1.6 Motivations for Financial Statement Fraud

Motivations to issue fraudulent financial statements vary from case to case. A common theme in many of the frauds is an attempt to improve the reported financial information to support a high stock price, to support a bond or stock offering, or to increase the company's stock price. In many companies issuing fraudulent financial statements, the top executives owned considerable amounts of company stock, or stock options, and a decrease in stock price would have significantly decreased their own personal net worth or made the stock options worthless. As a result, top executives needed to keep the stock price high and, therefore, needed high income to support a high stock price. Investors place value on stocks that report increased earnings each year. Indeed, a dip in income can significantly reduce a company's stock price. To illustrate, consider this actual complaint in a financial statement fraud case:

Sometimes, fraudulent financial statements result because division managers overstate their results to meet company or other expectations. Sometimes the price of failure in corporate management is high, and when it comes to choosing between failure and cheating, some managers quickly turn to cheating. In the case of Phar-Mor, Mickey Monus wanted the company to grow quickly, so he lowered the prices on 300 "price sensitive" items to amounts that were lower than those of Wal-Mart, and even lower than Phar-Mor's cost. The strategy helped Phar-Mor win new customers and open dozens of new stores each year. However, it turned out that many of the new customers were coming into Phar-Mor specifically to purchase only the price-sensitive items, thus magnifying the company's losses. Rather than admit to David Shapira and Giant Eagle that Phar-Mor was suffering losses, Mickey Monus chose to hide the losses and make Phar-Mor appear profitable. As it turns out, Mickey Monus could not admit failure. In fact, Mickey Monus was bigger than life in his hometown of Youngstown, Ohio, where he was the "local boy made good" who gave back to the community. Rather than lose that reputation, Monus turned to fraud to cover up what he hoped would be "temporary losses." He lived a lavish lifestyle and intended only to hide the losses until the company turned around, which did not happen. The fraud was discovered when a travel agent noted that Phar-Mor's checks were being used to cover World Basketball League expenses, the travel agent then showed the check to her landlord, a Phar-Mor investor. The investor brought the matter to CEO David Shapira, who ordered an investigation that uncovered the fraud. While the motivations for financial statement fraud differ, the result is always the same – misrepresented financial results, bad decisions made on the basis of those financial reports, and adverse consequences for the company, its principles, and investors.

The examples above illustrate two different motivations for committing financial statement fraud. In the first case, managers were motivated to commit fraud in order to meet Wall Street's earnings forecasts, and in doing so, boost the company's stock price and subsequently the value of management's personal stock. In Phar-Mor's case, it was the fear of failure that motivated the fraud. In the end, these two reasons, greed and fear, motivate not just financial statement fraud but nearly all types of fraud.

After Enron, Worldcom, and other major corporate scandals rocked America during the past decade, it seemed that nothing would surprise investors and regulators. However, almost everyone was shocked to learn that as many as 20% of all public corporations may have allowed officers and directors to illegally "backdate" personal stock options.

A stock option is an award granted under which key employees and directors may buy shares of the Company's stock at the market price of the stock on the date of the award. As an example, assume that Company A's stock price is $15 per share on January 1, 2013. Further assume that the company's CEO is awarded 200,000 stock options on that date. This means that after a certain holding (vesting) period, the CEO can buy 200,000 shares of the company's stock at $15 per share, regardless of what the stock price is on the day he or she buys the stock. If the stock price has risen to, say $35 per share, then the CEO can simultaneously buy the 200,000 shares at a total price of $3 million (200,000 times $15 per share) and then sell the shares for $7 million ($35 per share times 200,000 shares), pocketing $4 million (less taxes owed). Stock options have typically been perceived as a way to provide incentives to executives to work as hard as they can to make their companies profitable and, at the same time, have their own personal net worth increase.

Until 2006, if the option granting price ($15 in this case) were the same as the market price on the date the option was granted, the company was not required to report compensation expense on its income statement. However, if the options were granted at a price lower than the market share price (referred to as "in-the-money" options) on the day the options were granted, say $10 in this example, then the $5 difference between the option granting price and the market price had to be reported as compensation expense by the company and represented taxable income to the recipient.

The fraudulent stock option backdating practices involved corporations, by authority of their executives and/or boards of directors, awarding stock options to their officers and directors and dating those options to a past date in which the share price of the company's stock was unusually low. Dating the options in this manner ensured that the exercise price was set well below market, thereby nearly guaranteeing that these options would always be "in the money" when they vested and thus provided the recipients with windfall profits.

Backdating stock options is a type of fraud because it violates accounting rules, tax laws, and SEC disclosure rules. Almost all companies that were investigated "backdated" their options so that they would appear to have been awarded on the low price date despite having actually been authorized months later. While the amounts involved in many of these cases were not material to the financial statements (they were in a few cases), backdating was another fraud motivated by greed.