Markopolizing conversion fraud: understanding and identifying opportunities for US financial reporting conversion fraud.

Author:McAfee, Kimberly
 
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INTRODUCTION

Harry Markopolos discovered the largest fraud in US history, while working as a derivatives portfolio manager at Rampart Investment Management. His co-worker and marketing representative, Frank Casey, asked him to analyze Bernie Madoffs "investment" plan in hopes of creating a similar financial product that would rival the stunning moneymaker. Upon review, Markopolos came to the conclusion that Madoffs plan was in fact a fraud and reported his findings to the SEC, but his warning fell upon deaf ears. For almost ten years, he resubmitted warnings to the SEC, but to no avail (Markopolos, 2010). The result of his ordeal uncovered extreme negligence by the US Securities and Exchange Commission (SEC), all while under fear of duress for nearly a decade. The SEC repeatedly refused to thoroughly investigate Bernie Madoff, the former NASDAQ chairman, but Markopolos continued sounding the alarm.

The United States is now embarking on a potential fraud explosion: the conversion from the US standard of General Accepted Accounting Principles (GAAP) to the universal standard of International Financial Reporting Standards (IFRS). The former has more stringent accounting practices that the latter; GAAP are rules-and principles-based with a compliance-based focus, while IFRS is purely principles-based, which allows for managerial discretion, and has an economic-based focus (Cancino, 2010, p. 34). To mitigate the risk of fraudulent activities--such as accounting manipulation and earnings management-originating from this conversion, a greater understanding is needed in order to identify such practices when they are present, and create processes that will deter such fraudulent behavior from beginning in the first place.

In the spirit of fraud-fighter extraordinaire Harry Markopolos, we must "Markopolize," potential GAAP/IFRS conversion fraud. This term can be defined as:

Markopolize: (v) to identify with gusto; to identify with single-minded determination; calling for justice with wanton abandon for self; doing what's right/ethical in face of adversity.

In order to carry this out effectively, our understanding of GAAP and IFRS must be strengthened.

PURPOSE OF REGULATION AND ESTABLISHMENT OF GAAP

Regulation of financial records has developed in the United States since the end of the 19th century. Leuz (2010) determines that there are four core reasons for regulation, "the existence of externalities, market-wide cost savings from regulation, insufficient private (or stricter public) sanctions, and dead-weight costs from fraud and agency conflicts that could be mitigated by disclosure" (p. 231). The origin of regulation in the United States reflects Leuz's rationale.

The industrial revolution of the late 19th century spawned a need for common accounting principles which was addressed when the Joint Stock Companies Act of 1884 required an audited balance sheet from firms incorporated under the act. With the stock crash of 1929, "There was a growing realization that a company's stock price was a function of its earnings potential rather than the value of its assets. Hence, the concept of matching revenues and costs became the accountant's primary task and focus" (Close, 2007, p. 38). Following the crash, the Securities and Exchange Commission (SEC) was established by the Securities Act of 1933 and the Securities Exchange Act of 1934. The SEC drew on private organizations for the establishment of accounting standards, namely the American Institute of Accountants, predecessor of the American Institute of Certified Public Accountants. In 1973, the Federal Accounting Standards Board (FASB) became the designated accounting standard setter in the United States, developing the Generally Accepted Accounting Principles (GAAP) that comprise the accounting standards practiced in the US today (SEC, 2012b).

CALL FOR INTERNATIONAL STANDARD

As the US developed GAAP, many countries also developed their own local standards. With the expansion of globalization many countries started issuing financial statements using GAAP, "Foreign companies trading on US stock exchanges currently reconcile their financial statements to US Generally Accepted Accounting Principles (GAAP) if the statements are not prepared in accordance with US GAAP. In an effort to achieve consistency and transparency without undue cost, national standard setters recognize the need for convergence" (Close, 2007, p. 41). Local reporting standards were sometimes viewed as having gaps in financial reporting (Callio & Ignacio Jame, 2007). Globalization and the need for common, comparable financial standards are widely acknowledged to be the main reasons for the development and adoption of the International Financial Reporting Standards (IFRS) (Dask, Hail, Leuz, & Verdi, 2008; FASB & IASB, 2002; Leuz, 2010; SEC, 2008; SEC, 2012a).

RULES VS. PRINCIPLES

While GAAP and IFRS share some similarities, there are core differences between the two financial reporting standards. As mentioned previously, GAAP are more rules-based, while IFRS are purely principles-based. Leuz (2010) states that conversion difficulties are created as:

Rules-based standards tend to be more bright-line and are generally easier to apply, but they are likely to invite more gaming behavior ... compared to principles-based standards. Principles-based standards in turn give more discretion to firms, which can enable managers to convey private information to the markets in a less costly fashion, but the discretion also allows managers to pursue ulterior reporting motives, (p. 235) So, while IFRS allows for more flexibility, this flexibility can be taken advantage of, and situations may arise where a central authority is needed to interpret the new standard.

One example of the difference between GAAP and IFRS involves timing and recognition of revenue and expenses. GAAP allows usage of Last in First Out (LIFO) costing methodology for inventory, while IFRS does not permit LIFO. LIFO allows firms to attribute costs to inventory based on the inventory most recently received, which can impact the balance sheet because of changes in market price. The Internal Revenue Service (IRS) allows methods of...

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