ACCOUNTING FRAUD

 

For companies and governments alike, massaging the numbers is a losing long-term strategy. When you have good accounting, you make good decisions. This is true for any organization in any sector.

Many Fortune 500 companies have learned the importance of transparency in financial disclosures—some of them the hard way. But the recent string of municipal bankruptcies, including Detroit, suggest that plenty of governments are still not convinced. And what they don’t believe can hurt them.

Rigorous accounting is the key to ensuring that capital is allocated in the right way. This is well-established when it comes to private enterprise, but it’s true for governments as well. There is plenty of evidence that strict reporting regulation improves public welfare.

So what should companies—and especially governments—be doing to increase transparency, boost investor confidence, and ultimately make better decisions?

Financial disclosure regulations exist for a good reason: they are essential for a successful stock market. After the stock market crash of 1929, a series of regulations were introduced to protect investors, and new rules were added over time to enhance transparency. It’s like the market for lemons.

Joon H. Kim, the Acting United States Attorney for the Southern District of New York, announced that a federal jury today found BRIAN BLOCK, the former chief financial officer of the publicly traded real estate investment trust (“REIT”) formerly known as American Realty Capital Partners (“ARCP”), guilty of inflating a key metric used to evaluate the financial performance of publicly traded REITs in ARCP’s filings with the U.S. Securities and Exchange Commission (the “SEC”).  BLOCK was convicted after a three-week trial before U.S. District Judge J. Paul Oetken.

 

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BLOCK’s co-defendant, former chief accounting officer Lisa McAlister, pled guilty to securities fraud and related charges on June 29, 2016.           

Kim said:  “As a unanimous jury found today, Brian Block, the former CFO of ARCP, intentionally misled investors by overstating the health and profitability of his company.  This trial revealed that when it looked like ARCP would not meet investors’ expectations, Block made up numbers and fudged the books.  The integrity of our markets rests on the truth of the financial information provided to investors.  And those like Block who lie and manipulate the markets must be identified and held to account.”

According to allegations contained in the Indictment and evidence presented during the trial in Manhattan federal court:

In 2014, ARCP was a publicly traded REIT headquartered in Manhattan, New York.  ARCP’s securities traded under the symbol “ARCP” on the National Association of Securities Dealers Automated Quotations (“NASDAQ”) exchange.

ARCP, like many REITs, measured its financial performance through metrics besides, or in addition to, traditional measurements of company performance calculated using Generally Accepted Accounting Principles (“GAAP”).  ARCP calculated and reported to the investing public a non-GAAP measure called adjusted funds from operations, or AFFO, which was designed to more accurately reflect ARCP’s cash flow and financial performance by presenting ARCP’s income before consideration of non-cash depreciation and amortization expense and by excluding certain one-time charges and expenses.  REITs such as ARCP commonly reported their AFFO figures, including AFFO per share, to the investing public and in filings with the SEC.  ARCP also provided forward-looking guidance to the investing public regarding their anticipated AFFO performance in upcoming time periods.      

Prior to the filing of ARCP’s Form 10-Q setting forth ARCP’s financial statements for the second quarter of 2014 (the “Second Quarter 10-Q”), BRIAN BLOCK, along with Lisa McAlister and others, came to understand that the method used by ARCP to calculate AFFO in the first quarter of 2014 and in certain previous quarters was erroneously inflated.  Another employee of ARCP (“CC-1”) had brought this methodological error to the attention of BLOCK, McAlister, and others shortly before the filing of ARCP’s first quarter 2014 10-Q (the “First Quarter 10-Q”), but no corrective change was made to the First Quarter 10-Q while the issue was under review.  Following the filing of the First Quarter 10-Q, CC-1 concluded, and advised BLOCK, McAlister, and others, that the reported AFFO per share calculation for the first quarter of 2014 was overstated by approximately $0.03 per share.  Instead of $0.26 per share, which was publicly reported by ARCP to its shareholders and the investing public, and which placed ARCP on track to meet its full-year AFFO per-share guidance, the correct AFFO for the first quarter of 2014 was $0.23 per share.  

Despite his knowledge of a material error in ARCP’s previous filings with the SEC, BRIAN BLOCK took no steps to advise the Audit Committee of ARCP’s Board of Directors, or ARCP’s outside auditors, of the error in the First Quarter 10-Q.  Moreover, BLOCK, McAlister, and CC-1 then knowingly facilitated the use of the same materially misleading calculations in ARCP’s Second Quarter 10-Q.  For example, on or about July 24, 2014, a draft of ARCP’s Second Quarter 10-Q was circulated to members of ARCP’s Audit Committee.  The draft included an AFFO calculation for the six-month period ending June 30, 2014, that incorporated AFFO figures from the first quarter of 2014 that BLOCK, McAlister, and CC-1 knew to be erroneously inflated.

On or about July 28, 2014, BLOCK met with McAlister and CC-1 in his office in Manhattan for the purpose of finalizing the financial figures that were to be included in ARCP’s Second Quarter 10-Q.  Utilization of a proper method to calculate ARCP’s second quarter 2014 AFFO would have exposed that the reported AFFO and AFFO per share figures from the first quarter were inflated.  Accordingly, during the meeting, BLOCK, McAlister, and CC-1 inserted into a spreadsheet BLOCK was using to calculate AFFO and AFFO per share for the first and second quarters of 2014 and for the first six months of 2014 (“YTD 2014”) figures that fraudulently inflated the AFFO and AFFO per share calculations that were to be included in the Second Quarter 10-Q and the related ARCP press release.  The fraudulent numbers BLOCK, McAlister, and CC-1 used to inflate the AFFO and AFFO per share figures had no basis in fact, were without documentary support, and did not tie to ARCP’s general ledger accounting system, as BLOCK knew and understood at the time.  The fraudulent numbers included in the spreadsheet prepared by BLOCK were then incorporated into ARCP’s Second Quarter 10-Q, which was filed with the SEC the following day.  As a result of the manipulative efforts of BLOCK, McAlister, and CC-1, ARCP’s SEC filings included AFFO and AFFO per share figures for the second quarter of 2014 and for the first six months of 2014 that were fraudulently inflated.    

The Second Quarter 10-Q was signed by, among others, BRIAN BLOCK.  Additionally, on a certification accompanying the 10-Q, BLOCK falsely certified, among other things, that the Second Quarter 10-Q did not contain any materially untrue statements or material omissions.  He further falsely certified that he had disclosed to ARCP’s auditors and the audit committee of its board of directors: “Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal control over financial reporting.”  In a second certification accompanying the 10-Q, BLOCK falsely certified that: “The quarterly report on Form 10-Q of the Company, which accompanies this Certificate, fully complies with the requirements of Section 13(a) or 15(d) of the Securities Exchange Act of 1934, and all information contained in this quarterly report fairly presents, in all material respects, the financial condition and results of operations of the Company.”

With regard to YTD 2014 specifically, the fraud resulted in an intended overstatement of AFFO by approximately $13 million and an intended overstatement of AFFO per share by approximately $0.03, or approximately 5% of total AFFO per share.  By reporting AFFO per share of $0.24 in the second quarter, after having reported AFFO per share of $0.26 in the first quarter, BRIAN BLOCK and his co-conspirators misled ARCP’s shareholders and the investing public by falsely representing that ARCP’s AFFO per share for the first six months of 2014 was consistent with analysts’ expectations and on track to meet ARCP’s guidance for AFFO per share for calendar year 2014, when in fact, they were not.

Without reliable, transparent and accurate disclosure, the market breaks down.

But transparency benefits companies as well as investors. A number of studies have shown that investors are more willing to buy stock in a company when they have a clear understanding of the company’s finances. So while it may be tempting for business leaders to manage for the short term by massaging their numbers before the disclosure deadline, ultimately that can be a losing strategy.

It’s like managing a persona or the perfect profile. It’s unsustainable. It’s better for business leaders to accept that investors are sophisticated and to think from their perspective. If you put yourself in the shoes of an investor and ask, ‘What would I want to know about this company?’ rather than sticking to what’s required under regulation, I think that would improve your firm’s position in the market.

Plus, transparent accounting has the added benefit of helping organizations develop more effective long-term strategies. When organizations are rigorous with their accounting, they know better how to allocate resources and plan for the future.

The same principle holds for government accounting. When accounting information is inaccurate or incomplete, states and cities will make bad financial decisions. Understating the cost of employee pensions not only leaves state pensions underfunded—it also leads states to overestimate how many workers they can afford going forward, thereby exacerbating fiscal problems. It’s similar to a CEO who believes his own inflated numbers. It compounds any financial problems.

One way organizations can ensure accurate and transparent accounting is to remove the incentives leaders have to manage for the short term. This means avoiding a system that rewards biased disclosures.

If you are the CEO of a company, the incentives you have for your executives should never be only tied to short-term financial results that are reported externally, such as earnings reports. They should be based on internal metrics, especially those that can be tied to long-term value creation.

Businesses can always say, ‘the success of our company is tied to activity x,’ and they can create incentives to promote that activity. Focusing on the short term is an even bigger problem when it comes to government accounting, since politicians often have greater incentives to cut corners, overpromise, and scrub losses from the books.

There also seem to be fewer consequences for public sector distortions. Most serious accounting scandals, from Enron and Worldcom in the early 2000s to more recent cases such as Autonomy and Toshiba, involved the use of accounting gimmicks to boost profits. In each case, executives faced substantial fines and even jail time. In contrast, when states use accounting gimmicks, politicians are rarely held accountable. For example, when a recent accounting gimmick employed by Illinois reduced its pension obligation by $6–$8 billion, no public official faced any adverse consequences.

Individual politicians face such limited consequenes that there’s almost a reward for accounting gimmicks. This is why states and municipalities should begin to adopt private sector accounting norms for budgeting purposes—specifically, accrual accounting, which more accurately reflects the long-term situation of a government or business than cash flows. A government’s source of revenue may be different from that of a business, but both share the same financial objectives. And a well-run government can decrease taxes, which is the equivalent of a dividend payout.

The best financial decisions are made when those who crunch the numbers are distinct from those who set an organization’s strategy. So independence between accounting and decision-making is key. Financial reporting should be about the state of the firm or the government, not the CEO’s or the governor’s narrative of the firm or the government.

In the for-profit sector, a lot of financial reporting regulations are designed to minimize the discretion in what companies report. Companies not only get audited, but there is also the Public Company Accounting Oversight Board (PCAOB) that verifies that audits meet certain standards.

For states and municipalities, the picture looks quite different. Elected officials often work on a budget without independent oversight. One solution could be to have an independent agency responsible for communicating to politicians what their proposed plans would cost—something similar to the service that Congressional Budget Office provides at the federal level. Currently, each state manages its budget in its own way, which can lead to extreme variation in accounting practices, and occasionally some very fuzzy math.

Businesses and governments operate under different constraints and toward different purposes. But the upshot is that transparency is critical to any organization that wants to spend money wisely. Accounting helps you know what’s working, and what you need to improve. Whether you want to increase your market share or improve public welfare, transparency can help.

The largest international accounting firms have no trouble attracting applicants despite the intense workload and stressful selection process. In fact, quite the opposite: the up or out  system may well be the key motivating factor for employees. 

Technical ability and accounting know-how have become secondary skills since the introduction of standardized methods of auditing. Firms hire non-specialist graduates who are not always particularly interested in the job per se but are keen on pursuing career opportunities, elitism and prestige. Interpersonal skills then become more important than professional expertise if you want to make progress: you need to make sure that you are selected, work with the right people and develop good relations. This political aspect, which can be found in many companies, is even more striking in the Big Four since the “up or out” system organizes competition into a formal framework. Co-workers are ranked against each other on an annual basis, separating employees who are allowed to pass to the next grade from those who are asked to leave.

The social interactions create an internal market that puts a price on the reputations of individuals. This is used to identify “cooptable” profiles (who will be promoted) and exclude others, such as women who have had children. Mothers are asked to undertake assignments less often, their power relationships are diluted and it is not long before they stop making progress. In spite of certain initiatives to encourage equality (such as crèches and coaching), no more than 17% of partners on average are women with children.

The managerial approach in the Big Four is both highly structured and highly structuring. As well as being a source of motivation, excitement and rivalry, selection generates anxiety and frustration. It is a demanding and sometimes exhausting process, which auditors often compare to sport. The interviews conducted by Stenger show that motivation does not simply boil down to the salary, interest in the work or career ambitions; it is rooted in the desire for recognition. The experience is valued for itself because it generates the feeling of belonging to a select elite. This membership group is not defined by the profession itself but by submitting to a challenging and competitive system. Prestige is derived from the competition that serves as the basis for the group’s superiority. The ability to withstand stress, fatigue and a substantial workload helps determine the value of the experience. “Being snowed under” is a sign of social superiority in the same way as “pulling an all-nighter” is regarded favorably. Anyone who refuses to bow to the pressure is punished and pushed aside. As a result, the group tends to turn in on itself, and the social existence of the auditors becomes dependent on their place in the firm.

Once an auditor has been asked to quit a leading firm, he or she usually joins the finance department of a top company. Many feel as though they have suffered a loss of status. In any event, former auditors have an ambivalent relationship to their old firms: they might have an emotional pull towards this intense period of suffering and stimulation at a time in their lives when they were forging strong relationships. Nevertheless, most tend to remember it as an abnormal existence, which they describe as “not being like real life”. Stenger demonstrates how the relationship to work is reconfigured according to gender and social background after an auditor has left a firm. He distinguishes three different character types in this conversion: the “integrated-detached” (who accepts that opportunities for promotion in the firm are finished without too much dismay); the “withdrawer” (the auditor who suddenly removes him or herself from the competition); and the “true believer” (whose self-esteem is heavily dependent on his or her position in the firm and who sees the end of promotion as a failure).

The individuals who do best are those who manage to retain an alternative set of values to the firm’s together with a social life that bolsters their self-esteem and whose family, spouse or other relations do not set great store by their experience in the firm. It should be clear that an auditor’s perspective is heavily shaped by their previous educational experiences, mostly in preparatory classes and in the Grandes Ecoles where intelligence is associated with quick thinking and a thirst for work for work’s sake, regardless of concrete outcomes. In such a context, an auditor’s professional rationale, or her valuing of her own independence and expertise, may take second place to and be weakened by commercial and social rationale.

Discount rates and risk: Frequent mistakes in discount rates and risk occupy the first section. For example, calculating “risk” for a public company’s stock price with historical data on volatility (i.e., beta) is a bottomless well of confusion.

Cash flows: It is wrong to consider the increase of liquid assets as cash flow for shareholders, among other things.

Terminal value: Here we shine a light on the use of inconsistent cash flows to calculate perpetuity and the inappropriate use of arithmetic averages (in lieu of geometric averages) to estimate growth.

Inconsistencies and conceptual errors: As an example for this section, we recall a company that registered a large volume of oil sales in Russia, where it intended to build a plant. According to an investment bank, the net present value of future investments should be considered zero, thus mistakenly disregarding the cash flows deriving from future investments.

Interpreting valuation: Valuations are contingent upon a series of expectations (re: the company’s future, the industry’s, the country’s and the global economy’s) and also upon estimations of the company’s risk.

A prime example here is confusing “value” with price. Value always depends upon expectations, and thus a company’s value will vary from one buyer to another. Meanwhile, the price is whatever ends up being paid following a negotiation or depending on the dynamics of the market.

Interpreting accounting: In terms of errors in this section, we include the tendency to confuse net profits and cash flows. We also cite the mistaken belief that a company’s equity or capital somehow determine its stocks’ value.

Organizational missteps: Finally, we delineate organizational problems, including making valuations without reviewing the forecasts of the client and assigning an economics professor to the task who doesn’t have real-world business experience.

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