Abhinav Ramchandran and Dylan Sharma
Student of B.A.LL.B. (Hons.) at Symbiosis Law School, Hyderabad
Phone number: +91-9731021337
Email ID: firstname.lastname@example.org
Student of B.A.LL.B. (Hons.) at Symbiosis Law School, Hyderabad
Phone number: +91-9704940851
Email ID: email@example.com
Logitech International is a highly reputed company from Switzerland. The company has significant business operations in the United States and focuses primarily on the personal peripherals and video conferencing sectors. As a result, there is a high chance that the speakers or mouse used by us may bear the Logitech branding and logo. In November 2009, Logitech acquired Life-Size Communications, which was a company which had originated from Austin, Texas in the United States. The company had its business set up in the high-definitions video communications industry.
In April 2016, the SEC (Securities and Exchange Commission of the United States) initiated a cease-desist proceeding against Logitech after discovering “recurring instances of improper accounting in three separate areas during a five-year period.” These actions eventually gave rise to inflated earnings and improper accounting for some of its products. Two former executives were also charged with having committed securities fraud. The company also failed to amortize intangible assets at the time of acquiring Life-Size Communications, adding to its already growing tally of financial irregularities. In early 2013, despite repeated warnings and communications which were made regarding the material errors in the amortization of Life-Size Communications, senior accounting officials ignored the errors and overstated the company’s investment by $1.87 million.
Toshiba, one of the most respected players in the technology sector and perhaps one of Japan’s oldest companies, like many other companies suffered rather terribly during the global financial crisis which rocked the world in 2008. The company gave stern warnings to its employees and business leaders working in different units to meet aggressive targets relating to revenue, profitability and growth. Realizing that the targets were impossible to achieve, the managers eventually altered the books to provide a “much-needed illusion” that the company had achieved its goals and targets. Once news of the fraud began to surface, the company set up an independent team to investigate the matter. A report was released in July 2015, which exhibited the findings of the team.
The accounting and financial frauds that were committed, took many different forms and occurred over a long period of time under the leadership of several CEOs. The company’s accounting technique with respect to the percentage of completion method for contract work was one of the primary frauds that were committed in the company. This principle is commonly used in contracts for services related to civil engineering, architecture, shipbuilding and manufacturing of machinery.
The report also identified multiple projects for which expenses were not recorded until the project reached completion during the period 2008-2013. In almost every situation, the managers told the investigative team they hoped cost overruns would be nullified as a result of cost reductions during the course of time.
In both the cases, we have seen two established companies, both highly reputed and well respected in their fields committing such crimes. Thus this clearly proves that fraudulent financial reporting is a practice that is followed by many firms across industries. In the case of Logitech, we saw how two former executives were charged with committing securities fraud and we also saw how improper financial reporting resulted in inflated earnings. With Toshiba as well, a similar incident was witnessed with a lot of accounting and financial frauds taking place to “adhere” to the astronomical and seemingly impossible to achieve targets as set by the company.
Meaning of fraudulent financial practices:
What exactly are fraudulent financial practices then? While there is no exact or precise meaning to that effect, it can be stated that the concept of fraudulent financial practices refers to an intentional misrepresentation of the state of affairs of the company and to give investors a wrong idea or impression about the firm’s profitability or operating performance. It simply refers to the tampering of financial statements to provide investors and those associated with the company an incorrect idea of the state of financial affairs of the company (like high profitability, high return on investment (ROI), high turnover rate etc.). According to the Association of Certified Fraud Examiners, financial statement fraud is a “scheme in which an employee intentionally causes a misstatement or omission of material information in the organization’s financial reports.” While instances of financial statement fraud are much lower than other types of fraud, such as embezzlement or corruption, the losses are much higher.
Why do such fraudulent practices occur in the first place? There are many reasons as to why this takes place. One of the most common reasons as to why such practices take place is because of corporate restructuring policies or practices of firms. Corporate Restructuring refers to a process where a firm or a company is reorganized so as to make it more profitable. Thus, the entire structure of the firm maybe reorganized (ownership, management, employees, diversification of business operations etc.).
This could prove either beneficial or it could prove to be an absolute disaster. Poor corporate restructuring can destroy the very foundation of an organization, if left to persist. Examples of poor restructuring include: Rigid ownership policies (due to a change in ownership), poor company division or diversification, fraudulent and unethical management etc. All of these characteristics often result in companies and firms often going down the path of following and incorporating fraudulent financial practices. Take the example of Toshiba discussed above. After the onset of the global financial crisis in 2008 which engulfed world markets and took the economy by storm, the management of Toshiba became stern with their decision making and decided to impose tough targets and goals across the leadership board at Toshiba. What followed afterwards only resulted in pandemonium for one of the widely respected companies not only in Japan, but across the world. A slew of accounting and financial frauds were unearthed by a team of investigators appointed by the company. Hence factors like rigid management or ownership coupled with cut-throat competition which every market witnesses, can often aggravate this situation.
There are also other factors which are responsible for this problem. Personal preferences have almost always taken precedence over the collective interest of working in an organization. This is also another reason as to why such scandals take place. The Satyam Computers Scandal serves as a reminder as to what personal and unethical practices can do to an organization. At the time the scandal broke out, Satyam was India’s 4th largest IT company, it had captured about 9% market share, had about 53,000 employees at their disposal and it was first ever Indian company to be listed on three foreign exchanges (NYSE, DOW, EURONEXT). In short, it was a company that was poised for greatness and success on the world stage.
However, a letter revealed that Satyam’s Founder Mr. Ramalinga Raju, had been overstating the company’s assets in the company balance sheet by $1.47 billion and had manipulated the company’s accounts ranging from the period 2003-2008. What followed was one of the world’s biggest scams and certainly India’s biggest scandal in recent memory (Satyam lost about 77% in shares and ended at Rs. 40.25 from Rs. 175, BSE closed at 9586.88, having come down by about 749 points or 7.25%). The board of Satyam was also barred by the Company Law Board who later appointed 10 nominal directors. Thus personal preferences and unethical behavior ultimately resulted in an unworthy downfall for one of India’s rising companies.
Legal provisions relating to fraudulent financial practices:
In India specifically speaking, the Companies Act 2013 serves as a deterrent and it aims at preventing fraudulent practices in companies. Other legislations that act in a similar fashion and aim at protecting the status of companies and prevent fraudulent practices in organizations are the Prevention of Corruption Act (PCA), 1988 and the Prevention of Money Laundering Act 2002 (PMLA). Both contain provisions that deal with the prevention of corporate and business fraud. Section 447 of the Companies Act has been invoked in cases of fraudulent practices with relation to company affairs. This includes act, omission, concealment of any fact or abuse of position committed by any person or any other person with the connivance in any manner, with intent to deceive, to gain undue advantage from, or to injure the interests of, the company or its shareholders or its creditors or any other person, whether or not there is any wrongful gain or wrongful loss.
The main intention behind this legislation is to penalize the wrongdoer who committed such fraudulent acts rather than the loss which is caused to the affected individuals. The Indian Penal Code (IPC) also has an important role to play in the development of legal provisions of fraudulent financial practices as offences of forgery, criminal breach of trust and dishonest misappropriation of property are also included in its ambit. Additionally the Prevention of Money Laundering Act (PMLA) 2002 also describes the offence of money laundering in detail. The activities of possession, concealment, acquisition or use of the proceeds of the crime are also included under this legislation.
Another important piece of legislation with respect to fraudulent financial practices is the Sarbanes Oxley Act. The Act was enacted in 2002 with the intention of protecting shareholders and the public from accounting errors and fraudulent financial practices. It is primarily a federal law which is aimed at regulating the financial and auditing system of companies. The act has been hugely beneficial to companies as it allows major loopholes within the financial setup of an organization to be detected and it also repays investor confidence. The Act can be regarded as a step in the direction towards curbing the ill effects of fraudulent financial practices.
The Act has numerous advantages and benefits which makes its significance all the more crucial. The public companies are required to strengthen their position when it comes to audit committees. There are a variety of internal control tests that are required to be adhered to. Perhaps the biggest advantage of this legislation is that the aspect of transparency is also paid close attention to. The Act personally holds directors and the officers so concerned liable for any inaccuracy of the financial statements. It also imposes harsher penalties and punishments on those who have committed such crimes. Therefore, the significance of this Act cannot be ruled out.
Case study of the Enron scandal:
The case study hereinabove is based on the infamous Enron Scandal, which at the time it was discovered, resulted in what was probably the most infamous and biggest financial scandal to have erupted in the world. Very much like the Satyam Scandal which was to occur years later, the Enron Scandal sent shockwaves throughout the economy and the world because of the extent and the gravity of the accounting and financial scandals that came to the forefront.
Enron was the biggest corporation in the world and at its absolute peak, its shares were valued at a mind-boggling $90.75. However, when the corporation declared bankruptcy on 2nd December 2001, the value of the shares witnessed a jaw-dropping fall, to a mere $0.26. This begs the question as to how could possibly the world’s biggest corporation witness such a staggering fall from grace?
For a bit of background on the case, Enron was formed in 1985 as a resultant of the merger between the Houston Natural Gas Company and InterNorth Incorporated which was an Omaha based Company. The company quickly began achieving success and was rebranded in a sense as an energy trader and a supplier. Enron was well on its way to becoming a successful organization as the energy sector underwent deregulation. Enron was at the forefront of improving their technology and the way they went about handling their resources. They replaced the traditional system of accounting with the mark to market (MTM) accounting method. This was consequently approved by the SEC in 1992. This was a revolutionary change for the company as the MTM was indicative of a fair measure of assets and liabilities that change over time. Thus a realistic view of the accounts was provided and therefore a fair and unbiased view of the financial statements was provided.
Around the 1990s, Enron was also credited for its innovation and creativity in the technology sector. So much so, that Fortune rated Enron as “America’s Most Innovative Company” between 1996 and 2001, for a period of six consecutive years. Enron also started an online website that focused on trading commodities (Enron Online in 1999). Enron also offered exciting deals and schemes by way of giving its users reputation, credit etc. in the energy sector and had expansive and ambitious plans to build the scope of its business operations for which they were heavily praised.
All the praise and adulation that was coming in the way of Enron making it as a successful organization was to last for only so long. By 2000, there were serious problems that were starting to surface in the organization. The MTM accounting technique which was used by Enron successfully and which was seen a major overhaul in terms of technology had witnessed a paradigm shift. That same MTM technique was used by CEO Jeffrey Skilling to hide the financial problems and irregularities such as losses and other problems that the company faced. The situation was very grave and almost seemed irreparable to the point if Enron produced or manufactured an asset or a product, they would immediately without any delay put out the projected profit that they earned, even when a single dollar wasn’t earned. This only shows the sheer disaster that was unfolding for the corporation.
The MTM technique should be looked into some more detail. The technique was used by Enron a lot in order to mask their liabilities and problems that they were facing. The technique was extensively used to overstate profits and the scope of business operations. In fact, the CFO of Enron in 1998 even hatched a deliberate plan to overstate the profits and earnings of the company, despite the fact that most of its subsidiaries were losing money and profits by the day. The scheme used by Enron involved using off balance sheet special purpose vehicles (SPVS), also commonly known as special purpose entities to hide the mound of liabilities that had mounted upon the company. The main intention was to hide the actual position of the assets and liabilities and project and show a projected value that didn’t exist.
The aspect of transparency was also heavily compromised with. Arthur Andersen LLP, one of the biggest accounting firms in the US looked after the accounts of Enron. Despite the several discrepancies and irregularities with the accounts and the financial statements of the organization, Arthur Andersen LLP gave a green light and even signed many of Enron’s reports for the year. This was done despite the firm’s reputation for maintaining high standards of performance and quality risk management.
The ill-effects of the scam were starting to show. In February of that year, the then CEO Kenneth Lay retired and the reigns were handed over to Jeffrey Skilling. Less than 6 months after his appointment, Skilling also resigned as the CEO citing “personal reasons” for his sudden resignation in August 2001. Analysts across the spectrum began to linger on the impending financial crisis that was looming over the Enron Corporation. Trade analysts began to downgrade their rating for Enron’s stock and as a result, the stock came crashing to an all-time low after almost a year (52 weeks). The effect was immediate, as the share value of Enron came down, suffered huge losses (about $591 million in losses and about $628 million in debts). Employees were forbidden from selling their shares and the last straw came about when (NYSE:DYN), a company pulled out of its planned merger with Enron. On 2nd December 2001, Enron filed for bankruptcy.
The above case study of the infamous Enron scandal indeed cuts a very sorry figure. As the authors discussed above with the smaller cases of the Logitech and Toshiba scandals as well as the Satyam scam, it is very important to note that personal preferences and unethical behavior often take precedence in the business and technology sector. All of these examples only go to show that the need for excessive power can lead one down an extremely dirty path.
All of these organizations had pretty much everything going for them, they had great turnovers, had a lot of employees at their disposal and were tipped to become global leaders of the market. As greediness and personal and unethical objectives began to take center stage, devious and terrible schemes were used by these firms, ultimately bringing them down the ladder.
This only begs the question, how can such incidents be prevented? In today’s big bad modern world which is grossly competitive and ambitious, people can be compelled to try and explore numerous possibilities. The authors believe that organizations should take the initiative and go about explaining to each and every employee as to what is expected of them and what they mean for the organization.
Every employee should be made aware of his/her roles in the organization and what they mean to the company. Managers should lead from the front and motivate the employees and direct to perform responsibly and put the organization’s needs ahead of theirs (Subordination of Individual Interest to General Interest). Therefore it is up to the top level management to instill the right balance and promote the right working culture within the organization.
What about the laws and the various provisions that have been enacted? Laws and statutes have always been developed and created keeping in mind the best interest of society and to deter criminals from committing crimes in the future. However these provisions are also heavily misused and nobody ever pays any heed to them. In order to safeguard its position as watchdog of the companies, the internal management and the employees must ensure that such provisions are followed stringently.
The top level management must lead by example and set up internal committees and teams to investigate any wrong doing and must heavily penalize such defaulting employees. Proper systems of accounting need to be followed by organizations and a strict watch must be kept over the way and the manner in which the accounts are handled. Employees must be made to understand the importance of working in an organization and as a team. They must be made aware of the risks and the hazards of following fraudulent financial practices. This would hopefully go a long way in if not entirely preventing, but at least reducing the level of crimes that are committed.
 Investigation Report: Summary Version, 20 July 2015, Independent Investigation Committee for Toshiba Corporation (English translation version).
 Association of Certified Fraud Examiners. Report to the Nations on Occupational Fraud and Abuse: 2016 Global Fraud Study, Glossary of Terminology, pg. 90
 Ibid., pg. 12.