Today, the Securities and Exchange Commission sued Nortel Networks Corp. on charges of engaging in accounting fraud schemes. The charges include allegations of overstating revenue in 2000 to fool outsiders into thinking that the company was doing better than competitors during difficult market conditions.
The other scheme related to manipulating earnings to make it appear as if the company was profitable, when it was not. This manipulation caused the company to meet Wall Street’s expectations on paper for several years, when in reality the company’s figures were much poorer than represented.
This lawsuit by the SEC follows charges brought against four Nortel executives last month for manipulating reserves to increase earnings. The charges against the executives are related to their alleged assistance to Nortel’s former CFO Frank Dunn, who has also been charged, along with the company’s former controller, Michael Gollogly.
Schemes to inflate revenue and earnings figures are not new. They have seemed to be commonplace in publicly traded companies since at least the beginning of this century. But how do they escape the watchful eyes of auditors?
Simple. Probably the two biggest factors influencing whether or not an accounting manipulation will be discovered are the design of the audit and the collusion between employees (especially executives.)
Audits are not designed to detect fraud, pure and simple. They never were designed that way, and probably will not ever be. Quite simply, independent audits are done to check the math on the financial statements and determine whether accounting rules have been properly applied. They are not a search for fraud, and they never have been. The purposeful manipulation of financial statements by a dishonest employee is hard to detect with a traditional audit.
Collusion between employees makes fraud more difficult to find, especially when the employees colluding are executives, who have much access to data and control over the company. When working together, employees can more easily cover their tracks, making it next to impossible to discover a fraud. They are purposefully trying to avoid detection by auditors and are often successful, at least for some period of time.
In all, Nortel had to restate financial results going back to 1999, reducing sales figures by a total of $3.4 billion. The company has paid a fine in Canada, without admitting wrongdoing, and has also agreed to pay $2.4 billion to settle shareholder lawsuits related to the accounting scandal.
How do companies stop situations like this? By engaging in activities that proactively prevent fraud. This includes shoring up the controls over the accounting process and teaching employees about fraud. Most importantly, it is stopped by creating an ethical corporate culture in which fraud by no one, especially executives, is tolerated.