Accounting scandals occur when an entity, usually a corporation, but sometimes a government agency or charity, willfully and illegally alters its books for the financial advantage of the corporation or of some select group of individuals. These scandals often involve overstating assets or profits, hiding or understating liabilities, masking the actual structure of a corporation’s finances, or facilitating insider trading or other types of illegal or unethical financial transactions. Questionable accounting practices alone do not guarantee that scandal will erupt. Only when these practices are detected by investors, regulators, or watchdog groups do accounting scandals actually occur.
Market economies function well only when investors have access to accurate data about the finances of corporations in which they might choose to assume a stake. Corporations and their executives can derive personal advantage from manipulating information that is made available to investors. False information about a company’s value may drive up the firm’s share price, allowing insiders to sell their shares or cash in options for an inflated value. The scandal surrounding the 2001 collapse of Enron included this variety of malfeasance.
A common variety of scandal involves the willful misrepresentation of the financial health of a company. This may be done simply by keeping multiple sets of books, but modern accounting scandals of this sort have tended to revolve around more complicated practices. In some cases, two corporations will nominally exchange assets, and both will then be able to claim a financial transaction on their bottom line, while no real business has been done. Shell corporations are sometimes used to warehouse liabilities for a firm, allowing the books of the parent company to appear more solid than they actually are.
Other accounting scandals feature more outright fabrication. The collapse of Bernard Madoff’s financial empire revealed that the entire investment business was essentially a vast and carefully-orchestrated pyramid scheme. In this case, creative accounting had covered up the fact that Madoff’s company had never really engaged in market trading at all, but had simply used fund contributions from new shareholders to pay off older shareholders.
Accounting and audit firms are often employed to monitor the books of corporations. In the most severe accounting scandals, these firms may also be either complicit in the crime itself, or may simply fail to adequately monitor the finances of the firms under their supervision. Enron’s finances had been under outside observation, but this proved to offer no protection.
It is worth noting that accounting scandals can appear in any money-based economy, not merely a Western one. Mikhail Khodorkovsky, the wealthy Russian oligarch, obtained much of his first fortune through a complicated variety of currency exchange and creative bookkeeping, which may not have been against the letter of the law, but would certainly have been perceived as both illegal and scandalous by higher officials in the Soviet Union, had they known of it and understood it.