Enough of the accounting philosophy, let’s talk about something more fun. Fraud!
If accounting is as old as the hills, so is fraud. If you recall my post about Clay Balls a few days ago, you may remember that they were storage for tokens carried by tax collectors. The tokens were stored inside hollowed balls to “prevent tampering.” In other words, tampering–tax collectors collecting a few of the tokens to barter for their own purposes–was already a common practice in 3000 B.C.E. Where there are tax collectors, there are corrupt tax collectors, apparently.
Oops! My Warehouse Burned Down…Insurance Fraud
There was also ancient insurance, and with that came ancient insurance fraud. Ancient merchants purchased “bottomry” contracts (now there’s a word!) in Babylon as early as the third millennium BCE, as did Hindus, Greeks, and others. A trader would get a loan for his cargo and pay an extra fee for insurance, with the interest on the loan also helping cover the loss. When the ship came in, if he defaulted on the loan, the insurer would keep the cargo.
The Greek merchant Hegestratos decided to try an end run around his bottomry contract, in 360 BCE. He had received a cash advance and figured to keep it–and the corn–and claim an insurance loss. He put the corn in secret storage and sailed the ship, but empty. However, there were other passengers on the ship, and they were not too keen when they noticed him trying to scuttle the empty vessel. They chased him off, and he drowned. So much for early insurance fraud!
I’ve Got a Bridge Here For Ya…Sales Fraud
If you remember the scam in “The Producers,” you already know that fraud can often involve selling what you don’t have. Bialystock and Bloom sold 100% of the profits for a Broadway show several times over, say 2000%, hoping a bad show would close with a loss. The problem was that the show was So Bad it was Good. This was also a common scam with racehorse owners; sell more than 100% of shares in a horse and then it suddenly develops a limp or mysteriously dies.
A variation on the theme is to over-inflate profits from a venture, attracting new investors who are hypnotized at the thought of 250% returns. Fraudsters create fake statements that falsify results. One rule of thumb with investing is if it seems too good to be true, it probably isn’t. The trick is to collect enough money to pay enough early investors so that their word-of-mouth can convince others. That’s when it becomes a pyramid scheme, also named after the famous Charles Ponzi.
What Ponzi was selling was something obscure: International Reply Coupons (IRC). These allowed people in different countries to prepay postage, but in the currency of other countries, taking advantage of differing currency exchanges and prices in postage. Another rule: if it sounds too complicated to understand, don’t invest in it. There could be profit between the two valuation exchanges for the middle man to take a cut. Ponzi, however, inflated the profit to over 400%.
As he gathered enough investors, Ponzi began siphoning off their investments and using the newest money to pay something to the oldest, who then left most of their investment intact. Between February and July of 1920, he rose from collecting a few thousand dollars to millions per day. Eventually, the house of cards collapsed. Ponzi, in that time frame, couldn’t actually convert the IRCs to money–he had nothing to create actual returns. Publicity created a panic, and Ponzi was given life in prison on 86 counts of mail fraud.
The Public Trust…Embezzlement
The key difference between ordinary theft, or larceny, and embezzlement involves trust. Embezzlement happens when someone in a position of authority siphons of assets under their trust. One estimate is that $50 million is stolen every year, and typically, it’s stolen by the accountants or someone with privileged access to the money. The noblest of us find these crimes the most despicable.
Rita Crundwell, the controller for the town of Dixon, Illinois, stole $54 million from the city over her 29-year-tenure. Her approach was simple. She created fake invoices, payable to something called the Reserve Sewer Capital Development Accountant, which happened to be overseen by Rita Crundwell.
Crundwell herself stole nearly $2.5 million per ear, funding not just a lavish lifestle but an entire Quarter Horse breeding operations, which earned her Horsewoman of the year and so forth. She was audited, but the small accounting firm couldn’t fathom such a long-term employee being a criminal, so they signed off on her financial statements year after year, without much digging.
In the meantime, as Crundwell was living high on the hog off taxpayer money, she constantly claimed that the city wasn’t collecting enough taxes. City departments had to make service cuts, employees went years without raises, and the street was full of potholes. It all came crashing down when Crundwell did what most accounting fraudsters are usually reluctant to do–she took a long vacation. The 2017 documentary on this topic, All the Queen’s Horses, is worth watching.
When in Doubt, Pay Off the Auditors…Complicated Accounting Fraud
So what exactly happened at Enron? A little bit of everything. Enron traded in energy and commodities, originally formed from a group of natural gas Texas companmies. At one point, they ran natural gas pipelines, but then quickly discovered that trading in gas working with the market-pricing system for natural gas would be much more lucrative. Thus, by the time the company reached the 2000s, they were working more as traders than as gas providers.
At some point, they had even owned a company that was building fiber optic cable, planning to trade in broadband in the same way they traded in gas. As their ownership diversified and their assets became hard to explain, it was easier and easier to use strange accounting methods… excuse me… creative accounting methods to describe their assets.
For example, special subsidiaries called limited liability special-purpose entities allowed Enron to move the liabilities off their books. In other words, through accounting “magic,” they were able to put their debts somewhere else. This inflated their net worth and stock prices.
The company did have auditors. Auditors must be the most honest of this noble profession since they are entrusted with reviewing the books in order to provide a clean stamp of approval. Arthur Andersen, a well-respected and major national accounting firm, did perform audits. But here was the problem. Auditing had become less and less profitable over time. The real money for such firms was in consulting–providing expertise at helping companies create complex structures to make money. The consulting wing of Andersen was helping suggest ways to improve profit, some of which Enron falsified, while at the same time pressuring the auditing wing not to disapprove those practices. The Andersen consultants won the arguments but lost the company.
When the more blatant examples of fraud were discovered–because the CEO, CFO, and COO (Chief Executive, Chief Financial and Chief Operating Officer) were falsifying financial statements — the auditors themselves were held liable. Arthur Andersen went under along with Enron.
The Malebolge, the Special Circle of Hell for Fraudsters
Finally, there are printing scams. More than once, a fraudster has printed fake blank deposit slips, with the name of the bank and his own account number MICR-encoded at the bottom. They would slip those into the pile provided next to the bank teller line, and unsuspecting investors would deposit their own money into the criminal’s own account.
In Dante’s Inferno, there is an entire circle of hell just for fraudsters, called the ten ditches of the Malebolge. Speculators are thrown into boiling pitch; embezzlers set on fire. Falsifiers are given diseases, ranging from a rash to leprosy.
I think the deposit-slip thieves should get leprosy.