Warren Buffett, the second richest man in America after Bill Gates, told his senior managers at Berkshire Hathaway Inc. in a memo published by FT.com, to resist the temptation to use “accounting gimmicks” to manipulate earnings, Bloomberg.com says. “Every time you hear the phrase ‘Everybody else is doing it’, it should raise a huge red flag,” Buffet wrote. “Why would somebody offer such a rationale for an act if there were a good reason available?”
The rationale for “accounting shenanigans” can sometimes be a little more complicated, however, especially for smaller companies that make up the bulk of accounting fraud cases (as many as 75 percent from 1998 to 2003), according to Todd Wenning, writing for MotelyFool. These companies often lack the strong internal controls of a Berkshire Hathaway and the capital to invest in large audit departments.
A 2006 Securities and Exchange (SEC) Report on small companies suggests that “investors in these companies don’t particularly care about internal control protections and that these companies represent an inconsequential bottom 6 percent of total U.S. market capitalization,” according to a report authored by Kurt Schacht, director of the CFA Center for Financial Market Integrity, Wenning writes.
Small cap investors do not seem to expect the same standards from these companies, Wenning says, because they want to see money invested in growth and in areas like research and development. And since smaller companies are not scrutinized by Wall Street analysts, they have more opportunity to engage in accounting manipulations.
Examples of small cap companies that were prosecuted for accounting failures include KrispyKreme and Rite Aid. It should be no surprise that these companies engaged in fraud during periods of rapid growth, Wenning says.
While the Sarbanes-Oxley Act of 2002 (SOX) has required companies to strengthen their controls, Wenning says that there are still terms left open to interpretation. It is still possible to inflate earnings figures through ‘aggressive’ revenue recognition, and varying inventory calculations and depreciation methods.
Buffett referred to the stock options backdating scandal in his memo and said his guess was that “a great many of the people involved would not have behaved in the manner they did except for the fact they felt others were doing so as well.” He said that he expects the number of companies being investigated will increase, Bloomberg.com says.
Speaking to his own managers about their responsibilities at Berkshire Hathaway, Buffett said, “Somebody is doing something today at Berkshire that you and I would be unhappy about if we knew of it. That’s inevitable. . . . But we can have a huge effect on minimizing such activities by jumping on anything immediately when there is the slightest odor of impropriety.”