Forensic accountant explains why fraud thrives on Wall Street

• If you ever look at your phone, there's a ticker tape at the bottom that's showing you how stocks are trading every day, all day. Those numbers are coming from accounting transactions: investors, creditors, lenders, potential investors rely on this information. Auditors and accounting firms have a really tough position because they're trying to manage client expectations. When they ask things like, "Just book the revenue, we'll fix it later." Or, "I don't wanna know anything about the numbers. That's why I hired you- I don't wanna know anything about it." Those things can land you in jail.

Why does fraud happen? Accounting is like a superpower. Understanding the reason "Why?" Why would someone wanna overstate revenue? Why would someone want to understate expenses? If you understand it, if someone is stealing and you say, "Well, what period should that have been recognized?" They're gonna say, "They understand some accounting." Accounting is my superpower, so I want it to be yours.

So if you are a publicly traded company, you have an estimate that you told Wall Street you're gonna meet, and let's say you're under that estimate. You're trying to call everything you possibly can revenue; every company wants to be able to recognize revenue when they want to. Nobody wants to wait.

Why does all this matter? There are two types of accounting that you have to understand: There's something called 'Cash basis accounting' and 'Accrual basis accounting.' Most medium to small businesses really operate on a cash basis type of accounting system. You go in the store, you pay for a product, cash in, cash out—simple. Accrual basis accounting is where it gets just a little sticky. We recognize revenue when earned and expenses when incurred, regardless of when cash is received or paid out.

So think about what that means: Say for instance, I have a business and I have a friend that has a large business, and I think I'm gonna get $10 million of sales from my friend. What I don't know is my friend's business is about to file for bankruptcy. I can book revenue on my income statement and say I have a revenue of $10 million. Well, what if I never received the cash? I've used the word "cash" and I've used the word "revenue"—they don't mean the same thing. Cash is cash. If I give you $10 million cash you know you have $10 million cash. If I say you have $10 million in revenue that doesn't mean you have $10 million in cash.

So that's why you see companies recognize the revenue in crazy ways sometimes because of whatever they've told Wall Street. There was a gentleman that I interviewed years ago. Andrew Johnson was a director of finance at a company called Nine Corp; one of the nicest men I've ever met. Andy ended up engaging in what we know today as 'earnings management.' And about a year and some change later, the FBI came knocking at his door. The reason why was really about timing.

His bosses wanted to recognize revenue too soon because they wanted to meet Wall Street expectations, and his bosses really weren't interested in learning about accounting. They didn't wanna know the details about accounting. They didn't wanna hear any of that. All they wanted to know was make the numbers work; we're trying to be acquired, just make it work.

• 'I never felt like I was in over my head but reflecting back on it, I was in way over my head.' - He didn't get any personal gain. He was following his boss's orders. He knew it was wrong, but he's trying to be a team player.

• 'There became this implied pressure that if we complained that we were gonna lose our job.' - And so what Andy did is he overestimated something that made their financial statements look better than they actually should. Andy knew it was wrong, but what is he gonna do? Is he gonna push back? No, he didn't. That's what landed him in federal prison.

• 'The culture of the accounting department just became afraid. We just weren't honest with ourselves.' - Now, I may be going too fast, so let me back up: When you take an accounting class, they're gonna tell you something called the 'accounting equation.' And what that equation is, is it says, "Assets equals liabilities plus owner's equity." So if I do something on the left side of that equation, I then have to do something on the right side to make it balance.

Why auditors get in trouble when fraud happens: If I take cash away, what am I plugging in on the right hand side of that equation to make it balance? Because everything has to stay in balance. When fraud happens, you gotta be pretty savvy to make everything work.

So you think about somebody like Rita Cranwell. - 'Rita Cranwell.' - 'Rita Cranwell.' - 'Rita Cranwell.' - 'The largest municipal embezzlement in U.S. history.' - Rita stole $53.7 million over 20 years and kept balanced financial statements the entire time. So she was maneuvering a lot. She was like a magician. Clearly she was really good at what she did until she wasn't, but to be able to keep that going and keep that balance for so long, because it has to balance.

So you might be asking yourself, "Well, why does fraud happen if auditors are supposed to come in, review everything, and opine if things are the way they should be?" The financial statements are the property and responsibility of management. Management compiles them. Management makes all the decisions around the transactions. The auditor comes in to say what management has said is true or false.

Well, there's a little bit of conflict here because guess who pays the auditors? The client. So, how would your client like it if you have bad news to tell them about the financial statements that they just put together? Andy is a perfect example of a CPA that was placed in a very difficult situation. He knew generally accepted accounting principles, but yet he didn't feel comfortable pushing back.

So accountants and auditors often find themselves in a really tough dilemma. Did Arthur Anderson, who was the auditor for Enron? Did they really wanna lose Enron as a client? If they said, "Uh, these transactions, you don't have the right things. This is closed, this is wrong, this is wrong, this is wrong, this is wrong." You know what Enron would do? They'd just go find another firm.

It's the life of a CPA, a life of an auditor. Pressure impacts decisions. Understanding those pressures can also help the future CPAs of the world understand the positions that they could be placed in. I try to let my students know that it's not if fraud happens in their career, it's when it shows up—how are you going to respond?