Die Hard Accounting Methods

I recently watched the movie Die Hard 2: Die Harder. One scene in the movie made me think of our current economic collapse and the accounting scandals of the past several years. The scene is the one where Colonel Stewart, played by William Sadler, pretends he's the control tower and contacts a plane flying over Dulles Airport. First he calibrates the instruments. He lowers the reading of sea level by 200 feet. This makes the runway appear 200 feet lower to the pilot. He then guides the pilot in for a landing. By the time the pilot realizes the situation, he crashes into the ground.

When watching this scene, it occurred to me that this is a visual metaphor which answers the questions: What is accounting fraud and why is it so bad?

Most people, outside of the accounting and finance professions, probably look at financial statements the same way they would hieroglyphics. Naturally, understanding accounting fraud would therefore be difficult. Those committing the fraud and those defending the guilty are aware of this and use this fact to their advantage. Many defenders claim that regulation of accounting fraud is bad for business and the economy; even creating a term for it: creative accounting. I suspect some of these people are aware they are hoodwinking everyone. Sadly, some, due to their own ignorance of accounting, probably believe their own words.

Accounting fraud masquerades as creative accounting and is in a word: counterfeiting. That is a term no one seems to use when these corporate scandals surface. The term “the bottom line” is one that is familiar to many people. Even if they do not know it's origin. It's an accounting term that refers to the bottom line on the income statement. It represents an entity's income or loss for a given accounting period. This brings us back to Colonel Stewart.

Like Colonel Stewart, practitioners of “creative accounting” make adjustments to financial statements in order to “recalibrate” the bottom line. While this may make an entity look better on paper, the fact is, an entity cannot be made financially sound as a result of accounting gimmickry. Eventually, reality sets in and a troubled entity will, like the jumbo jet in Die Hard 2, crash and burn.

If an entity is healthy, poor accounting practice could make it unhealthy. Those guiding it could be making decisions on erroneous data; much like a pilot flying with inaccurate instrument readings. In addition, investors are duped into investing into a corporation based on an inflated bottom line.

What happens with accounting fraud, the financial statements are altered through accounting entries to make the company look better to investors. Insiders trading the stock use the stock market as a place to launder the inflated stock. Uninformed investors are then left holding the stock while stockholders who are aware of the true financial position of the company have sold their shares at the inflated prices.

This is exactly what Ken Lay, the CEO of Enron did. He was busy selling his shares of Enron while at the same time issuing statements and e-mails which encouraged employees to buy Enron stock. They bought because he claimed it was a good buy; he knew different.

This is similar to what a counterfeiter does when laundering counterfeit currency. Ken Lay exchanged his “counterfeit” shares for genuine U.S. Dollars. The effect on the national economy is the same as counterfeiting. If we lived in a paperless economic system where there was no currency, counterfeiting would be conducted in the same manner Ken Lay used. You would counterfeit earnings or services and convert them to currency.

The same thing happens with the Ponzi schemes like the one Bernie Madoff pulled off. He inflated the earnings in his fund by moving money around among his individual investors. This created the illusion of enhanced performance of the overall fund. Again, he counterfeited the results. Time and a dramatic drop in the stock market revealed the actual returns his fund was getting.

The last time “creative accounting” was in vogue was during the roaring 1920's. In October of 1929, the stock market crashed. Then, as now, the Stock Market after the crash, reflected accurately, the true price of the market. The prices before the crash reflected inflated figures. The stock market crash of 1929 helped usher in the Great Depression of the 1930's and prompted the creation of the Securities and Exchange Commission.

Recently, the Dow Jones Industrial Average dropped below the 8,000 range from its all time high. As in 1929, this is the market seeking its true level. It fell from a level inflated by accounting fraud. What caused the crash then and now was a sudden adjustment to the true level of the stock market. A level significantly lower than the one artificially created by accounting fraud.

Who is responsible for policing counterfeiting in this country? According to the U.S. Constitution, Congress. Article One Section Eight reads: “Congress shall have the power to provide for the punishment of counterfeiting the securities and current coin of the United States.” By definition, accounting fraud violates the principals of the Constitution. So much for the theory that government should not interfere with free markets.

Unfortunately, the most notorious counterfeiting ring in the country works out of Capitol Hill. It doesn't matter which party is in power, Congress has acted the same. A stimulus plan, which consists of increasing the national debt by trillions, may have the same effect that “creative accounting” has had on the health of our nation's economy. Some believe the printing of more money to solve the current economic problem is like throwing gas on a fire. Others may view it as a “die hard” move.