Welcome back to the Deep Dive. I have to say,
looking at the stack of research we have on the
desk today, I feel like we need to put on some
latex gloves. Ha! Yeah, this is not a clean subject.
Not at all. We are digging into something that,
on the surface, seems incredibly dry. You know,
ledgers, balance sheets, audit reports. But when
you actually peel back the cover, it's a crime
scene. It really is. We are entering the world
of forensic accounting today. And you're right.
Usually when people hear accounting, they think
of a beige office, a calculator and a very risk
averse person worrying about tax compliance.
Totally. It's viewed as the most rigid black
and white profession on Earth. Most boring, some
would say. Exactly. Math is math. Two plus two
equals four. There's no room for interpretation,
right? That is the perception. But the reality
we are going to explore today is that accounting
can be incredibly creative. And you don't mean
creative in a good way. No, not at all. Not like
a beautifully designed building. I mean, creative
in the way a fiction writer creates a dragon.
We are talking about the moment where numbers
stop representing reality and start representing
a fantasy. We are talking about accounting scandals.
the cooked books. And the scope of what we're
covering today is massive. I mean, we aren't
just looking at petty theft from the cash register.
No, no. We are looking at the heavy hitters from
the Enron era that really defined the early 2000s
to the massive modern collapses like Evergrande
that are shaking up the global economy right
now. And we aren't just going to list the crimes.
Anyone can read a headline about this stuff.
Our mission today is to understand the mechanics.
How do you hide a billion dollars? How do you
make a company that is bleeding money look like
it's the most profitable business in the world?
And perhaps most importantly, why do they do
it? The psychology of the con, I think that's
the part that fascinates me the most. We tend
to think of these fraudsters as these, like,
evil masterminds, but often they're just desperate
people who painted themselves into a corner.
Or, on the other hand, they're narcissists who
genuinely believe they are smarter than the market,
smarter than the auditors, smarter than everybody.
It's a real mix. So let's set the stage. We have
a lot of ground to cover everything from what
we're calling the fraud triangle to the hall
of shame. But I think we need to start with a
definition. What is the line between a mistake
and a crime? Because I definitely messed up my
own budget before, but I don't think the FBI
is coming for me. Well, let's hope not. But you've
hit on the key word, the legal pivot point. It's
intent. Intent. An accounting error is just that,
an error. You forgot to carry a one or you categorized
a lunch receipt as office supplies by accident.
It's a mistake. a scandal a fraud that arises
from the intentional manipulation of financial
statements so it's a deliberate act it's a deliberate
act by trusted executives or employees to misuse
funds or more often to just misrepresent the
truth okay so the difference between tripping
over a rug and deliberately pushing someone down
the stairs. Precisely. And in the world of corporate
fraud, we generally categorize these pushes into
two main buckets. Okay. The first one is the
most intuitive. It's called misappropriation
of assets. Which is just a fancy suit and tie
way of saying theft. It is. Exactly. The industry
term is often defalcation, but yeah, it's theft.
This is when an employee steals the company's
assets. Now, historically, this meant... stealing
cash. You're working the register, you pocket
a 20. Right. Or you're in the warehouse and a
box of inventory falls off the truck. You know,
the classics. The classic shrinkage that companies
used to budget for. Exactly. But as the economy
has evolved from physical goods to information,
so has the theft. Now we see the theft of intellectual
property becoming a huge problem. So not stealing
the computers, but stealing what's on the computers.
Right. Stealing the customer list, stealing the
source code for the new software, stealing proprietary
data. Things that are intangible, but incredibly
valuable. That seems infinitely more damaging.
If I steal a laptop, the company's out, what,
$2 ,000? If I seal the design for the new prototype
that's on that laptop, the company could be out
millions or even its entire future. It can be
an extinction -level event for a small to mid
-sized business. It's terrifying. There was a
striking statistic in our research notes from
2015. It found that 33 % of all business bankruptcies
that year were caused, at least in part, by employee
theft. Wait, a third? A third of businesses that
failed were essentially eaten from the inside
out. Yes. It really highlights the internal controls,
you know, making sure you know who has the keys
to the kingdom, aren't just bureaucratic red
tape. They are survival mechanisms. Wow. But
while asset misappropriation is common and devastating,
it's usually the second bucket of fraud that
ends up on the front page of the Wall Street
Journal. This would be the big lie. Correct.
Bucket number two is fraudulent financial reporting,
or as it is sometimes euphemistically called
in the business world. Earnings management. Okay.
Earnings management sounds so much nicer than
fraud. It does, doesn't it? That's the point.
And this is the one that always confuses people
because money isn't necessarily being stolen
in the traditional sense, right? The CEO isn't
walking out the door with a duffel bag full of
cash. Not directly, no. Not usually. In this
scenario, the goal is to manipulate the financial
statements, which are basically the report card
of the company, to make it look better than it
actually is. So they're lying on the report card.
They are. They are overstating revenue, they're
understating expenses, or they're inflating the
value of their assets, all to create a false
picture of health. So if asset misappropriation
is stealing a slice of the pie, fraudulent financial
reporting is lying about the size of the pie.
That is a perfect analogy. And the motivation
is usually about external perception. They need
to secure investor interest, you know, keep the
stock price high to please Wall Street analysts,
or they need to convince a bank to give them
a loan. Or, and let's be cynical for a second,
they need to hit a specific number on a spreadsheet
to trigger their multimillion dollar bonus. That
is unfortunately a very, very common motive.
We call it gaming the metrics. If your contract
says you get a million dollars, if the company
earns $100 million and the company only earns
$98 million, well, the temptation to find that
extra $2 million in the cushions is immense.
Just find it somewhere, anywhere. It's amazing
how creative people can get when a bonus is on
the line. And the SEC has a whole list of tricks
they use to do this. Period end stuffing was
one that jumped out at me from our notes. It
sounds like a Thanksgiving activity, but I assume
it's less delicious. Much less. Period end stuffing,
or it's sometimes called channel stuffing, is
when a company forces sales into the current
quarter that really shouldn't happen yet. How
do they do that? Let's say it's March 30th, the
quarter is about to end, and you're short on
your sales numbers. You might call up a customer,
a distributor, and pressure them to take a huge
delivery they don't need yet. You promise them
deep discounts or you tell them they don't have
to pay for 180 days just so you can record the
revenue now. Ah, so you're borrowing from the
future to survive the present. Exactly. But the
problem is when the next quarter starts on April
1st, you're already in a hole because you've
cannibalized your own future sales. So you have
to cheat even more just to stay flat. It's a
treadmill that just keeps speeding up until you
fly off the back. It becomes a cycle that's almost
impossible to escape. It sounds exhausting. And
this brings us to the core question of why. Why
do people who are often already wealthy, successful
and respected risk everything? Their reputation,
their freedom to fudge a spreadsheet. Criminologists
have spent decades studying this. The gold standard
model for explaining it, the one that comes up
again and again, is called the fraud triangle.
I love a good geometric model. Let's walk through
the corners of this triangle. What's the first
one? The first corner is incentive or pressure.
This is the motive, the why. We just talked about
bonuses. It's a powerful incentive, but often
it's pressure. Yes. A lot of the time it boils
down to fear. Fear of failure. At the corporate
level, there is just immense pressure to meet
analysts' forecasts. If Wall Street expects you
to make a $1 per share and you come in at 99,
just one penny short, the stock might tank 10%.
The market punishes misses severely. It's completely
unforgiving. And there are debt covenants, right?
That sounds like something from an Indiana Jones
movie, but it's a banking term. It is. It's a
very serious one. When a bank lends a company
money, they often include covenants, which are
basically rules. For example, a rule might...
be your total debt cannot exceed 50 % of your
total equity. If you cross that line, if you
violate the covenant, the bank can call in the
loan immediately, demand repayment in full. And
that would bankrupt the company overnight. Absolutely.
So if you're getting close to that line, the
pressure to fix the numbers, to inflate your
equity or hide some debt just to stay compliant
is existential. It's life or death for the business.
Yeah. And then there is the personal pressure,
which can be just as strong. For sure. Things
like gambling debts. substance abuse issues,
a messy and expensive divorce, or something a
little more sinister like the golden handshake.
I wanted to ask about this. This is the idea
that an executive might actually want the company
to struggle. That seems counterintuitive. It
does, but it happens. A golden handshake often
refers to a massive payout an executive gets
if the company is sold or merges. So sometimes
you see executives manipulate the books to make
the company look like a juicy acquisition target
or even distress it slightly to force a sale
just so they can cash out their stock options
and walk away with a huge check. That is incredibly
dark. You're essentially tanking the ship so
you can sell the records you get paid for it.
It happens. So that's pressure. The first corner.
The second corner of the triangle is opportunity.
The open door. Exactly. You can be as desperate
as you want, but if the vault is locked and you
don't have the key, you can't steal. Opportunity
arises when internal controls are weak or when
the accounting is so complex and opaque that
no one can really figure out what's real and
what's not. Our notes mention that industries
relying on significant judgments are more vulnerable.
Can we unpack that? What does that mean? Sure.
Think about it this way. If you run a trucking
company. It's pretty easy to verify your assets.
I can go to the parking lot and count the trucks.
One, two, three. It's hard to fake that. They're
tangible. Right. But what if you are a bank holding
complex derivatives or a software company trying
to place a value on goodwill from an acquisition
you made five years ago? The value is an estimate.
It's an opinion, not a hard fact. Exactly. If
I say this patent is worth $100 million and you
say it's worth $50 million, who is right? It's
objective. It's a judgment call. And that ambiguity,
that gray area, creates the opportunity to nudge
the numbers in your favor without it looking
like an outright lie. It's not a lie. It's just
an optimistic valuation. That is the defense
lawyer's favorite phrase. And that leads perfectly
to the third corner of the triangle, attitudes
and rationalization. The mental gymnastics. Yeah.
This is how they sleep at night. This is how
they look in the mirror. The fraudster rarely
sees a criminal staring back. They tell themselves
stories to justify their actions. What kind of
stories? Things like, I'm underpaid, the company
owes me this so I deserve it. Or, everyone else
is doing it, it's just how the game is played.
Or, the most dangerous one of all, I'm just borrowing
it, I'll pay it back next quarter when things
turn around. And of course they never do. They
never do. Another big one is the noble cause,
corruption. Right, the idea that... I'm doing
this for the good of the company. Exactly. I'm
cooking the books to save jobs. If I tell the
truth, we go under and everyone gets fired. So
I'm actually the hero here. They reframe the
fraud as a heroic act. That's a powerful rationalization.
And this is all heavily, heavily influenced by
the tone at the top. If the CEO cuts corners,
cheats suppliers or laughs about regulations,
that sends a message. The mid -level managers
feel authorized to do the same. It creates a
culture where fraud becomes normalized, just
business as usual. So pressure, opportunity,
rationalization. That's the triangle. But I noticed
in our research that the triangle wasn't enough
for some modern theorists. They've added more
shapes. We have a diamond and a pentagon now.
We do. We are getting into advanced fraud geometry
here. The fraud diamond was proposed later, adding
a fourth critical element. Which makes total
sense. I might have the pressure and the opportunity,
but if I don't know how to hack the accounting
software or structure a complex deal, I can't
actually. Right. You need the technical skill
and crucially, the position of power. A janitor
cannot commit financial statement fraud. You
need the CFO or the controller, someone who understands
the plumbing of the financial system and has
the access to change it. OK, so that's the diamond.
What about the Pentagon? What's the fifth side?
The Pentagon adds arrogance or ego. The master
of the universe complex? It's that specific brand
of narcissism where the individual believes the
rules simply do not apply to them. They think
they're smarter than the auditors, smarter than
the regulators, and smarter than the market.
When you looked at the major scandals we are
about to discuss, that arrogance is the common
thread that runs through almost all of them.
Well, speaking of major scandals, I think it's
time to open the doors to the Hall of Shame.
We have quite the lineup today. We certainly
do. Where should we begin? We have to start with
the big one, the patient zero of modern corporate
fraud, Enron. Enron. It's almost a cliche at
this point, but you really cannot overstate how
shocking this was back in 2001. Enron wasn't
some shady back alley operation. It was voted
America's most innovative company by Fortune
magazine for six years in a row. They were the
golden child of the new economy, trading energy,
bandwidth, even things like weather derivatives.
They were seen as the future. They were. But
underneath all that innovation, it was a house
of cards. And it was built on two main mechanisms
that are pretty complicated but worth understanding.
Mark -to -market accounting and special purpose
entities. Okay, let's get technical for a second
because this is fascinating. Explain mark -to
-market to us. What is that? So traditional accounting
is usually based on history. You sell a widget
for $10. You record $10 in revenue. Simple. Mark
-to -market accounting is based on future value.
The future value of something. Yes. Enron was
signing these massive 20 -year contracts to supply
energy. Instead of booking the profit year by
year as they actually earned it, they would estimate
the total profit they thought they'd make over
the next 20 years and book all of it today. So
if I sign a deal that might make me $20 million
over two decades, I can tell my shareholders,
hey, we just made $20 million today. Essentially,
yes. You book the net present value of Alder's
future profits. But here is the catch. Predicting
energy prices 20 years out is basically impossible.
So Enron was just making up the assumptions.
They were booking massive hypothetical profits
based on their own optimistic models. So they
had huge profits on paper. But they didn't have
the cash to back it up. It's the ultimate paper
rich, cash poor situation, but on a massive scale.
Yeah. And when the deals actually went bad, which
they often did, Enron didn't want to admit it,
that would hurt the stock price. So what do they
do with the losses? This is where mechanism number
two comes in. Special Purpose Entities, or SPEs.
These were the infamous shell companies, right?
The ones with the crazy Jurassic Park names like
Raptor. Raptor, Chuco, LJM. These were partnerships
created and controlled by Enron's own CFO, Andrew
Fastow. When Enron had a bad asset, a losing
investment, or a massive debt, they would sell
it to one of these shell companies. So they just
moved the toxic waste off their own balance sheet
and onto the balance sheet of this other company
that nobody's looking at. Correct. But here's
the fraud. The shell companies were backed by
Enron stock. It was completely circular. It was
like taking debt off your Visa card and moving
it to a MasterCard that is guaranteed by your
Visa card. So if the Visa card fails... The whole
thing collapses. And that's what happened. When
Enron's stock price started to fall, the SPEs
became worthless, and all that hidden debt came
rushing back onto Enron's books. And the craziest
part of this whole saga is the auditor's role.
Arthur Anderson. They were one of the big five
accounting firms. They were supposed to be the
referees, the independent watchdogs. They were,
but they were making so much money from consulting
fees with Enron. At one point, it was roughly
a million dollars a week that they lost their
independence. They became enablers. And when
the SEC started investigating, Arthur Anderson
didn't say, here are the files, let's get to
the truth. They started shredding. The image
of auditors frantically shredding documents by
the ton while the feds are closing in is just
cinematic. It cost them everything. Arthur Anderson
was convicted of obstruction of justice. They
were forced to surrender their CPA licenses.
The firm collapsed. 85 ,000 employees lost their
jobs essentially overnight, most of whom were
completely innocent. And the big five became
the big four, which it still is today. A stark
reminder that trust takes decades to build and
just seconds to destroy. Okay, let's move down
the timeline just a year later, 2002. Enron is
still fresh in everyone's mind, and then bam.
WorldCom. The too -big -to -fail era, as you
said. It was one body blow after another to the
market's confidence. And if Enron was this complex
magic trick involving derivatives and shell companies,
WorldCom feels almost dumber, like brilliantly
stupid in its simplicity. It was certainly less
sophisticated, but no less devastating. WorldCom
was a massive telecom company, the second largest
in the U .S. They grew by buying up dozens of
other companies, but when the dot -com bubble
burst, their revenue stalled. The growth story
was over. And the shroud they use to hide this
involves something called capitalization of expenses.
We probably need to explain the difference between
an expense and a capital asset for the listeners.
Right. It's a fundamental accounting concept.
Think of it this way. If you buy a sandwich for
lunch, that is an expense. You eat it. It's gone.
It reduces your profit for the day immediately.
If you buy a house, that is a capital asset.
You exchange cash for a house. Your net worth
doesn't go down. You just have a house instead
of cash. You get to use that house for years.
Okay. So expenses hurt profits now. Assets don't.
Correct. You depreciate assets over time, but
the immediate hit to your profit is minimal.
Now, WorldCom paid billions of dollars in line
costs. These are fees to other phone companies
to use their networks to complete calls. So it's
a regular recurring cost of doing business, like
the electric bill. Exactly. It's clearly an operating
expense. You pay it every month. But WorldCom
CFO Scott Sullivan told his team to start recording
these bills as if they were assets. Wait, they
took their monthly phone bill and called it an
investment? Essentially, yes. They took $3 .8
billion of these daily operating costs and just
wrote them down on the balance sheet as investments
in infrastructure. So instead of telling investors,
we spent $3 .8 billion this quarter, they said,
we bought $3 .8 billion worth of new assets.
Which meant their profit looked $3 .8 billion
higher than it actually was. It was a simple
journal entry in the ledger. Debit asset, credit
cash, no complex shell companies required. Just
a lie. And the scale, it was ultimately revealed
to be an $11 billion fraud, is staggering. At
the time, it dwarfed Enron. It was the largest
corporate insolvency ever. And it wasn't uncovered
by the SEC or a Wall Street analyst. It was caught
by a small team of internal auditors led by Cynthia
Cooper. They worked in secret, often at night,
digging through the company's own systems because
they knew something was wrong. They are the real
heroes of that story. Truly. Okay, let's jump
forward a few years to 2008. The great financial
crisis is unfolding. And the name that dominates
that era of fraud is, of course, Bernie Madoff.
The $64 billion question, as you called it earlier.
Now, everyone knows it was a Ponzi scheme. He
took money from new investors to pay off old
investors. The basic mechanism is well understood.
But what I want to focus on is the single biggest
red flag that everyone, including the SEC, missed
for decades. The auditor. This is the detail
that still keeps regulators up at night. Madoff
Investment Securities claimed to be managing
tens of billions of dollars for thousands of
clients globally. You'd expect a firm of that
size to be audited by a global powerhouse. PwC,
Deloitte, EY, KPMG, one of the big four. Right.
You'd want an army of forensic accountants combing
through every trade. Instead, the auditor of
record was a firm called Freeling & Horowitz.
Which sounds respectable enough, right? Maybe
a boutique, high -end firm. But in reality, what
was it? It was a tiny office in a strip mall
in New City, New York. It was basically one room,
a storefront. One room to audit a $60 billion
operation. And the firm consisted of one active
accountant, David G. Freeling. He was in his
late 70s working from this tiny office. He didn't
have a team of forensic analysts. He barely had
a secretary. So how does one guy audit a global
hedge fund of that size? He doesn't. He couldn't.
He simply rubber stamped the documents Madoff
gave him for 18 years. He admitted he didn't
perform any actual audit procedures. He didn't
independently verify the trades. He didn't even
check to see if the bank accounts with the supposed
billions actually existed. And why? Was he just
lazy? Incompetent? He was hopelessly compromised.
He and his family had millions of dollars of
their own money invested in Madoff's fund. No.
That is the single biggest conflict of interest
imaginable. Audit rule number one. You must be
independent in fact and appearance. Exactly.
If he found the fraud, he would not only lose
a major client, he would lose his own life savings
and his family savings. He was financially incentivized
to be blind. It's a perfect, tragic example of
why auditor independence is the absolute cornerstone
of the whole financial system. It's just incredible.
The biggest financial crime in history was hidden
behind a strip mall storefront. Now, we've been
very U .S.-centric so far, but creative accounting
is a global language. Let's take a quick trip
around the world. Let's do it. We're two first.
Let's go to Europe. Italy, 2003. Parmalat. Ah,
Parmalat. The European Enron. Parmalat was a
massive company, a dairy giant. They made milk,
yogurt, cookies. They were a huge family -owned
conglomerate, a point of national pride in Italy.
But it turned out they had a 14 billion hole
in their books. 14 billion euros. And the way
they hit it... Honestly, it sounds like a prank
from a bad sitcom. It does. It's almost comical
in its audacity. They claim to have a bank account
with Bank of America in the Cayman Islands. And
this account supposedly contained nearly $4 billion
in cash. Nice little rainy day fund. The auditors,
for years, would ask for proof of this cash.
So Parmalat executives simply forged a letter
on Bank of America letterhead confirming the
balance. Like they just made it up in Microsoft
Word and put a fake signature on it. Even cruder.
It was essentially cut and paste, scanned and
faxed. The prosecutors later said it was a clumsy,
obvious forgery. But for years, the auditors
just accepted the facts as proof. They never
once picked up the phone to call the bank and
verify it. The old mantra of trust but verify
minus the crucial verify part. Exactly. When
a new auditor finally took over and said, hey,
out of an abundance of caution, let me just double
check this with the bank. Bank of America's response
was, we don't have an account for this company.
We've never heard of it. The whole thing collapsed
instantly. Unbelievable. Okay, let's move over
to Asia. Japan, 2011. Olympus, the camera company.
Yes, Olympus. This one is fascinating because
of the cultural element involved, a practice
known as Tobashi. Tobashi. What does that translate
to? It roughly means to make fly away. And it
refers to a financial maneuver where you shift
your losses off your company's books to hide
them from investors, often by moving them to
obscure shell companies. So similar to Enron's
SBEs. Very similar in concept. Olympus had made
some terrible speculative investments back in
the 1980s during the Japanese asset bubble. When
the bubble burst, they were sitting on huge,
embarrassing losses. So instead of admitting
it and taking the hit to their stock price. They
spent the next 20 years hiding it. Their method
was to overpay for acquisitions. They would buy
other companies at massively inflated prices.
The extra money they paid for these acquisitions
wasn't for the company itself. It was secretly
being funneled into show companies to pay off
those old investment losses from the 80s. So
they were buying companies not because they wanted
the technology or the business, but because they
needed a laundry machine for their old debt.
It was a very expensive and elaborate way to
hide the truth. And this went on for two decades
until a new CEO, Michael Woodford, who was British
and the first non -Japanese CEO in the company's
history, started asking questions. Simple questions
like, why did we pay $2 billion for a small recycling
company that makes no money? And because he was
an outsider, he didn't understand the cultural
rule of silence and not rocking the boat. He
broke the Japanese concept of harmony. The board
fired him for asking too many questions, but
he went to the press and the police, and the
entire 20 -year -old scheme came crashing down.
Incredible persistence. Okay, let's hit our neighbor
to the north, Canada. Nortel Networks, 2003.
This is a classic example of earnings management,
driven by pure... unadulterated greed. This was
the return to profit scheme. That's right. Nortel,
the telecom giant, was struggling after the dotcom
bust. In 2002, the top executives realized they
weren't going to hit their profit targets for
the year. So they decided to take what's known
as a big bath. A big bath. What does that mean?
It means you make the current year look as bad
as humanly possible. You write off every bad
asset you can find. You prepay future expenses.
You accrue massive liabilities. You basically
flush all the bad news through the system at
once. Why on earth would you want to make your
company look terrible? Because it dramatically
lowers the bar for the following year. If you
make 2002 look like an absolute disaster, it
becomes very easy to make 2003 look like a miraculous
recovery. And why did they specifically need
2003 to be a recovery year? Because their executive
bonus plan had a special return to profitability
trigger. If they could just show a profit, any
profit in 2003 after the disaster of 2002, the
topic... executives would share a bonus pool
of $70 million. So they deliberately engineered
a loss in one year so they could engineer a profit
the next, solely to unlock a wire transfer to
their personal bank accounts. It is arguably
the most cynical form of fraud. It wasn't about
saving the company or protecting jobs. It was
purely about the payout. And finally, let's bring
it to the present day for the biggest one of
all, China. Evergrande. The scale of this one
just makes the others look small. Evergrande
is or was one of China's largest property developers.
In 2023, Chinese regulators accused the company
of overstating its revenue by $78 billion over
two years. $78 billion. That is the entire GDP
of a decent -sized nation. How is that even possible?
It stems from how they recognize revenue. In
China, real estate is often sold presale. You
pay for the apartment years before it is actually
built. OK, that's common here, too. Right. But
proper accounting says that money you receive
is a liability. a customer deposit until you
actually finish the building and hand over the
keys. You haven't earned it yet. Evergrande was
allegedly booking all that cash as revenue the
moment they received it. So they were counting
the chickens not just before they hatched, but
before the eggs were even laid. And then they
were using that fake revenue on their books to
go out and borrow more money to buy more land
to sell more unbuilt apartments. It was a classic
Ponzi scheme, but fueled by real estate debt
instead of investor cash. And when the Chinese
government tightened lending rules to cool the
property market. The liquidity dried up and the
music stopped. The whole thing imploded. And
because real estate is such a huge part of China's
economy, this sent shockwaves globally. It did.
It's a powerful reminder that these aren't just
numbers on a page. When these giant companies
collapse, construction stocks, people who paid
for homes lose their life savings, suppliers
don't get paid, banks are left with bad loans.
The ripple effects are very, very real. So we've
seen the anatomy of the crime. We've been through
the hall of shame. Let's talk about part three,
the fallout. What happens after the dust settles
from one of these massive scandals? Usually the
government steps in with a big regulatory stick.
The biggest and most famous response to the Enron
and WorldCom era was the Sarbanes -Oxley Act
of 2002, known universally as SOX. I have friends
in finance who still shudder when they hear the
word SOX. It's famous for being a paperwork nightmare.
But what did it actually change in a meaningful
way? I think the most critical change was establishing
personal liability for executives. Before SOX,
a CEO could plausibly say, hey, I'm the big picture
guy. I focus on strategy. I didn't know what
the accountants in the basement were doing. The
old sheet and Schultz defense. I know nothing.
Plausible deniability. SOX killed that defense.
Section 302 of the act requires the CEO and CFO
to personally certify to sign their names on
the dotted line that the financial statements
are accurate and not misleading. So they can't
hide anymore. If the statements turn out to be
fraudulent, the executives can face massive fines
and prison time, regardless of whether they knew
the specific details of the fraud. It forces
them to take responsibility. It forces them to
know. I remember President Bush, when he was
signing it, said something to the effect of the
buck stops here and the buck is fake. You're
going to jail. That's essentially the spirit
of it. But this whole episode sparked a massive
philosophical debate in the accounting world
that is still raging today. The debate between
rules versus principles. This sounds a bit academic,
but bear with us, listener, because it really
gets to the heart of why fraud. keeps happening.
What is the difference between these two approaches?
The U .S. system called generally accepted accounting
principles is a rules based system. It's like
a massive, incredibly detailed instruction manual.
It says if you have a lease that covers 75 percent
of the assets useful life, you must treat it
as a capital lease. If it's 74 percent, you treat
it as an operating lease. It's very specific
checklist, black and white. Exactly. But that
very specificity creates loopholes. Smart fraudsters
like the guys at Enron, they don't break the
rules. They read the rule book and design transactions
that are technically compliant but ethically
bankrupt. They might structure a deal to be 2
.9 % owned by an outsider because the rule says
3 % ownership triggers a certain disclosure.
So they follow the letter of the law precisely
to violate the spirit of the law. Perfectly put.
Now, contrast that with principles based systems
like the IFRS international financial reporting
standards used in Europe and most of the rest
of the world. That system is much broader. It
says something like the financial statements
must present a true and fair view of the company's
financial position. It's more like a guiding
principle. Don't be evil. Right. It relies on
the professional judgment of the accountants
and auditors. Does this look right? Does this
reflect the economic reality of the transaction?
But the problem there is that judgment is subjective.
harder to enforce in a courtroom. And the great
paradox here is that we see massive fraud happening
in both systems. Enron happened under the strict
U .S. rules. Parmalat and more recently Wirecard
happened under the European principles. It really
suggests that if someone is truly determined
to lie, the specific rulebook doesn't ultimately
matter that much. Speaking of Wirecard. That
was a huge scandal in 2020. SOX had been around
for 18 years by then. We had all these new regulations.
Did the system fail? Regulation is a deterrent,
not a cure. It can't eliminate bad actors. Wirecard
was a German payment processing company, a tech
darling. They claim to have $1 .9 billion in
cash sitting in trust accounts in the Philippines.
And let me guess. Just like Parmalat. The money
didn't exist. The accounts were fake. The auditors,
Ernst & Young in this case, had failed to verify
the cash directly with the banks for years. They
relied on documents and confirmations provided
by a third party trustee who was in on the scheme.
It just seems like call the bank directly is
the one simple step that auditors keep skipping
over and over again. It seems to be the Achilles
heel of the audit profession. And then just this
year, 2024. We have the case of BF Borgers. This
is the most recent one on our list, and it feels
different. It's different because the fraud wasn't
at the company being audited. It was the audit
firm itself that was the fraud. BF Borgers was
an audit firm in Colorado. They filed reports
for over 1 ,500 SEC filings for various small
companies. The SEC found that in 75 % of those
filings, they hadn't even done the work. What
do you mean they hadn't done the work? They just
fabricated the audit documentation. They would
copy and paste work papers from previous years,
change the dates, and sign off on the audit.
They were selling the appearance of an audit
to companies that needed one to be publicly listed.
So it's like buying a car inspection sticker
from a guy in an alley who never even looks at
your brakes. That is exactly what it was, a fake
audit factory. It just goes to show that no matter
how many rules and regulations you have, you
can't regulate away fundamental dishonesty. So
if humans keep failing, if auditors are lazy
or compromised or just plain tricked, is technology
the answer? We hear about AI revolutionizing
every other industry. Can AI catch a Bernie Madoff?
It is the new frontier, and there's a lot of
hope there. We are seeing the rise of things
like continuous auditing using deep learning
and AI. How does that actually work? Well, a
human auditor can only ever spot check. They
might look at 50 transactions out of 50 ,000.
It's a sample. An AI can look at 100 % of the
transactions instantly, and it can spot anomalies
and patterns that humans would never, ever miss.
Like that thing called Benford's Law. I read
about that. Yes. Benford's law is fascinating.
It's a mathematical observation that in naturally
occurring sets of numbers like utility bills
or stock prices or street addresses, the leading
digit is most likely to be a 1. In fact, about
30 % of numbers in the real world start with
a 1. Only about 5 % start with a 9. That seems
so counterintuitive. You'd think all the digits
would have an equal chance. You'd think so, but
they don't. But here is the catch. When humans
try to make up random numbers to fake a ledger,
we tend to distribute the leading digits pretty
equally. We put in too many eights and nines
and not enough ones and twos. Our fakes don't
look natural. So the AI scans the entire general
ledger, sees that the distribution of first digits
is unnatural, and flags it for review. Exactly.
It says these numbers look cooked. It's an incredibly
powerful tool for fraud detection. But of course,
as the detection gets better with AI, the fraudsters
will likely start using AI to generate more natural
-looking fake numbers. So it's a perpetual arms
race. Robo Auditor versus Robo Fraudster. It
is and always will be the nature of the game.
Well, on that slightly dystopian note, let's
wrap this up. But before we go, you found a detail
about an award that I think sums this entire
deep dive up perfectly. The Imaginary Numbers
Award. I love this. This was from the Ig Nobel
Prizes. the parody Nobel Awards that honor achievements
that make you laugh, make you think. And this
is in 2002, right in the thick of the Enron and
WorldCom scandals. The recipients of the Ig Nobel
Prize in economics were the CEOs and executives
of Enron, WorldCom, Arthur Anderson, and a dozen
other companies that imploded that year. And
the citation for the award, what did it say?
It said they won the prize for adapting the mathematical
concept of imaginary numbers for use in the business
world. It's funny, but it stings, doesn't it?
It really cuts to the core. These people treated
business not as a mechanism to provide value
to build cars or supply energy or connect phone
calls, but as a theoretical math problem where
the variables could be adjusted to fit whatever
answer they wanted. And that brings us right
back to the fraud pentagon, that fifth element,
the arrogance. Absolutely. The systems we all
rely on, global trade, the stock market, your
retirement fund, they all function on a baseline
assumption of truth. We assume a dollar is a
dollar and a sale is a sale. When the people
at the top decide that reality is optional, that
the map is more important than the territory,
the damage is truly limitless. So here is our
final provocative thought for you, the listener.
The next time you see a company that is constantly,
quarter after quarter, beating Wall Street's
expectations by exactly one penny, or you see
a company that reports perfectly smooth, steadily
climbing profits in a market that is chaotic
and volatile. Ask yourself, is this unparalleled
operational excellence? Is this management genius
at work? Or is it creative writing? It is a question
worth asking. Thanks for diving deep with us.
Keep your eyes on the numbers and we'll see you
next time.