Introduction

The purpose of accounting is providing information and control. Audited financial statements provide assurance that the financial and other information is accurate and fully disclosed based on existing rules. However, key providers of that information may be unwilling to present accurate and complete disclosure. The incentives to cheat can be substantial and those at the top may be especially ethically-challenged and greedy.

Business history includes incredible examples of disgraceful acts and, to some extent, scandal becomes a central part of the story of economic history. To get certain things done, corruption could be encouraged— political machines in major cities or states, for example, could become amazingly efficient ensuring businesses quickly accommodated after appropriate “consulting fees.” The second half of the 19th century was almost certainly the most corrupt in American history, but also one of the greatest periods of economic growth and innovation. Successful entrepreneurs and managers had little choice but deal with the dark side—many, of course, did it with gusto.

George Washington assumed the presidency in 1789, but before the end of his term in office, the country has a revolt (the Whiskey Rebellion), a financial scandal (the Panic of 1792), and the first real estate scam (Georgia’s Yazoo land scandal). Along with the founding fathers was a list of founding villains (usually successful men with a dark side), including speculator, politician and thief William Blount; incompetent general and spy James Wilkinson; plus financial manipulator, political deal maker, and future vice president Aaron Burr, later indicted for treason.

Government regulation to combat corruption started early, including law codes from antiquity such as the Code of Hammurabi (1772 BC).

Government action was not particularly effective; even the threat of beheading did not put a dent in corruption. As economies got larger and more complex, legislation and enforcement expanded, sometimes effective, sometimes not so much. The American constitution of 1788 established federal responsibilities and left the regulations of corporations primarily up to the states—but Washington maintained the responsibility over interstate commerce. The United States was a more-or-less laissez faire economy similar to the description by economist Adam Smith in The Wealth of Nations, with little interference from government. Problems grew as businesses expanded and owners desired both monopoly power and great wealth. Corporate growth brought expansion across states lines, resulting in the inability of states to deal with rising commerce. Political history includes the dynamic patchwork of state and federal experiments with regulations. Business, in the meantime, sought regulatory responses for its own benefit—with little if any concern for the public interest.

Stories of American exceptionalism abound in the first century of industrial growth. From an agricultural backwater the U.S. became the industrial giant of the world by the end of the 19th century. Brilliant inventors from Eli Whitney and Samuel Morse to Alexander Graham Bell and Thomas Edison transfixed the lives of most Americans—as did entrepreneurs from Cornelius Vanderbilt to John D. Rockefeller and Andrew Carnegie. Speculators from Daniel Drew to Jay Gould proved equally innovative if less productive to broad economic interests—they were called Robber Barons for a reason. Success in both camps typically required ruthless behavior and it could be difficult to tell the heroes from the crooks—Vanderbilt, Rockefeller, and Carnegie were on most 19th century Robber Baron lists.

Accounting was a necessary part of the economic landscape. Early business relied on techniques similar to Italian merchants of the late Middle Ages. As businesses got big, especially railroads, the need for information required new accounting methods to understand and control costs and set prices, the requirements for cash and financing, and providing the necessary information to attract investors. Railroad managers in the mid-19th century developed many of these new techniques. Just as some railroad executives were forward thinkers, others were interested in manipulation and obfuscation to promote their own schemes. Jay Gould, for example, in control of several railroads at various times was predominately a speculator and made as much money driving down the price of his companies as driving them up—with little regard for actual corporate profitability or the long-term needs of his railroads. Although corrupt, his techniques were legal at the time (or at least never prosecuted). In fact, only a few of the 19th century villains were convicted and sentenced to jail, such as Boss Tweed of New York City’s Tammany Hall (the Democratic political machine). His crimes involved multiple examples of outright fraud, with bribery (a payment to influence conduct) and extortion (obtaining a payment through coercion) particular favorites.

After the corrupt Gilded Age (named by Mark Twain for the period of the recovery from the Panic of 1873 to the Panic of 1893), progressives gained power and attempts at real reform followed. The Interstate Commerce Commission, formed in 1887 to regulate railroads, became the first federal agency to restrain illicit business practices. The Sherman Antitrust Act followed in 1890 with modest success limiting business conspiracies and monopoly power. State regulations were a mixed bag. State banking regulations could be conservative and serve the public interest or allow wildcat banking with little oversight at all. Some states attempted to limit business monopoly powers, ban unsafe and unsanitary practices, or offer some protections for labor. Other states became servile to business. New Jersey offered the most liberal incorporation laws, allowing big corporations to create holding companies controlling operations across the country. The development of concentration and monopoly power in dozens of industries was possible because of the New Jersey laws.

The 1920s was an anything-goes financial period, with investor euphoria, a stock market bubble, and corruption in multiple forms. The 1929 market crash helped bring on a Great Depression. The Congressional Pecora Hearings uncovered substantial corruption but few illegal acts (mainly income tax violations), but still shocking the public. The result was the New Deal of President Franklin Roosevelt and the creation of the Securities and Exchange Commission (SEC) and other financial reforms. Wall Street was restructured and the regulatory process started the creation of a formal accounting system (soon to be called generally accepted accounting standards or GAAP) and standardized financial audits.

After World War II America was the global economic colossus, producing half the world’s output with the most productive manufacturing processes anywhere. Accounting, particularly managerial accounting, also was highly sophisticated and advanced, with computers just being introduced. Formal accounting and financial reporting procedures were developing nicely and the SEC maintained considerable control over and respect of financial markets. For the next thirty or so years (depending on what measures to focus on), the country maintained global economic and financial leadership. Corruption and fraud generally were small scale, either big frauds at small companies such as ZZZZ Best or small (and often obscure) frauds as major corporations such as General Electric.

Inflation, intense foreign competition with improved manufacturing methods, and finally “stagflation” (the simultaneous rise of both inflation and economic stagnation) brought severe economic and financial problems. Financial “innovations,” often involving accounting issues (such as acquisition accounting techniques), led to increasingly illicit acts (hostile takeovers, junk bonds, and insider trading to name a few) resulting in financial markets and corporate headquarters becoming nastier places. The “Reagan Revolution” (or more accurately the tough love of Federal Reserve Chairman Paul Volcker) tamed inflation in the early 1980s and the economy and stock market boomed. The computer and Internet revolutions of the 1990s led to the tech bubble, ridiculous stock prices, and corporations behaving badly. After the tech collapse in the new millennium, the world discovered the horrendous corruption of major corporations including Enron and WorldCom. One result was the Sarbanes-Oxley Act of 2002, a major regulatory overhaul.

The major economic story of the 21st century was the rapid growth of the banking and financial world, concentrated on the financial manipulations of structured finance, compounded by illicit use (and little regulation) of derivatives (contracts derived from existing contracts such as forwards and options) and special purpose entities (legal entities created for specific purposes). These techniques (reasonable financial innovations in and of themselves) were used in such an outrageous fashion that the resulting subprime meltdown almost destroyed the financial world. Instead, the Federal Reserve (America’s central bank, responsible for monetary policy though money supply and interest rates) and Treasury Department (executive department to manage revenue and debt) invested in a multi-trillion dollar bailout of the banking system. Despite all the regulations on the books, financial and accounting manipulations were worse than ever (at least in total dollar terms)—corresponding to the misaligned incentives of the key players, especially the outrageous compensation of banking executives.

This is the story I want to tell in this book: defining the various illicit financial and accounting acts over time (with considerable overlap over the last 200 plus years), attempting to identify the major perpetrators and the reasons for their actions, determining what regulations were effective and why, and using the historical evidence to attempt to predict the future. No question, there will be more manipulation and fraud. The historical evidence, reinforced by psychology and economics, points to the critical importance of the incentives of key players whatever the existing institutional framework. Describing incentives in place and how they can go awry is a critical part of the historical analysis and predicting future abuse.

Accounting fraud and manipulation are summarized in seven chapters. The first chapter introduces the dynamic environment of deceit and illicit acts, and why the major players (even if rich and successful) would be willing to commit heinous acts. The roles of regulation and disclosure are explored, including when and why they are either successful or failures (or some combination of the two). The next five chapters cover American business, scandals and attempts at reform, in roughly chronological order. Chapter Two covers the broad period before the reforms of the New Deal. Chapter Three looks at the Great Depression in some detail. The Securities and Exchange Commission, other federal regulations and private sector reforms (such as establishing accounting standards) are still of considerable importance today. Chapter Four covers the post-World War II period through the savings and loan crisis of the 1980s, with a focus on the movement from relative honesty in industrial and financial markets to the development of pockets of extreme corruption—perhaps the start of modern accounting and auditing issues. Chapter Five reviews the 1990s and early 21st century, including the rise and collapse of the tech bubble. Particular attention is paid to Enron, perhaps the greatest corporate fraud case in American history. In terms of perverse incentives, corruption through government and financial markets, massive use of deceit and reporting of bogus numbers, and violating regulatory and disclosure requirement at every level, Enron had it all. Chapter Six covers the strange story of the subprime meltdown, creating a financial crisis of epic proportions—out of the safest of credit instruments, the mortgage (accounting was a bit player here). Chapter Seven sums up historical finding and considers key points for predicting future abuse. The major frustration of speculating about the future is the continued existence of perverse incentives within financial markets, politics, and global corporations.