Fraud and the lure of corporate estimates

In 2020, American Airlines (AA) grounded hundreds of planes and relegated them to long-term storage in the Arizona desert as the largest airline in the U.S. responded to sinking demand in the wake of the COVID-19 pandemic. By the end of March 2021, the planes were still in storage and hadn’t earned revenue for over 12 months, which meant they’d need to be “impaired” (written down to their current value) as defined by the accounting standards.

At the end of 2020, AA impaired five asset groups — Airbus A330-200s and 300s, Boeing 757-200s and 767-300ERs, and Embraer E190s — totaling 150 planes and $1.5 billion in impairment. Many of those planes were in excellent condition and had several years of useful life before they’d normally be retired, but impairing the entire asset group satisfied accounting standards. AA planes in storage, in other asset groups (i.e., 737s), didn’t need to be impaired because under “group asset” accounting rules, the asset group they belonged to was still earning revenue that exceeded the total value of the asset group. While the “group” is earning revenue, there can be individual assets within the group that aren’t. The challenge is knowing where the tipping point lies, and for AA that involved assumptions about when planes would start transporting passengers again.

AA executives had estimated in the company’s 2020 annual report that they’d have all planes that weren’t impaired back in the air by summer of 2021. (See “American Airlines, 10K, for fiscal year ended December 31, 2020.”) But that didn’t happen. Another COVID variant hit, and staff refused to come back to work. Pilots “timed out” and couldn’t fly until they retrained. AA didn’t have enough flight crews to man the scheduled flights, resulting in thousands of canceled flights in 2021. (See “American Airlines Says Scheduling Problems Are Summer-Only Issue. Philly Pilots Say They Could Linger,” by Ted Reed, Forbes, June 26, 2021; “American Airlines cancels hundreds of flights amid staffing, maintenance issues,” by Mina Kaji and Sam Sweeney, ABC News, June 20, 2021; and “Airlines cancel more than 800 U.S. flights as Covid hits crews,” by Leslie Josephs, CNBC, updated Dec. 25, 2021.) Storing the planes caused other challenges. It turns out that it takes roughly 1,000 hours of maintenance to get a plane back into service. And planes in storage require significantly more maintenance than planes routinely flying. (See “How American Airlines pulls planes from pandemic storage,” by Gregory Wallace and Pete Muntean, CNN travel, April 12, 2021.)

Storage and maintenance cost increases, combined with revenue shortages, were only some of the challenges AA was facing that impacted its financials. AA also waived change fees for customers, reduced flights and flight plans and received a $4.75 billion cash infusion from the U.S. Treasury to help them stay afloat. (See “American Airlines Takes Strategic Action in Second Quarter to Prioritize Safety, Flexibility and Efficiency in Response to COVID‑19,” AA, July 23, 2020.)

As the troubles faced by AA illustrate, determining an estimate and translating the true impact of the pandemic into the financials can be complicated and confusing, which is why it provides ample opportunity for manipulation and fraud.

AA was completely transparent at the time it released its 2020 annual report. Executives tried to make solid business decisions, but they were still wrong, as all companies can be even in normal times.

But these unprecedented times are forcing organizations to navigate uncharted waters and account for how a whole host of events are impacting their businesses and financials. Real estate booms, cryptocurrency volatility, supply chain disruptions, the “great resignation” of employees from their jobs, political unrest, Russia’s invasion of Ukraine and an ongoing COVID pandemic are events no one ever expected to see at once.

One of the most difficult challenges organizations face from an accounting perspective is change and uncertainty. Change makes it difficult to identify trends that accountants need to create financial estimates used to report financial results. With the last pandemic occurring over 100 years ago, organizations have nothing to draw upon — no experience, no trends and no “history” — to help them determine their financial estimates.

Even with best intent, getting it wrong

Even experts get it wrong. A look back at AA’s estimates illustrates how difficult these calculations can be during uncertain times. Here are some examples of what the company got wrong:

Future cash flows based on future sales. AA estimated all planes would be back in the air by summer 2021. They weren’t. Thousands of scheduled flights were canceled due to staff shortages, impacting actual cash flow.

Number of planes grounded. Management’s estimates were incorrect.

Salvage value — impacted by market demand. AA wasn’t the only airline reducing its plane count. Almost all airlines faced the same situation, impacting supply and demand, and salvage values.

Useful lives — impacted by long-term storage. The additional maintenance required for planes in storage was expensive and made it difficult to keep up.

The necessity for estimates, the changes that organizations are still facing and the uncertainty during these unprecedented times makes it difficult to get the right answers. And if the answers aren’t right, evaluating and analyzing their financials is nearly impossible. Traditional analysis isn’t going to work.

Financial statements are filled with accounting estimates. Valuations, reserves, impairments, warranties, useful life of assets, long-term contract values, litigation and goodwill are just some of the accounts that require estimates. And determining an estimate relies on experience, judgment and an organization’s history.

Indeed, it may surprise people outside of the accounting world how big a role estimates play in the financial statements that major companies release each quarter, and how this impacts the financial markets and the broader economy. A glance at just one section of the AA 2020 annual report illustrates this point. Here are some excerpts from that annual report, which focus on fixed assets only (emphasis on estimates added by author):

“Long-lived assets consist of flight equipment, as well as other fixed assets and definite-lived intangible assets such as certain domestic airport slots, customer relationships, marketing agreements, tradenames and airport gate leasehold rights. In addition to the original cost, the recorded value of our fixed assets is impacted by a number of estimates made, including estimated useful lives, salvage values and our determination as to whether aircraft are temporarily or permanently grounded. Definite-lived intangible assets are originally recorded at their acquired fair values and are subsequently amortized over their estimated useful lives

“We assess impairment of long-lived assets used in operations when events and circumstances indicate that the assets may be impaired. An asset or group of assets is considered impaired when the undiscounted cash flows estimated to be generated by the assets are less than the carrying amount of the assets and the net book value of the assets exceeds their estimated fair value. If such assets are considered to be impaired, the impairment to be recognized is measured by the amount by which the carrying amount of the assets exceeds the fair value of the assets. Estimates of fair value represent management’s best estimate based on appraisals, industry trends and reference to market rates and transactions.

“The majority of American’s aircraft fleet types are depreciated over 25-30 years. It is possible that the ultimate lives of our aircraft will be significantly different than the current estimate due to unforeseen events in the future that impact our fleet plan.”

Opportunities for fraud

The difficulty in calculating estimates under current conditions poses a challenge to organizations worldwide, but it also provides greater opportunities for fraud. AA was very transparent in its finances at a time when external events were in flux and outside its control. But that won’t be the case for a lot of industries and companies.

There will likely be two opportunities for organizations to manipulate their financials: now, while estimates are so highly subjective and again in coming years after honest accountants, who tried their best during these times, realized they got it wrong. When a company’s estimates are wrong, it’s expected to correct them, resulting in a negative financial impact. That may not always sit well with executives, who risk losing their jobs and/or bonuses, and they may be tempted to fiddle the numbers. It wouldn’t be the first time that executives used estimates to improve their financial numbers until they had no more wiggle room and crossed the line into fraudulent territory. (See sidebar “The long history of fraudulent estimates.”) Under current circumstances, this is likely to happen again.

Oversight responds

Often all it takes is a good narrative. People believe the story and don’t question the numbers. This isn’t a new issue. In early 2014, The Wall Street Journal quoted Martin Baumann, the then-chief auditor of the Public Company Accounting Oversight Board (PCAOB), saying: “When we look at an audit, the rate of failure has been in a range of around 35 to 40%.” He was speaking in reference to external audits the PCAOB had reviewed, which had failed to identify material misstatements. (See “One in Three Audits Fail, PCAOB Chief Auditor Says,” by Emily Chasan, The Wall Street Journal, Jan. 24, 2014.)

At about the same time, the PCAOB also listed five common trouble spots for auditors: 1) complex “fair value” measurements for hard-to-price financial instruments, 2) management’s estimates, 3) revenue recognition policies, 4) internal controls, and 5) relying too heavily on the use of data prepared by the company being audited. In addition to those five specific issues, the PCAOB also said that both internal and external accountants often fail to understand the financial impact of “change” to the organization.

The plight of companies facing the economic fallout from the pandemic has arguably magnified those trouble spots cited by the PCAOB, which were listed at a time of relative economic stability. This is particularly true of the PCAOB’s concerns about accountants’ failures in understanding the financial impact of change, which applies more than ever during these uncertain times. All this creates a perfect storm that enables the manipulation of financial statements. Here are some examples of how organizations might run into trouble with estimates and how executives could be tempted to commit fraud to hide the poor financial health of the organization.

Reserving for bad debt

When a company sells its product or service, oftentimes on credit, it reports the amount as accounts receivable until it gets paid. Inevitably, some of those customers don’t pay. Under Generally Accepted Accounting Principles (GAAP), companies must estimate the total amount of bad debt and “reserve” for it in an account called bad debt reserve or allowance for doubtful accounts. This amount reduces the overall accounts receivable and shows up on the balance sheet as net accounts receivable. Normally, calculating this bad debt reserve is fairly straightforward.

The bad debt reserve is calculated using historic data and current economic conditions to produce an estimated percentage of noncollectible receivables. As in the balance sheet example above, if a company was unable to collect 5% of receivables in the past few years and it has an accounts receivable balance of $300 million, the bad debt allowance would be $15 million (5% of $300 million). The $15 million reduces accounts receivable and also is reported as a $15 million expense on the income statement, reducing profit.

Two of the most common ratios — the current ratio (current assets to current liabilities) and the quick ratio (cash and cash equivalents to current liabilities) — are used to determine a company’s short-term liquidity, which essentially measures its ability to pay its bills over the next 12 months. In this example, the current ratio for the company would be 1.3 ($744 million to $558 million) and the quick ratio 1.0 (cash, accounts receivable and short-term investments = $558 million to current liabilities = $558 million). While industries differ, these ratios generally signify a healthy company.

The pandemic, however, complicates how we calculate these ratios and leaves them more vulnerable to manipulation. With many companies watching clients go out of business or facing financial troubles, how do accountants and management estimate the percentage of receivables that will soon become bad debt? Do they continue to use 5%? Do they even know how many customers have gone out of business, shut down or greatly reduced operations in the past year?

Let’s assume that 5% has really increased to 15%, everything else being the same. Here’s how that 15% bad debt reserve will impact the financials and the ratios:

The bad debt reserve increased by $30 million, reducing profitability and net accounts receivable. This in turn negatively impacts the quick ratio by bringing it down to 0.9. Analysts and investors normally would see that ratio as a red flag, and executives would rather not report it. That could create pressure and motivation to manipulate the estimate for a more favorable result. Just a small one percentage-point difference — 14% vs. 15% — results in a quick ratio of 1.0 and a $3-million improvement in profitability. And with no history as a guide, who could argue for the higher, but more accurate, 15%?

Assets values and old cellphones

What if a business has 10,000, 12-year-old smartphones stored in a warehouse? How much is each one worth? Zero? After all, who wants to buy a 12-year-old smartphone? But there’s a market for them. You can sell them online to a worldwide market for $10. Scrap dealers will pay $25 for the parts if sold in bulk. And they can be shipped to parts of Africa and sold for $75.

What’s the value of those assets on the financials? An accountant could reasonably argue any of these numbers and come up with a total value of $0, $100,000, $250,000 or $750,000. Each valuation will have a different impact on the financial statements. Now, what if there are a million phones instead 10,000? A good narrative would help support how the company values the inventory at the higher end of the price range. For example, it could say: “We intend to ship the phones to Africa where there’s a market value of $75.” But the question is: Would it be able to sell all the phones in Africa and at that price?

Think how consumer demand and purchasing habits have changed over the last two years. While Amazon has thrived, what about makers of luggage, birthday candles, restaurant supplies, office furniture and office supplies? What has happened to all their inventory, and how’s it valued on their financials today? The smartphone example is theoretical, but many companies are facing these types of decisions right now.

Trucks sitting in a parking lot

Have you tried to buy a new truck lately? The pandemic caused disruptions in the global supply chain which impacted many industries and organizations. Ford, for example, had 60,000-plus trucks sitting in lots that were finished but couldn’t be sold because they were waiting on microchips. By the end of 2020, Ford had $6.1 billion in finished goods, much of it waiting for microchips. (See “Ford Motor Company, 10K for fiscal year ended December 31, 2020,” under Note 11. inventories, finished products,” page 134.) How long could those trucks sit before their value was impacted by weather damage, obsolescence or other causes? Inventory that has lost value due to age or damage should be impaired, according to accounting standards. If those trucks continued to sit for a lengthy period, Ford would’ve had to make significant adjustments to its inventory valuations, which would negatively impact their financials. Fortunately for Ford, by the summer of 2021 it had replenished its microchip stock enough to finish and sell the trucks piling up.

What’s a grounded airplane worth?

Other industries and organizations haven’t been so lucky. The airline industry is still struggling to recover. And again, American Airlines serves as a good example of the prevalence of estimates when accounting for assets at a time when there’s no history of planes being grounded during a pandemic.

American Airlines wants to keep those assets on their books as they comprise a huge part of their balance sheet. So, they use “group asset” accounting, optimistically assuming those planes will soon be in the air and avoiding a massive write-down in the process.

Companies use asset groups when it’s too difficult to determine cash flow from a single asset, but they can do so through a group of assets. This would be like a group of machines in a production line at a manufacturing plant. For AA, an asset group would be a particular type of airplane — Boeing 747s, as an example. AA’s annual report goes on to further explain:

“Accounting Standards Codification (ASC) 360 – Property, Plant and Equipment (ASC 360) requires long-lived assets to be assessed for impairment when events and circumstances indicate that the assets may be impaired.

“An impairment of a long-lived asset or group of long-lived assets exists only when the sum of the estimated undiscounted cash flows expected to be generated directly by the assets are less than the carrying value of the assets. (See “Carrying Value,” by Will Kenton, Investopedia, Oct. 28, 2020, and “Undiscounted future cash flows,” Accounting Tools, CPE Courses & Books, June 5, 2021.)

“We group assets principally by fleet-type when estimating future cash flows, which is generally the lowest level for which identifiable cash flows exist. Estimates of future cash flows are based on historical results adjusted to reflect management’s best estimate of future market and operating conditions, including our current fleet plan.

“If such assets are impaired, the impairment charge recognized is the amount by which the carrying value of the assets exceeds their fair value. Fair value reflects management’s best estimate including inputs from published pricing guides and bids from third parties as well as contracted sales agreements when applicable.”

What we still don’t know

Cellphones, Ford trucks and American Airlines are examples of the easier estimates that could be a problem down the road. But there are more complicated accounting issues that fraud examiners still need to consider. Here are some potential dilemmas that companies might face when calculating financial estimates during this pandemic or any other future health crisis the world might face.

• The use of manufacturing equipment. How do you value manufacturing equipment that temporarily stopped producing certain products to ramp up production for pandemic-related items? What about assets that are no longer in use but will be put back into use later? Under current accounting rules, those assets should be impaired or written off. But in doing this, will those companies be more susceptible to bankruptcy due to bank foreclosures or takeover targets from corporate raiders?
• Real estate holders and lease accounting. How do landlords and other property owners account for tenants who’ve failed to pay their rent for months or years during the pandemic? Does the company incorporate the expectation that it will eventually receive this revenue?
• Banks and lender accounting. Do banks increase the bad debt reserve or write off everything not paid? Will federal regulators give them a pass?
• COVID-relief funds. Should relief funds during the pandemic be recorded as loans or revenues? And should companies expect the government to forgive those that are classified as loans?
• Protective gear and other pandemic-related costs. Should those costs be capitalized? Are these changes permanent, or are the costs just a new but “regular” short-term business expense?

While some accounting guidance has been issued by FASB, the SEC and Government Accounting Standards Board, regulators have yet to address many of these questions, primarily because there are still so many unknowns. (See “FASB Response to COVID,” FASB, and “Financial Reporting Considerations Related to COVID-19 and an Economic Downturn,” Deloitte, last updated Jan. 11, 2021.)

Is it bad enough to impact the market?

Financial statement fraud often doesn’t start as fraud but through overt optimism. Accountants, executives and board members are commonly more upbeat than realistic when faced with uncertain futures. Sometimes, they blindly believe in themselves and their organizations’ ability to rebound and thrive during times of change despite obvious obstacles. We know that many of those organizations didn’t survive.

When the world watched the Enron, WorldCom, Tyco and HealthSouth frauds unfold we were witnessing companies that created their own destruction but also economic fallout that led to a recession. In 2008, we witnessed this again with the collapse of Bear Stearns and then Lehman Brothers six months later, sparking the global financial crisis.

The banks that took part in the subprime crisis should’ve known it wasn’t sustainable. They could’ve chosen not to participate or require better “rules,” but they couldn’t resist the temptation to make millions, sometimes billions. While there were clear risks, most were overly optimistic, and it didn’t end well.

We should be concerned that we’re about to embark on a similar period, only this time it could be worse. The 2008 market crash and resulting recession was the result of a single industry. Today, every organization has been impacted by the pandemic. The opportunity for manipulation is clear. If too many organizations are overly optimistic in their approach to valuations and estimates, we may see a wave of scandals, frauds and collapses in the coming years that could ultimately result in another market crash and recession.

We must work to lessen the blow. Auditors, accountants, fraud examiners and analysts need to be engaged. They need to understand the business. They need to identify all the key estimates that impact operations and the financials. They need to be involved or understand how those decisions are made and understand the narrative. They need to be curious. They need to be skeptical. They need to be informed. And they need to be bold and ask the hard questions.

[See "The long history of fraudulent estimates" at the end of this article.]

Mary Breslin, CFE, CIA, is president and founder of Verracy, a training and consulting company specializing in risk management, data analytics, fraud and corruption, investigations and forensics, and internal audit. Contact her at mbreslin@verracy.com.

The long history of fraudulent estimates

Estimates are subjective under normal circumstances. Here are some examples over the past 25 years where management used estimates to fraudulently manipulate their results.

Remember HealthSouth? In 2003, investigators found that management at the health care company had overstated revenues by $2.7 billion over the prior 17 years. While the fraud was centered around fabricated revenue, it didn’t start that way. It began with the manipulation of accounting estimates to improve the perceived financial health of the organization to shareholders. “I started doing things like changing any accounting estimate I could, involving bad debts or whatever,” Aaron Beam, the company’s CFO at the time, was quoted saying in 2017. (See “Two CFOs Tell a Tale of Fraud at HealthSouth,” by David McCann, CFO, March 27, 2017.)

But HealthSouth wasn’t the only large-scale financial statement fraud that started with or involved estimates. Here are several other cases.

In 1998, a newly appointed CEO and his team discovered that Waste Management had reported about $1.7 billion in fake profits over the prior five years by manipulating estimated depreciation. (See “SEC vs. Dean L. Buntrock, Phillip B. Rooney, James E. Koenig, Thomas C. Hau, Herbert A Getz, and Bruce Tobecksen,” U.S. District Court for the Northern District of Illinois Eastern Division, March 26, 2002.)

In 2005, the U.S. Securities and Exchange Commission (SEC) charged Friedman’s Jewelry with financial statement fraud after it improperly accounted for its bad debt. Friedman had lax controls around extending customers credit and underestimated how it calculated allowances for doubtful accounts (sales expected to be uncollectible), making the company appear financially healthier than it was. Bradley Stinn, the former CEO, was sentenced to 12 years. (See “Former Chief Executive Officer of Friedman’s Inc. and Crescent Jewelers Indicted in Accounting Fraud Scheme,” U.S. Attorney’s Office, Eastern District of New York, March 9, 2007.)

In 2019, the SEC charged executives at brand management company, Iconix, with fraud. To beat Wall Street expectations, they failed to impair the value of the company’s licensees. The value of the licenses had been declining for years, but they didn’t make the appropriate impairments (reduction to value). Iconix CEO Neil Cole and CFO Warren Clamen settled with the SEC. (See “SEC Charges Iconix Brand Group and Former Top Executives with Accounting Fraud,” SEC, Litigation Release No. 24682, Dec. 5, 2019.)

Many question why auditors, investors, analysts or fraud examiners don’t catch these types of manipulations sooner. Estimates can be subjective and often come with a supporting and convincing narrative, which explains how values and estimates are determined. In the Friedman’s Jewelry case, Friedman’s said its credit program adhered to strict and conservative procedures in granting credit and non-discretionary standards in writing off bad debt. But the company’s representations were false. In fact, Friedman’s delegated to store employees wide discretion when granting credit, resulting in increasing amounts of bad debt. And the bad debt calculations were highly subjective and not representative of reality.