What Is Voodoo Accounting?###
Voodoo accounting refers to a creative and unethical method of accounting that artificially inflates figures on a company’s financial statements. Using various accounting gimmicks, it boosts the bottom line by inflating revenue, concealing expenses, or both.
Individual accounting maneuvers in voodoo accounting may be minor, and one-time accounting gimmicks might be dismissed by investors. Yet, repeated malpractices often deteriorate the company’s market value and reputation.
Key Insights###
- Voodoo accounting involves illegal or unethical practices that seem to magically improve a company’s financial standing, inflating revenues and hiding expenses.
- These practices came under scrutiny after scandals like Enron, Tyco, and WorldCom.
- Reform came with the Sarbanes-Oxley Act of 2002, which enforces stricter penalties for financial fraud.
How Voodoo Accounting Works###
Voodoo accounting tricks help a company hide its losses and inflate its profits, appearing as though profits and losses magically appear using accounting stunts. This deceives investors and analysts into believing the company is more profitable than it truly is. While it’s challenging for companies under rigorous analysis, smaller public companies often get away with it.
Creative accounting techniques aren’t a modern invention. Highlighted by former SEC Chair Arthur Levitt during the 1990s dotcom bubble, voodoo practices include:
- Big bath charges: Reporting one-time losses incorrectly to mask lower-than-expected earnings.
- Cookie jar reserves: Gimmicks used for income smoothing.
- Recognizing revenue before it is actually earned.
- Merger magic: Writing off an acquisition price as in-process research and development (R&D).
Companies usually engage in voodoo accounting to prevent loss of investor confidence, especially with the pressure of meeting quarterly earnings expectations. But once discovered, the consequences are severe, risking executive compensation, jobs, reputation, and market value.
Lessons from Past Scandals###
As the accounting profession evolved with stricter regulations, voodoo accounting got scrutinized heavily, specifically post-Enron scandal. Enron’s use of off-the-book accounting practices tricked shareholders and regulators into a false sense of profitability. Utilising Special Purpose Vehicles (SPVs), Enron hid losses, toxic assets, and debt, ultimately filing for bankruptcy with executives facing fines and charges.
The stinging revelations from the Enron, Tyco, and WorldCom scandals catalyzed the Sarbanes-Oxley Act of 2002 - a legislative milestone enforcing truthful, transparent financial reporting with stringent penalties for financial misconduct.
Illustrative Example of Voodoo Accounting###
A fictional scenario: Imagine a company using voodoo accounting to prematurely recognize $5 billion in revenue while hiding $1 billion in unexpected expenses within a quarter. By these means, the company falsely represents a net income $6 million higher than the actual figure for the quarter.
Such practices may temporarily inflate the stock price but once the false additional profits and management’s lack of credibility are uncovered, a sharp decline in share price and investor trust can follow.
Related Terms: creative accounting, fraudulent reporting, financial scandals, Sarbanes-Oxley Act, corporate fraud.
References
- Securities and Exchange Commission. “Remarks by Chairman Arthur Levitt”.
- Journal of Accountancy. “The Rise and Fall of Enron”.
- Securities and Exchange Commission. “Speech by SEC Commissioner: SEC Initiatives Under the Sarbanes-Oxley Act of 2002”.
- 107th Congress, 2nd Session. “H.R.3763 - Sarbanes-Oxley Act of 2002”.
