Indeed, this post may be of particular use to entrepreneurs, who may not have an extensive financial background and can benefit from a quick rundown of many accounting and legal practices that could be used in legal and illegal ways. In fact, having a solid understanding of corporate law and advanced financial practices can be invaluable to the business person or startup founder: a deep understanding of how to use shell corporations and accounting practices in innovative (legal) ways can be the thing that helps set a startup apart. This is why throughout this article I give book recommendations for the reader who wishes to learn more about a particular legal or accounting technique.

This article is organized as follows. Upon giving a brief note on financial fraud, we review the financial and legal practices that may or may not be used for illegal purposes, such as the development of shell corporations or mark-to-market accounting practices. Practices used strictly for illegal purposes will then be described, such as cooking the books and money laundering, as well as basic techniques used in the detection of financial deceit. Finally, I compose a list of books and articles that would be of particular use to entrepreneurs and business people looking to learn more about the useful facets of finance and law.

Introduction

Modeling extreme events and the behavior of complex systems is an absolutely fascinating task. Certain models, often developed with ideas stemming from chaos theory, can be used to model complex systems from neuron firing patterns to catastrophic events such as terrorist attacks and natural disasters.

As enthralling as discovering latent power laws and modeling such complex systems may be, developing robust predictive models for contagion or terrorist attacks doesn’t make the topic being modeled any less terrifying or awful.

Analogously, taking interest in the facets of financial fraud does not absolve the fact that financial fraud (such as misappropriation of assets or fraudulent financial reporting) absolutely undermines the free market, thereby degrading the composure of ideas such as the American Dream.

One of the fundamental principles of free-market capitalism is one of natural resource flow, where wealth and esteem flow at a faster rate to those entities generating a disproportionate amount of value (value is loosely defined in this case). There are situations however in which resources are misdirected to entities producing little to no value, and in many cases these “sinks” are entities engaged in financial fraud. Those engaged in nefarious business methods disrupt the natural flow of resources in the free market, severely damaging the economy as entities producing real value are suddenly unable to compete in a market where investors are simply not privy to the true value generation of each corporation.

Book Recommendation: Empire of Deception

This type of fraudulent activity is often a product of avarice and crooked incentives or pressures, which are often manifest in the types of questionable “creative” financial and legal practices that will be explored below.

Practices Often Used Legally

This section will review some practices that are often used for legal purposes but may be used for illegal purposes as well.

Mark-to-Market Accounting

Mark-to-market (MTM) accounting is an accounting system developed to provide a realistic appraisal of an entity's current financial situation, where assets are valued based on how much they could sell under current market conditions. Mark-to-market differs from historical price accounting, which lists the value of the asset at its original purchase price. This accounting practice is legal and has grown in popularity in recent years as it is a perfect accounting practice for trading and investing institutions such as financial institutions and real estate companies.

An example of a legal way to use Mark to Market accounting is as follows. Take a real estate company that purchased a property in the year 2003 for $250,000. Over time, the real estate market in the area increases dramatically, and the value of the property purchased for $250,000 in 2003 is now worth $800,000 in 2018. Using historical price accounting, the company would report the asset being worth $250,000, which is clearly not the case, so they opt to use MTM and present the asset value at its expected current value of $800,000.

Mark-to-market accounting is a solid go-to accounting method, however, the flexibility the practice gives can easily lend itself to helping a company commit fraud.

In historical price accounting, the price of the asset is grounded on very solid reasoning and does not allow for interpretation of the asset's value. Mark-to-market accounting however allows for the value of the asset to be pushed around, as the value of the asset is often subjective and much of valuation is grounded in intangibles such as location and aesthetics.

As such, a real estate company seeking to bolster its image can raise the reported value of its properties, justifying the value of the asset with arguments invoking intangible value adds whose true value may not be possible to prove, as they are up to ones own subjective interpretation.

Enron provides a classic example of the deceitful use of mark-to-market accounting. Enron would build an asset, such as a power plant or drilling rig, and immediately claim the assets projected future profits, despite having not made a cent from an asset. Take Enron’s development of a large power plant in India for example. Enron spent over a billion dollars developing power plants, and when they were finished construction they immediately recorded the plants' projected profits in their books. However despite the company’s promises that everything in India was in fact ok, the reality was the locals didn’t have the money to pay for the energy the plant provided, so Enron ended up hemorrhaging money while continuing to claiming a profit from it on their books.

Book recommendation: The Smartest Guys in the Room: The Amazing Rise and Scandalous Fall of Enron

Special Purpose Entities (SPE)

Special purpose entities/vehicles (SPE/SPV) are legal subsidiary companies (companies owned by some parent or holding company) that have a full asset and liability structure, as well as full legal status; created to complete specific or temporary objectives. Generally, these companies are used as a way for a company to isolate financial risk, so if the parent company goes bankrupt, the obligations are still secure.

One common use of SPE’s is in project development, where a project is funded through an SPE. The reason for this being that if insolvency issues were to occur, the parent company would not be put at risk. This is also known as “risk sharing”, as multiple investors can put money into the SPE to share the risk.

One other nice example of SPE use is in asset transfer. Certain assets require the ownership of many permits and other legal documents in order to run our own said asset (examples could be anything from mining equipment to a manufacturing facility or power plant). When it comes to transferring these assets (through a sale for example), the large number of permits can make the transfer difficult if not impossible. However, if the asset is owned by an SPE, the parent company of that SPE may simply transfer the SPE instead, which already contains the asset and the requisite permits, thereby allowing for the avoidance of difficult permit transfers and high legal fees.

When forming and using an SPE however, it is easy to quickly get caught between the legal and illegal. One thing SPEs do well is hiding assets and liabilities. This can of course be a good thing, such as if the parent company needs to maintain the secrecy of intellectual property (see Intel and HP’s use of an SPE to develop the IA-64 processor architecture in secrecy). However, the power of SPEs can also be abused.

One of the most famous cases regarding the abuse of SPEs stems from, once again, Enron. Enron executives used the off-balance-sheet property of SPEs (no need to report the assets contained in an SPE on the balance sheet) to hide massive amounts of debt and toxic assets from investors and creditors. Enron employed an off-hand form of debt securitization, a common use for SPEs, to hide accounting realities from investors, obvious illegal use of such entities. Myriad blatant mistakes as described neatly in this article, set the SPEs up for failure, from only capitalizing them with Enron stock, to not disclosing obvious conflicts of interest (the CFO handling everything).

Book recommendation: Structured Finance and Collateralized Debt Obligations: New Developments in Cash and Synthetic Securitization

Shell Corporations

A shell company is a beautiful, abstract artifact of the human imagination that happens to be ratified in our legal systems. Shell companies are entities that only exist on paper, with no active business operations. The beauty of a shell company is manifest in the many ways they may be used, both for legal and illegal purposes.

“Shell company” is an umbrella term, subsuming many ideas such as “offshore holding companies”, “front companies”, “international business companies”, “special purpose entities”, “startups” and more. Companies such as Apple or Caterpillar may construct shell companies and base them in tax havens, so that their overseas profits may not be taxed at the higher American corporate tax rate. Shell companies created for this purpose are often referred to as “offshore holding companies”, and are (generally) legal.

Companies can also use these offshore holding companies to offshore not only profits but much of the work as well, further taking advantage of looser tax codes in the process known as “offshoring” or “outsourcing” work once conducted domestically.

Shell companies can also be used to facilitate anonymous transactions between two entities that do not want to be associated with each other. For example, if Entity A and Entity B do not want to be associated on account of any reason, they may set up a shell corporation used to bounce transactions through, thereby disguising the true identity of the other party. There is nothing illegal about doing this, however, it is often the case that shell companies are used in this way to hide illegal transactions or relationships.

Other legal uses of shell companies include the protection of intellectual property, the facilitation of mergers and acquisitions, cross-border currency and asset transfers, the holding of intangible assets for another entity, and so on. As with any tool, however, shell corporations can be just as easily used for illegal purposes.

When structured in the right way, shell companies can act almost as layers of armor that keep the owner of the shell company completely anonymous, making them ideal for illegal uses. Illegal uses of shell companies are money laundering, tax evasion (Panama Papers), pump and dump schemes, and the abuse of the off-balance-sheet features of shell corporations in hiding debt and toxic assets (such as in the Enron case).

Book recommendations: The Hidden Wealth of Nations,* *The Law of Corporations In a Nutshell

Misleading non-GAAP Financial Measures

GAAP, Generally Accepted Accounting Principles, are a set of accounting standards meant to introduce more transparency into financial statements. When a company, especially a public company, reports its financial statements in say a quarterly earnings report, the way in which they report everything must be in compliance with GAAP and possibly other SEC reporting rules. When all companies follow the GAAP standard, they report their financial statements in the same way and investors are able to fairly determine a companies health. As such, no company is given an unfair advantage over any other company because they decide to report their financials in a creative way that makes them look better than they really are.

While companies tend to adhere to the GAAP standards, they also can report non-GAAP compliant measures when reporting financial results. Non-GAAP financial measures are where a company can begin to wander into a gray area of ethics and legality. When a company uses non-GAAP financial measures, it can mean they are using their own in-house financial measures to report financial results. The technique of using non-GAAP metrics can be a perfectly legal and ethical thing to do, for if GAAP does not give a clear picture into the nature of the sector the company is operating in, it makes more sense to report financials another way so the company will report “adjusted earnings” along with the GAAP compliant reports. This can give a different (and often useful) look into the true financial health of the business.

The problem, however, arises when the accountants get a little too “creative”, pushing their non-GAAP reports and their validity, when in reality the reported non-GAAP measures are so far disjointed from the companies real financial results that it can mislead investors.

Accounting and Finance Book Recommendations: Corporate Finance in a Nutshell*, *Accounting Handbook

Illegal Practices

Upon reviewing some of the financial practices lying in a legal grey area, we give some examples of practices that are strictly illegal.

A Classic: Money Laundering (and a note on “Round Tripping”)

Money laundering is unfortunately so ubiquitous most know what it is, so we will keep our description concise. In short, money laundering is a complex process through which those entities with money acquired through illegal means may obscure the origin of the funds. The origin of the funds is concealed by passing the money through a sequence of banking transfers and commercial transactions.

Today (unlike the early days of using laundromats and the like), the process of separating funds from its source happens through the use of shell companies, before the money is returned to the criminal through a legitimate-looking source. For example, a criminal who acquired $1 million through [arms trafficking] could clean the money by placing the cash in a bank account, wiring the money to a separate bank account owned by an anonymous shell corporation, and this shell corporation could then buy assets for the criminal, thereby “cleaning” the money.

Another common method used to successfully launder money is “smurfing” (structuring) where large portions of dirty money are broken up and spread out between multiple deposits so as to avoid triggering suspicion by anti-money-laundering watchdogs.

Also worth mentioning here is the concept of “round-tripping”. Round tripping has many meanings, however, the concept is commonly associated with money laundering. The general method of round-tripping is defined to be a method of bolstering apparent company revenue or cleaning money, by sending money to some entity only to have it returned at some later date. In the context of financial fraud (although it is not necessarily illegal), a company may sell some asset to another company (which may then sell it to another company and so on) with the promise of purchasing that asset back at a later date (hence the “round trip” of the asset). What this accomplishes is making the seller of the asset appear to have a higher sales volume than it actually does, thereby misleading investors. In the context of money laundering, round-tripping can “clean” the asset, as it appears to have been purchased from a viable entity.

Book recommendation for modern laundering methods: Trade Based Money Laundering

Cookie Jar Accounting (Smoothing Out)

Cookie Jar Accounting refers to saving money (developing the cookie jar reserve) only to report those savings as income at a later date. For example, if a company had a very profitable quarter, they could save some of the profits in a “cookie jar”, so when they have a bad quarter in the future the company can record the savings as earnings, giving the illusion that the company did better than it really had that quarter. Another method of cookie jar accounting is where a company can create some fake liability one quarter, only to erase that liability the following quarter and list the liability as income.

One particularly famous example of cookie jar accounting was when Dell had a several-year period where they dipped into reserves to smooth out shortfalls in operating results. Dell did not report it was drawing on these reserves to investors and thereby mislead investors on the true nature of its financial situation.

Sales Skimming

Sales skimming is a form of tax evasion where a company lowers its reported profits, so they are not taxed as much. This is analogous to “cooking the books”, where a company manipulates the numbers on its financial statements but instead of lowering reported earnings it lowers reported expenses and increases reported earnings to hide the true financial health of the company.

On the heels of the Enron and Tyco frauds, came WorldCom — giving perhaps one of the most famous examples of a company cooking its books. When the Dot Com bubble burst, WorldCom cooked its books to maintain its image of growth and health despite its true decline, thereby misleading and costing investors significant amounts of money.

Book recommendation: Fraud Examination

Other Illegal Practices

There are many other illegal practices used by corporations to commit fraud. Some other examples are period-end stuffing, fraudulent post-clearing entries, artificial income appreciation/depreciation of expenses, and the use of off-balance-sheet partnerships and reserves to manage reported earnings.

Detecting Financial Deceit

Upon reviewing methods of financial deceit, it is natural to close with a review of some common methods used in detecting financial malpractice.

In the movie The Accountant, Ben Affleck’s character used ideas stemming from Benford’s Law to detect financial fraud in a major corporation. In reality, such methods are seldom used, as detecting financial fraud is a far more nuanced task. Rather, fraud is often detected through watching for “red flag” indicators on financial statements such as breaks in trends or unusual transactions and then following up with a detailed examination of the entity’s accounting records (analysis of financial statements alone is seldom sufficient in discovering fraud).

Despite this fact, there are still clear “optimal” areas to search for fraud, such as large line items where discrepancies can be easily hidden, and other methods that can be used to detect dependencies. For example, the “special items” line item in company financial statements is often a particularly good place to hide a cookie jar accounting move for example. Transactions reported in “special items” can include any large payment or income the company expects to be a one-time event, so it follows that it is the perfect place for a company to hide money from a previous lucrative quarter which it can later use to inflate poor earnings numbers.

Some other red flags may be identified by comparing the financial reports of the company under review to the financial reports of similar companies in the same sector. If certain reported line items in the financial statements are highly unusual for a company in the given sector, this could be a sign of fraudulent activity. Similarly, if other companies in the same sector are underperforming while the company under review is significantly overperforming (without clear reason), this could be a sign of cookie-jar accounting or cooking the books.

There are many other “red flags”, such as an increase in revenue without a corresponding shift in cash flows or expenses. However, if a company is engaged in fraud they are likely concealing their illicit behavior through many highly complex means. Enron used off-balance-sheet special purpose entities, hid liabilities and inflated earnings, and used mark to market accounting practices to net income they didn’t actually have. It follows that uncovering fraud is never easy, and requires diligent and high-quality investigative work as conducted by the Wall Street Journal in revealing the true nature of Enron’s composure to the world.

Book recommendation: Money Laundering: a Guide for Criminal Investigators

Conclusion: This article neglects to mention so much about methods of financial deception, however, we,unfortunately live in a world where such practices are prevalent, so it is not difficult to learn more about these ideas. It is our hope that this article gave the reader a sufficient understanding of the basics of financial deceit, so they may carry a more nuanced perspective of the situations of financial corruption plaguing many of the world's institutions.

More Book and Article Recommendations

The Wall Street Journal occasionally publishes articles describing the current unveiling of such illicit practices in organizations. See How Tillerson’s Exxon Designed an Oil Deal to Skirt Anticorruption Scrutiny and North Korea Built an Alternative Financial System Using a Shadowy Network of Traders* *for more information.

Book list

1. The Role of Domestic Shell Companies in Financial Crime and Money Laundering

2. Global Shell Games

3. Federal Income Taxation of Corporations and Stockholders in a Nutshell

4. Accounting Made Simple

5. Advanced Accounting

6. Corporate Law

7. Fundamentals of Corporate Finance

8. Auditing For Dummies