Market downturns have a way of exposing accounting frauds

Warren Buffet, the king of folksy, one-liner investment aphorisms, has one for the problems that a bear market can cause: "It's only when the tide goes out that you can see who has been swimming without their trunks on."

For the last seven years or so, companies have been swimming in a rising market tide with only some minor ebbs and flows along the way. But we all know that bull markets don't last forever, and this one is likely running on borrowed time. So what should we expect when the stock market retreats? If history is any judge, expect a raft of accounting troubles and scandals.

Difficult economic times and declining stock prices have a way of exposing accounting frauds that can go uncovered for years. During the last downturn that followed the financial crisis of 2007 and 2008, for example, we got one of the most breathtaking frauds ever perpetrated in the Madoff Ponzi scheme. Madoff admitted he’d been pulling the wool for nearly twenty years before the economic downturn exposed his crime.

swimming trunksOf course, the financial crisis exposed a series of Wall Street corruptions that brought down once venerable titans like Bear Stearns, Merrill Lynch, and Lehman Brothers. And while the implosion of those financial icons was stunning enough, it didn’t have much to do with accounting. Indeed, the last downturn was surprisingly devoid of accounting scandals. After all, the proceeding downturn that started in the summer of 2001 and accelerated in the summer of 2002 brought us the Mt. Rushmore of accounting scandals in Enron, WorldCom, Tyco, and Adelphia. We’d even have to carve out room to add in HealthSouth, and several others deserve dishonorable mention.

This Time Could Be Worse

There may be reason to believe a coming downturn in the stock market—whenever it happens—could be particularly pockmarked with accounting frauds. For one, the reason that the 2008 downturn didn’t produce the kinds of frauds we saw in 2002 and 2003 may be that those Enron-era scandals were still fresh in the minds of many executives. Many companies were still in the process of adopting the practices and processes required of the regulation that resulted from the corporate crime wave of the early 2000s—the Sarbanes-Oxley Act. Now 15 years on, those lessons may easily be forgotten. The regulation eventually becomes a check-the-box exercise that doesn't really guard against creative circumvention. It’s true, too, that companies have had to devote lots of their risk-management bandwidth to other worries, like cybercrime.

It may already be starting with the accounting stumbles of Valeant Pharmacueticals, Toshiba, and others. Another flash of potential exposure became evident today, with word that the Securities and Exchange is investigating the accounting practices of Chinese Internet search firm Alibaba. Is it a coincidence that the problems are emerging now, when the Chinese economy is showing several signs of weakness and stock prices have declined there?

The Lesson for Auditors

So what is it about a downturn that forces the dark arts of accounting manipulation into the light? One is the Peter-Paul principle. As conditions slowly worsen, companies stretch to make their numbers, robbing next quarter’s Peter to pay this quarter’s Paul. What starts as fudging the date on a sale that is nearly closed to move it into this quarter's revenue column becomes a panic to make up for it the next quarter. The stretch becomes more and more difficult until the downturn worsens and the gimmick is exposed. Signs that companies are stretching to make numbers are also evident. Studies show that the gap between GAAP earnings and the non-GAAP numbers that companies like to report is growing. Companies are prettying up their numbers by making adjustments that aren’t blessed by accepted accounting principles.

The lesson here for auditors is beware the bear and don’t stray too far from your financial reporting roots. The financial crisis put massive focus on the risk-management apparatus at most companies. And that’s a good thing. But recently, lots of stuff is getting tossed into that risk-management bucket. Cybersecurity? Fine. Compliance? Fine. Third-party risk management? OK. Global warming risk management? Social media risks? ...Can we get some help over here?

Senior management and boards are asking internal audit to do a lot of things, and that is also a good thing. But financial reporting assurance can’t become an afterthought. If it does, you’ll likely get exposed. And when the tide goes out, that warm sunlight will be shining on places where it hasn't shined before.