fraud and bank fraud statutes within the criminal code. Cases involving the misappropriation of assets can be prosecuted as embezzlement under State or Federal law, sometimes both, depending on ease of likely prosecution. 

For example, the former Chairman and CEO of Enron was charged with conspiracy to commit securities fraud, four counts of securities fraud, two counts of wire fraud, one count of bank fraud and three counts of making false statements to a bank. 

Front page image of the Houston Chronicle newspaper proclaiming the guilty verdict on Enron's former heads Kenneth Lay and Jeffrey Skilling

Securities fraud occurs when an agent induces investors to make purchase or sale decisions on the basis of false information. 

Wire fraud occurs when a person intentionally and voluntarily uses a communication device that sends information over state lines as part of a scheme to defraud another out of money or other valuables. It can involve the use of a landline telephone, cell phone, computer, or any electronic device. 

Bank fraud includes any “scheme or artifice” intended to “defraud a financial institution,” or the use of deceptive means to obtain something of value that a financial institution owns or controls. 

In every legal action involving accounting fraud, the original accounting infringement(s) are quickly lost in legal technicality and the process of law.

In 99.9% of cases, companies pay fines when caught (and a clear infringement occurred) but unless a misappropriation of assets can be demonstrated, indictment is exceptionally rare.

Legal definition of accounting fraud

In summary, the legal definition of accounting fraud as applied by auditors is not directly relevant if prosecutors wish to press criminal charges. Offenders are never prosecuted for illegal accounting practices. 

In every jurisdiction, individuals are charged under separate criminal codes and statutes that were not designed for the complexity of accounting. Rather, they were designed for the complexity of the law. To be sure, accounting law is taken into consideration, but perpetrators of accounting fraud are not tried on accounting regulation.

Even in law, accounting fraud is a much broader concept than the illegal misstatement of financial accounts. It is a question of intent to deceive, the extent of damage inflicted by the deception and the monetary gain sought and received by the perpetrators.

Under the strict definition of accounting fraud, the extent of fraud does not matter. What matters is how a company misstates its accounts.

Under the strict definition of accounting fraud, the extent of fraud does not matter. What matters is how a company misstates its accounts. A company that inflates earnings by 0.1% might have committed accounting fraud under a strict interpretation whereas a company with more aggressive accounting that inflated earnings by 200% might not have committed accounting fraud.  

However, if both of these companies were to collapse you can bet that a law court would be more likely to find the latter guilty of fraud than the former.

Thus, while accounting fraud is a legal concept used by regulators to charge companies and individuals for illegal accounting practices, it is not used to prosecute fraud under criminal law. 

Under criminal law, aggressive accounting might be considered illegal if it intentionally deceived investors or creditors, if it harmed investors or creditors, or if it delivered specific financial benefit to the offenders. 

Back to top

Part 2: Accounting fraud in the finance industry

In the world of finance, agents do not care about legal distinctions between aggressive accounting and accounting fraud, they care about the extent to which account manipulation affects the risk of investing in or lending to a company. 

Since account manipulation artificially raises current profit at the expense of future profit, absorbs working capital and hides balance sheet weakness, it always affects the risk of investing in or lending to a company. It is deceptive and always represents a risk of accounting fraud.

Moreover, companies that pursue aggressive accounting practices can follow the letter of the law while deviating widely from the spirit of accounting rules. In this era of socially responsible investing, account manipulation is an ethical concern and a matter of trust to professional investors and creditors. It is much more than a legal issue. 

In the world of finance, all account manipulation is undesirable and more manipulation is worse than less. 

If we accept that a company can be ethically fraudulent before it breaches a legal technicality, we must also accept that the line between aggressive accounting and fraudulent accounting is meaningless. In the world of finance, all account manipulation is undesirable and more manipulation is worse than less. 

The danger, from the perspective of a creditor or investor, is that account manipulation can be a slippery slope. The fear is that minor manipulation today will lead to greater manipulation in subsequent years. 

We see this pattern of escalation time and again in some of the biggest cases of accounting fraud over the past half century; good companies turning bad partly due to increasingly aggressive accounting practices. Enron, WorldCom, Parmalat, Tesco, and Valeant Pharmaceuticals are good examples of this pattern. The list is long. 

Why we lie

Neurological research supports the contention that aggressive accounting can be a gateway drug to accounting fraud. Physiological studies of the brain show that lying becomes easier the more we lie and thus lying tends to be habit forming.

The study of lying within organizations is comparatively new. Psychologists have tended to focus on the study of deception in children. Anyone with a child will understand why. Interestingly, the first systematic observations of lying were undertaken by Charles Darwin on his own child. He was fascinated by his child’s incessant lying.

A pattern of lying, even small lies, by an organization’s leader can have a big impact on the organization’s culture

Nevertheless, a growing body of evidence suggests that a pattern of lying, even small lies, by an organization’s leader can have a big impact on the organization’s culture. In other words, small lies tend to encourage dishonesty.

Research in accounting has typically focussed on the ‘fraud triangle.' Under the fraud triangle, corporate fraud requires each of the following circumstances to prevail: (i) motivation/pressure; (ii) opportunity and (iii) rationalisation of actions.

In the context of the fraud triangle, even a small amount of manipulation will tend to foster increasing future manipulation because opportunity and rationalization become easier as a corporate culture becomes desensitized to dishonesty. Moreover, motivation/pressure will build over time because every accounting manipulation technique boosts current profit at the expense of future profit.

Financial markets are lubricated with trust. Once a company is suspected of account manipulation, investors will typically extrapolate the problem. Accenture’s Competitive Agility Index, a 7,000-company, 20-industry analysis, has been used to  quantify how a decline in stakeholder trust impacts a company’s financial performance. 

Following a material drop in trust, a company’s agility index score fell 2 points on average, negatively impacting revenue growth by 6% and EBITDA by 10% on average.

To summarise, in the world of finance all accounting manipulation represents a risk of accounting fraud. It boosts current profit at the expense of future profit and is undesirable because it lowers sustainability, raises financial risk and sets a precedent which can lead to increasingly severe manipulation over time. 

Back to top

How much account manipulation is excessive?

A zero-tolerance approach to account manipulation is impractical because all companies manipulate earnings to some degree. Companies need investors. The role of the CEO is to present the financial performance of a company in the best possible light so as to attract investors. This practice is well understood and accepted. Were it not so, investor relations would not report to the CFO.

In their efforts to present their company in the best available light, CFOs can use a variety of perfectly legal methods to allow premature revenue recognition, defer costs and lower the apparent cost of funding assets. 

The list of options is long and a good CFO can often pursue these options simultaneously within the letter of GAAP.  

However, the more a company manipulates revenue or expenses, the more its future results will be affected and thus the more a company is misrepresenting its true financial position. The more a company manipulates today, the greater the pressure to manipulate even more in the future.

Accounting fraud is a matter of degree. The more aggressive a company’s accounting, the more it manipulates accounts, the greater the risk that a company will be a poor investment or credit risk.

A company might be considered fraudulent when we stop investing in or lending to it from fear that its account manipulation might have undesirable financial consequences. 

In practical terms, a company might be considered fraudulent when we stop investing in or lending to it for fear its account manipulation might have undesirable financial consequences. This is a matter of judgment.

A priori, an external observer cannot say which companies are breaking legal technicalities. However, forensic accounting can assess whether a company shows evidence of potential manipulation across a number of fronts.  Using forensic accounting and the number crunching ability of modern data science, software can compare the risk of fraud across companies. 

Any company displaying above average account manipulation risk on an accounting fraud detection platform has potentially crossed the line from aggressive to fraudulent accounting. Every investor or analyst will have varying appetites for accounting manipulation risk and each can employ their own judgement.

What is account manipulation

Accounting fraud can occur anywhere in a company’s financial statements but is most commonly occurs in the income statement and the balance sheet.  In other words, revenue, expenses, assets and liabilities are the items most commonly affected. 

There are many, many types of accounting fraud and we can’t examine them all here. Our intention is simply to give a sense of what accounting fraud looks like.

From the outset, we must distinguish between account manipulation and account misstatement. 

Account manipulation occurs when accounting discretion is used to improve or change the impression given by a company’s accounts, for example, to boost earnings. Done properly, account manipulation is perfectly legal. Done improperly, account manipulation becomes account misstatement.

Account misstatement is an incorrect statement or the giving of false information. It is a factual error in the accounts which could be accidental or intentional.  

Many forms of account manipulation reflect accounting decisions that are perfectly allowable within the rules of GAAP. Frequent forms of manipulation relate to:

  • the timing of revenue or expense recognition
  • the re-valuation of assets and obligations
  • the treatment of income from related businesses
  • the treatment of non-cash expenses such as depreciation and amortization 
  • the reporting of related party transactions. 

For example, a company might use accruals to recognize revenue before a product has been delivered. Property companies are a great example. They typically book sales well before apartment construction is completed. 

This is a great way to boost earnings because revenue is recognized sometimes years before the expense associated with the sale is recorded. As you can imagine, this can inflate earnings and gross margin to a wondrous extent. 

The practice works well in a growing real estate market but typically leads to dire results in a property market downturn.  This is why real estate companies the world over collapse with great regularity. 

This example also illustrates how account manipulation weakens a company’s true financial situation. Anything that makes the accounts look better today will cause them to be worse in the future.

What is equity accounting

Asset valuations are another popular avenue for account manipulation, especially equity investments using the equity accounting method.

When a company invests in a new product or buys another business it can choose to buy it entirely and incorporate the business within its own accounts, buy more than 50% and run it as a subsidiary, or it can acquire between 20% and 50% and keep it as an equity investment on its accounts.  

In Asia, it is very common for entrepreneurs to invest alongside their companies in equity investments. 

The choice of acquisition methods typically says volumes about the way a company manages its accounts. Companies with conservative accounting will typically just fold acquisitions and investment in innovations into their existing business.  

Companies with aggressive accounting will prefer to keep investments at arms-length, either as subsidiaries or as equity investments. They like to develop new businesses as a JV or some other kind of start-up. We have documented the role of subsidiaries in accounting manipulation in a separate article.

Companies that practice aggressive accounting will typically use the equity accounting method for subsidiaries (where it is optional) and equity investments (where it is compulsory). Under equity accounting, the initial investment is recorded at cost and each reporting period adjustments are made, depending on the assessed value of the investment at the end of the period. Any profit or income on the investment will also reflect in changes in the value of the investment in direct proportion to the ownership percentage.

Think of how many songs you have heard in your entire life, multiply by 1,000, and this will approach the number of options for creative accounting available to an enterprising CFO. 

As you might imagine, this of kind of set-up allows tremendous scope for account manipulation. Think of how many songs you have heard in your entire life, multiply by 1,000, and this will approach the number of options for creative accounting available to an enterprising CFO. 

Back to top

Case study: Alibaba

In its filing for the December quarter of 2020, the Chinese eCommerce giant Alibaba reported quarterly net income of US$12.2 billion. 

This figure included valuation gains (asset write-ups) worth a staggering US$5.7 billion. Separately, the company reported income of US$735 million under equity method accounting from its 33% stake in Ant Group. 

In other words, the revaluation of assets and reporting of income from equity investments represented more than half the company’s reported earnings. 

From the time of its IPO in September 2014 until December 2020, Alibaba reported more than US$60 billion of asset write-ups, representing almost three quarters of its retained earnings at the time. Based on its accounts, Alibaba was essentially a private equity investor with a sideline in e-Commerce. 

Alibaba was a market darling for many years. Investors, bankers and analysts did not care that so much of the company’s reported income and indeed that so much of its balance sheet was concentrated in assets that nobody except the senior management at Alibaba were in a position to value.  

From the outside, this situation was cheered by analysts and investors alike. It reflected extremely aggressive accounting by any standard. Under conservative accounting principles, a company should report the lowest possible profit. Thus, while Alibaba's accounting may have been legal, some would say the company contravened the spirit of accounting principals. 

Companies with aggressive accounting practices frequently control a large number of separate entities. By late 2020, Alibaba had more than 350 subsidiaries and innumerable equity investments. You can imagine how difficult it might be for an auditor to track the value, income and potential related party transactions of such a complex entity. 

Typically, the smaller the company, the more aggressive the accounting. Equity accounting effectively allows a company to outsource its account manipulation.

We have shown two simple examples of account manipulation. In these examples, companies used discretionary accounting decisions to paint their financials in the best available light. 

Alibaba, for example, could have chosen to revalue its equity investments more conservatively. Chinese property companies did not have to use accruals quite so aggressively.

A high level of equity investment typically lead to a high volume of related party transactions. Prior to its aborted IPO, Ant Group generated about 60% of net income from related-party transactions with Alibaba and other related groups. As noted, 33% of this net income was then reported as profit for Alibaba, reflecting its ownership share. 

This all makes for highly complex accounts and tremendous opportunity for massaging of the accounts. This might be perfectly legal but goes against the spirit of conservative accounting principles.

What is account misstatement 

Account misstatement is an incorrect statement or the giving of false information. It is a factual error in the accounts which could be accidental or intentional.   

Material misstatement occurs when the financial statements presented by a client that are not in conformity with Generally Accepted Accounting Principles, in all material respects, and indicate the auditor's belief that the financial statements, taken as a whole, are materially misstated.

In other words, account misstatement occurs when the accounts are either fabricated or just plain wrong for some reason. 

There are a million possibilities for account misstatement, including: 

  • overstating revenue
  • understating expense
  • fictitious sales and expenses
  • incorrect timing of revenue or expenses
  • concealment of liabilities or obligations
  • improper or inadequate disclosures
  • misappropriations

To pick one of these, fictitious revenue involves claiming sales that did not occur. Common examples would include double-counting sales, creating phantom customers or overstating or otherwise altering the legitimate invoices of existing customers. 

Companies that undertake this kind of fraud sometimes reverse the false sales at the end of the reporting period to help conceal the deceit. 

Remarkably, this is what Wells Fargo did in a fraud case that surfaced in 2016. Wells Fargo employees were given impossible sales goals. To meet targets, employees created millions of checking and savings accounts on behalf of clients — but without their consent. The accounts were then cancelled after the reporting period.

A good example of a somewhat more elaborate misstatement is channel stuffing, in which a company ships more goods to distributors and retailers along its distribution channel than end-users are likely to buy in a normal inventory cycle. 

This is usually achieved by offering deep discounts, rebates, and extended payment terms, to persuade distributors and retailers to buy quantities in excess of their current needs. In most cases, distributors retain the right to return any unsold inventory which makes it dubious that a final sale has occurred. 

Unless fully documented, channel stuffing is considered illegal. It helps to boost sales and profit numbers, sometimes for as long as 6 to 9 months.  It is typically evidenced by a sharp jump in accounts receivable. Since channel stuffing comes at the expense of future sales, it always leads to a deterioration in financial performance.  

A very simple example of expense misstatement would be to an operating expense as capex. Thus, the expense is capitalized and becomes a depreciation expense, realized slowly over time, rather than an operating expense that is recognized immediately. 

Agricultural businesses, miners and companies with a lot of R&D have been notorious for this kind of expense manipulation in the past. 

Conclusion: Legal or illegal?

In summary, companies can manipulate their accounts in many ways. Manipulation can be legal or illegal. If it breaks the principles of GAAP or involves misstatement, it will be considered illegal. 

Only rarely can we detect when a company is engaged in misstatement from examining its public records. However, evidence of aggressive account manipulation can be observed by careful analysis of a company’s statements. 

The more conservative is a company’s accounting, the less likely it is that it will be engaged in accounting fraud. The more aggressive the account manipulation, the greater the risk of fraud because aggressive accounting worsens a company’s financial condition over time and conditions management and employees to engage in dishonest practices. 

Forensic accountants are able to uncover companies with a high risk of account manipulation. Fraud-detection software can perform the same task but by looking at thousands of companies at once.

Subscribe to our blog