Key Terms

• An accounting fraud is defined as a ‘business scandal which arises from intentional manipulation of financial statements with the disclosure of financial misdeeds by trusted executives of corporations or governments’.

• A liquidity crunch is defined as ‘an acute shortage of liquidity’.

• A stock market crash is defined as ‘a sudden dramatic decline of stock prices across a major cross-section of a stock market, resulting in a significant loss of paper wealth’.

Introduction

The relationship between accounting frauds, liquidity crunches, and stock market crashes has been a persistent issue throughout the history of the global economy. In April 2020, speaking on the major stock market crash caused by the COVID-19 Pandemic, the Economist found that ‘the economic crisis will expose a decade’s worth of corporate fraud’. More specifically, this is because an economic boom causes an increase in liquidity and allows the initiators of significant accounting frauds to go undiscovered, but an economic downturn causes a decrease in liquidity, and so they are only discovered and exposed when liquidity crunches and stock markets crash. This report evaluates the relationship between accounting frauds, liquidity crunches, and stock market crashes, including both the historical and empirical evidence, as well as the impact of the COVID-19 Pandemic, and its implications on investments.

The Indian Context

In the Indian context, it can be argued that the Satyam Computer Services scandal was the most significant accounting fraud in India up until 2010. In September 2008, the collapse of the Lehman Brothers caused the Global Financial Crisis and a liquidity freeze in India, which led investors all over the world to demand withdrawals. Satyam Computer Services was an Indian information technology (IT) services company headquartered in Hyderabad, India, that specialised in software development, system maintenance, packaged software integration and engineering design services. Its founder and directors falsified the accounts, artificially increased the stock price, and stole substantial amounts of money from the company, the majority of which was invested in real estate. In late 2008, this significant accounting fraud was discovered when it was linked to the collapse of the Hyderabad property market. In January 2009, it was exposed when the chairman, Byrraju Ramalinga Raju, admitted that the accounts of the company had been falsified. Other significant accounting frauds include:

• The Enron Scandal was a significant accounting fraud that involved Enron Corporation, an American energy, commodities, and services company headquartered in Houston, Texas. It was first discovered and exposed in October 2001, which was only fifteen months after the DotCom bubble, a stock market bubble that ballooned during the late 1990s and peaked in March 2000, and only one month after the September 11 attacks had further disrupted the stock market in the United States.

• The WorldCom Scandal was a significant accounting fraud that involved WorldCom, the second-largest long-distance telephone company in the United States at the time. It was first discovered and exposed in July 2002, which was at approximately the same time as the DotCom bubble.

• The Bernie Madoff Investment Scandal was a significant accounting fraud that involved his wealth management scheme Bernard L. Madoff Investment Securities LLC, which was in reality a significant Pozi scheme. It was first discovered and exposed in December 2008, which was only three months after the collapse of the Lehman Brothers in September 2008 caused the Global Financial Crisis.

All of these were discovered and exposed during liquidity crunches and stock market crashes when there was an increase in the cost of money.

How Does This Happen?

Therefore, it can be argued that significant accounting frauds do not increase when liquidity crunches and stock markets crash. Instead, significant accounting frauds are only discovered and exposed when liquidity crunches and stock markets crash. This is because an economic boom causes an increase in liquidity and allows the initiators of significant accounting fraud to go undiscovered, but an economic downturn causes a decrease in liquidity and exposes them. Baruch Lev, a professor of accounting at New York University, found, “In good times everyone looks good, and the market punishes you harshly for not keeping up.” This is consistent with many major accounting scandals in recent decades. Warren Buffett, a renowned investor, famously said “You only find out who is swimming naked when the tide goes out.” This time, the COVID-19 Pandemic has caused a major stock market crash, and the tide is going out quickly. To summarise, it is thought that there are three main reasons that significant accounting frauds happen:

1. It can be argued that the main reason that significant accounting frauds happen is the need or desire of the initiator of the accounting fraud to divert money away from the company. Again, an economic boom causes an increase in liquidity and allows the initiators of significant accounting frauds to go undiscovered. One way in which this happens is through the initiator borrowing money and injecting it into the company. For example, through obtaining short-term loans, either in their own name or through the company itself. An increase in liquidity within the company creates the illusion that everything is as it should be. But again, an economic downturn causes a decrease in liquidity and exposes them. For example, through the short-term loans drying up, and staff, suppliers, and creditors begin to raise concerns about the decrease in liquidity within the company. At this point, it is to be expected that the Indian initiator would have left the scene.

2. Secondly, it is to be expected that the initiator of the accounting fraud would borrow against collateral either in the form of their properties or their shares. Therefore, a liquidity crunch hits the assets of the initiator, which means that the lenders issue margin calls to the initiators. As a result, the initiator - who has already diverted money away from the company - is now being chased up by their own lenders. For example, from August 2017 onwards, there was an increase in wholesale money market rates in India, and it is thought that two well-known Indian jewellers left the scene only six months later. Therefore, unless there is a sudden and significant improvement in the value of real estate and shares in India, then it is to be expected that more initiators will leave the scene, instead of being chased up by the margin calls of their own lenders.

3. Thirdly, an economic boom means that companies have evidence of legitimate increases in revenue, which increases working capital requirements. Therefore, an economic boom means that auditors, lenders, and shareholders accept increases in short-term borrowing to finance working capital requirements, even though this is actually the initiator of the accounting fraud diverting money away from the company through short-term loans. However, an economic downturn, often because of an increase in the interest rate, causes a decrease in liquidity and exposes the initiator. As a result, the auditors become more reluctant because their professional reputation is on the line. Since 2018, the Ministry of Corporate Affairs has been overseeing the audit profession in India. Therefore it is to be expected that there will be an increase in the discovery and exposure of accounting fraud by auditors in the coming decades.

Stock Market Implications

In May 2024, the Business Standard found that there had been an increase in accounting fraud in India, which is particularly concerning for its small but booming market of Initial Public Offerings (IPOs). Furthermore, the Securities and Exchange Board of India found that Varanium Cloud Ltd. (NSEI: CLOUD) and Add-Shop E-Retail Ltd. (BSE: 541865), both listed as Small and Medium Enterprises (SMEs), had manipulated their financial statements in order to increase their share prices, and have been banned from the capital markets. Moreover, the analysts have confirmed that this suggests an increase in the regulation, discovery and exposure of accounting fraud in coming decades, which could slow down the S&P BSE SME IPO Index of micro listings, which has increased by over 5,000% since the beginning of 2021.

Investment Implications

It is thought that there are a significant number of companies in India which have benefitted disproportionately from favourable lending terms in both the private and public sectors, as well as Non-Banking Financial Companies (NBFCs) in recent decades. Therefore, it is always to be expected that some questionable accounting practices are happening. Perhaps there will be a sudden and significant decrease in the cost of borrowing within the next six months, through a notable decrease in the price of oil. Otherwise, there will be another increase in the discovery and exposure of accounting fraud in the coming decades.

Empirical Evidence 2: ‘Relationship Among Economic Crisis, Stock Market Crashes and Accounting Scandals’ by Pilar Lloret Millan and Nuria Arimany Serrat

Pilar Lloret Millan and Nuria Arimany Serrat from the University of Vic - Central University of Catalonia in Spain, investigated the relationship between some of the most significant accounting frauds and stock market crashes that have occurred in recent decades between 1980 and 2020.

Findings

There were three main findings:

1. Firstly, they found that most of the significant accounting frauds took place in the years in which a stock market crash occurred or within the following three years. This is consistent with the majority of the previous literature.

2. Secondly, they found that the average period of time between the initiation, discovery, and eventual exposure of accounting fraud is 5.4 years.

3. Thirdly, they found an increase in the likelihood of accounting fraud when stock markets crash and in the years immediately following.

Research Implications and Limitations

There are several limitations:

1. Firstly, it only considers significant accounting frauds that have been reported in Spanish and English. Therefore, it can be argued that the sample is biased, and over-represents companies from Anglo-Saxon and Spanish-speaking countries.

2. Secondly, the sample only consisted of 53 companies that met the search criteria used, which is a relatively small sample size.

Research Implications

Practical Implications: The findings are relevant today, to a significant extent. This is because of the major stock market crash caused by the COVID-19 pandemic in recent decades. Therefore, if significant accounting frauds continue to increase when liquidity crunches and stock markets crash, then it is to be expected that there may be an increase in significant accounting frauds in the next few decades.

Social and Investment Implications: The findings are especially significant for those who use corporate financial information, including auditors, consultants, investors, and regulatory bodies. They will need to exercise extreme caution when making financial judgements, valuations, and decisions in the next few decades, because of the major stock market crashes caused by the COVID-19 pandemic

Originality and Value

The findings provide valuable insights into the relationship between some of the most significant accounting frauds and stock market crashes that have occurred in recent decades between 1980 and 2020. Millan and Serrat found in the literature review, that no other studies have employed the same design and methodology, or used a similar sample of companies.

Conclusion

In conclusion, it is clear that accounting frauds increase when liquidity crunches and stock markets crash, to a significant extent. More specifically, it can be argued that this is because an economic boom causes an increase in liquidity and allows the initiators of significant accounting frauds to go undiscovered, but an economic downturn causes a decrease in liquidity, and so they are only discovered and exposed when liquidity crunches and stock markets crash. This is consistent with the historical evidence, including significant accounting frauds such as the Satyam Computer Services Scandal, the Enron Scandal, the WorldCom Scandal, and the Bernie Madoff Investment Scandal. It is also consistent with the empirical evidence, in which Millan and Serrat investigated the relationship between some of the most significant accounting frauds and stock market crashes that have occurred in recent decades between 1980 and 2020, and found that most of the significant accounting frauds took place in the years in which a stock market crash occurred or within the following three years. From an investment perspective, the Economist found that the stock market crash caused by the COVID-19 Pandemic ‘will expose a decade’s worth of corporate fraud’. Therefore, it will be crucial for auditors, consultants, investors, lenders, shareholders, and regulatory bodies to exercise caution in their investment decisions, judgements and valuations, in order to address and dissuade accounting fraud in the coming decades.