Article
Article
On 22 June 2020, payment service provider Wirecard suddenly announced that balances of over €1.9 billion that were reported on its balance sheet “most likely do not exist”. This amount corresponded to around a quarter of the balance sheet total for the group, which was listed on the German index of the largest listed DAX companies. Board member Jan Marsalek, the main suspect in this accounting fraud, has been on the run ever since. Rumours surrounding him are wilder than some spy thrillers.
This was only another accounting scandal. In the last 30 years, hardly any major global capital market has been spared. And the problems are not limited to listed companies; from the Swiss Erb Group in the late 1990s to the current collapse of Austrian financier René Benko's Signa Group, it always starts with inaccurate reporting.
Despite international differences, accounting worldwide aims to provide as transparent and reliable a picture as possible of the economic situation of a companies. In more traditional systems such as the Swiss Code of Obligations (OR) or the German Commercial Code (HGB), the principle of prudence dominates: most balance sheet items are recognised at their historical acquisition costs. Over time, this tends to lead to an unrealistically “pessimistic” presentation due to rising values, but it does contribute to greater resilience among companies. In Anglo-Saxon accounting systems, market values are more frequently reported in the balance sheet. These are often higher, but fluctuate more, so that investors have to make safety deductions. However, these differences play a minor role – and certainly do not amount to a quarter of the balance sheet total, as in the case of Wirecard. So, where is the problem?
Those who only had to deal with it casually at school may find accounting challenging. For trained professionals, it is not. The underlying system dates back to the Italian Franciscan monk Luca Pacioli, who first described double-entry bookkeeping in 1494. Since then, little has changed in terms of the fundamentals. As a result, there is only a limited range of possible misdeeds:
Overvaluation of assets or accounting for non-existent assets. This is what happened, for example, at the US telecommunications company Worldcom. There, billions in line costs were incorrectly recorded as fixed assets instead of being included in expenses.
Non-accounting or undervaluation of liabilities. For example, the US insurance group AIG had set aside insufficient provisions for claims and thus reported excessively high profits.
Incorrect inclusion of subsidiaries/affiliates (consolidation), i.e. companies that are subject to consolidation are omitted, or companies that are not eligible for consolidation are included. This was the case, for example, with the US energy group Enron, which had transferred its own debts to hundreds of de facto subsidiaries but did not consolidate them.
Virtually all major accounting scandals can be attributed to one of these three patterns. So it is always the same topics that lead to accounting problems. How can this be?
Despite the many figures involved, accounting is a social science: it is about communicating what has been achieved – and is therefore a deeply human challenge. Major accounting scandals often have one surprising feature in common: there is no clear intention or criminal energy at the outset. The problems usually arise step by step: high internal and external pressure to perform, combined with ambitious, perhaps unrealistic goals, give rise to a culture of “failure is not an option”, as seen in the excellent documentary about the Enron scandal.
If things do not turn out as expected (and communicated), the first step is to “design” the annual financial statements: “Accounting policy leeway” is exploited in the hope that future positive developments will quickly close the gaps. If these do not materialise, the amounts that have accumulated in the meantime are sometimes so high that it is difficult to admit the situation to oneself and for others and pull the ripcord. Those responsible for the balance sheet become prisoners of their own “success story”. Those who lack the necessary moral compass and sufficient independence may cross the line of what is permissible. Creative accounting policies thus become criminal accounting fraud, from which it is even more difficult to extricate oneself. A change in management may help, but not every organisation has the strength to do so. This is especially true when the founders are still at the helm or when high financial incentives play a role.
A second and common cause of incorrect accounting is simply technical in nature. One factor here is that accounting systems are traditionally designed for stability. Ongoing acquisitions and divestments, innovative and changing business models, internationally dispersed stakeholders with different requirements and increasingly comprehensive regulatory requirements are very different conditions from those Luca Pacioli faced. It costs companies considerable resources to keep up with accounting requirements in a dynamic environment. At the same time, management is generally much less willing to invest in its finance departments than, for example, in sales and logistics, where the focus is on immediate service provision. Accounting primarily only costs money, and if there are a few “hiccups” in this area, few people notice at first. It has no impact on turnover. So companies are happy to save money and then wonder why their staff and systems are suddenly no longer adequate.
A variety of governance mechanisms have been established to prevent accounting scandals: from the auditor and the audit committee to sovereign enforcement mechanisms such as stock exchange and audit supervision. Every major accounting scandal to date has had regulatory consequences. Most of these are extremely useful. For example, the Wirecard scandal led to the previously privately organised supervision by the “Deutsche Prüfstelle für Rechnungslegung DPR” (German Financial Accounting Enforcement Panel) now being carried out by the state-run “Bundesanstalt für Finanzdienstleistungsaufsicht” (BaFin) (Federal Financial Supervisory Authority). And due to the occasional failure of auditors, all major capital markets now also have state auditing supervision.
Is this enough to prevent future problems? Certainly not. Experience teaches that financial markets are always creating new ways to circumvent the existing framework. It is an illusion to think that accounting scandals can be permanently eliminated through regulation. This is why universities also have a role to play: we must not only teach the technical basics of accounting but also convey the message that we are dealing with a sensitive public good. The "Code of Ethics for Professional Accountants" of the international professional organisation IESBA expresses this very aptly: "A distinguishing mark of the accountancy profession is the acceptance of responsibility to act in the public interest. A professional accountant's responsibility is not exclusively to satisfy the needs of an individual client or employing organisation." We must repeatedly draw attention to the danger of the gradual transgression described above in our training and provide options for action. We must also make it clear that investments in accounting – including training – pay off in the long term.
Last but not least, we should enable our students, in their role as recipients of financial information, to recognise when reporting does not reflect reality. As the Enron film says: "If something sounds too good to be true, it probably is." A phrase that investors should also bear in mind.
Book
As a journalist at the German business magazine WirtschafsWoche, Christof Schürmann has been critically monitoring corporate reporting for many years. He not only looks at general business and financial developments but also addresses related issues of accounting and financial reporting. He shows where there is room for manoeuvre and provides examples of how this can be exploited.