Corporate Scandals

Enron, WorldCom, Tyco, Global Crossing, and other companies became major examples of corporate scandals in the early 2000s. These scandals resulted from "earnings management," a practice that became common in the 1990s. Companies used accounting methods to make poor results appear stronger than they were. The problem increased as financial controls became weaker. Boards often failed to question leaders or take action because of conflicts of interest. Financial analysts also promoted some companies to benefit their own firms' business interests.

Corporate lawyers and auditors often relied on company managers for their jobs and income, making it harder for them to question wrong actions. The system created to stop accounting fraud also failed. The Financial Accounting Standards Board could suggest new rules but did not have enough power to make companies follow them. In some cases, Congress removed helpful accounting reforms because lawmakers received support from companies, not from regulators. This made it difficult to know whether company leaders were truly protecting investors. Some managers used dishonest methods to hide financial problems, change records, and make company results appear better than they were. In the 1990s and early 2000s, the U.S. saw more than 900 cases where companies corrected their reported earnings and at least 50 major accounting scandals. Some of the biggest cases included:

• Boston Chicken: After a successful IPO in 1993 and raising money through bonds, Boston Chicken used unfair accounting methods to hide losses from its related companies. It created Financed Area Developers (FADs) and provided them with loans for starting franchises. Although Boston Chicken had the option to turn these loans into ownership, it waited. It showed franchise fees and lease payments as income from separate companies and did not show their early losses. When these companies later made profits, Boston Chicken converted the loans into ownership and counted those profits as its own. The FADs were actually subsidiaries under another name. Arthur Andersen, its auditor, did not inform the public about these problems.
• Waste Management: Waste Management made its financial results look better by using false estimates. It increased the expected life of its trucks, raised their estimated value, and overstated how long its landfills would last. These changes lowered reported costs and increased profits. Arthur Andersen did not reveal these issues.
• Sunbeam: CEO Al Dunlop used accounting methods to make the company appear more successful. Sunbeam recorded sales before products were made or delivered by allowing customers to order products early and pay later. This made current revenue look higher than it really was. Arthur Andersen failed to report the problem.
• Cendant: Cendant faced accounting problems from CUC International after their merger. CUC recorded money from long-term services too early instead of spreading it. It also recorded marketing costs as assets instead of expenses, which made profits appear larger.
• Sensormatic: Sensormatic changed computer dates to show sales from future periods as earlier sales. This helped the company meet financial goals by reporting revenue before it was actually earned. The controller knew about the fraud but did not inform the auditors or audit committee.
• AOL Time Warner: AOL Time Warner increased its reported profits by treating marketing and sales costs as assets. Instead of recording these costs as current expenses, it spread them over several years.
• Qwest: Qwest incorrectly reported revenue from asset exchanges. The company counted money from bandwidth swaps even though exchanging similar assets should not create revenue.
• Tyco: Tyco used aggressive accounting methods to hide problems in its business deals and transactions with related companies. It also changed the usual meaning of "free cash flow" to make its financial position look stronger.
• Enron: Enron became one of the most famous accounting scandals. The company used Special Purpose Entities (SPEs) to hide large amounts of debt. Similar accounting tricks were later found at companies like Global Crossing and WorldCom. WorldCom also recorded regular business expenses as investments to falsely increase profits.

The accounting scandals of these companies show the importance of transparency, ethical decision-making, and strong financial oversight. These cases highlight how misleading practices can damage investor trust and the reputation of businesses, emphasizing the need for responsible accounting standards.

Debt Risks

Debt can increase a company's returns, but too much debt can create problems. If a company raises all its money from investors, each shareholder owns a smaller share of profits. If it raises some money from investors and borrows the rest, shareholders own a larger share of profits. This effect is called leverage because debt increases the impact of shareholder investment. Leverage can be helpful, but excessive debt raises borrowing costs and makes repayment harder. Debt also creates fixed obligations, and lenders may set strict conditions when debt levels become too high.

Debt can raise a company's financial risk because shareholders only receive what remains after all debts are paid. If a company takes on too much debt, bankruptcy becomes more likely, and shareholders may lose most or all of their investment. Some companies use complex accounting methods to hide their debt and make their financial situation appear stronger than it really is. Showing higher profits and lower risks can increase stock prices and lead to larger bonuses for managers. Because of these rewards, managers may be tempted to use misleading accounting methods. However, careful review of financial reports can reveal many of these problems.

Equity Method and Hidden Debt

Boston Chicken used the equity method to hide debt by making a small investment in FADs and then giving them large loans. Since it owned less than 50%, Boston Chicken claimed it did not control FADs and did not need to report their losses. However, it actually controlled the company.

Coca-Cola has also been criticized for similarly using the equity method. Coca-Cola Enterprises includes bottling and franchise businesses. Critics say this structure makes Coca-Cola's debt and expenses appear lower. Coca-Cola argues that it can use the equity method because it owns slightly less than 50% of these businesses, but critics claim it still has control. By reviewing financial statement notes, investors can adjust the numbers to see the company's real financial position. If Coca-Cola fully included these businesses, its results would appear much weaker.

Lease Accounting

Lease accounting divides leases into two types: operating leases and capital leases. In an operating lease, the company receiving the payment records it as income, while the company making the payment records it as an expense or amount owed. A capital lease is recorded as a long-term asset and debt. It causes higher costs in the first few years and lower costs later.

Classifying a capital lease as an operating lease can make a company's expenses look lower at the beginning. Operating leases also do not add assets to the company's records, which can make its return on assets look better. They also do not show debt, making long-term payment responsibilities harder to see. Airlines often lease aircraft instead of buying them. These leases may be listed as operating or capital leases. A review of six airlines' reports shows that treating operating leases as debt would reveal higher obligations and make their financial condition appear weaker.

Pensions are a company's promise to pay employees after they retire, making them a form of delayed pay. Pension accounting is complicated because it requires companies to make estimates about future costs and investment returns. Before 1985, companies did not have to show their pension obligations. Later, the FASB required pension reporting, but it allowed companies to use methods that could hide the real financial impact. Companies can change pension reports by predicting higher or lower returns from pension investments and using those estimates when calculating pension expenses. The FASB also allows companies to spread differences between expected and actual pension costs over several years and does not require them to show all past service costs. Since pension numbers depend on company estimates, investors should carefully check the pension details in financial statement notes.

Special Purpose Entities Risks

Special purpose entities (SPEs) were involved in major financial scandals such as Enron, WorldCom, and Global Crossing. Companies can create SPEs through joint ventures, partnerships, trusts, or corporations to raise debt, fund research, and manage leasing activities. SPE accounting rules are complex and can be misused to hide financial problems. Limited disclosures make it harder for investors to evaluate risks. Companies that do not include SPE-related debt in their financial statements may raise concerns.

Recent business scandals revealed that managers manipulated financial reports. Stronger monitoring by boards of directors and securities analysts could have stopped these actions. New regulations have increased management's responsibility for compliance, but auditors remain responsible for ensuring proper accounting practices. Audit firms must protect the public by making sure companies provide accurate, complete, and honest financial reports.