What Is Voodoo Accounting?
The term voodoo accounting refers to a creative and unethical method of accounting that artificially inflates figures found on a company's financial statements. Voodoo accounting employs numerous accounting gimmicks to boost the bottom line by inflating revenue, concealing expenses, or both. Although they may be minor, one-time accounting gimmicks may be ignored by investors. But repeat offenses often affect the company’s market value and reputation.
- Voodoo accounting refers to a creative and unethical method of accounting that artificially inflates figures found on a company's financial statements.
- It employs accounting gimmicks to boost a company's bottom line by inflating revenue and concealing expenses—or both.
- Voodoo accounting came under scrutiny after a series of financial scandals came to light including Enron, Tyco, and WorldCom.
- The Sarbanes-Oxley Act of 2002 was passed in response to these scandals to reform regulations and enforce stricter penalties on those responsible for fraudulent acts.
How Voodoo Accounting Works
As noted above, voodoo accounting describes the tricks a company may use to hide its losses and inflate its profits. The reason behind the name is simple—profits and losses seem to magically appear and disappear using accounting gimmicks. This process is not only unprofessional, but it's also unethical. That's because companies that use this technique knowingly deceive investors and analysts into believing that they're much more profitable than they actually are. Accounting tricks are hard to pull off for companies subjected to higher levels of analysis. It is among smaller, less followed public companies that voodoo accounting can be more prevalent.
Creative accounting techniques are not new. In fact, they've existed for decades. Some of the voodoo accounting practices identified by former Securities and Exchange Commission (SEC) Chairman Arthur Levitt at the height of the dotcom bubble in the late 1990s included:
- Big Bath Charges: This technique involves the improper reporting of one-time losses. Companies do this by taking a huge charge to mask lower-than-expected earnings.
- Cookie Jar Reserves: This gimmick is used by companies for income smoothing.
- Recognizing revenue before it is actually collected.
- Merger Magic: When a company uses this trick, it writes off all or most of an acquisition price as in-process research and development (R&D).
Most companies take part in practices like voodoo accounting so investors don't lose confidence in them. After all, a profit is much better than losses—especially when they're consistent. And the pressure of meeting quarterly earnings expectations on Wall Street is also another primary motivation for using voodoo accounting. But when discovered, these tricks could have serious implications. Executive compensation and jobs are normally at stake, along with a company's reputation and value in the market.
As the accounting profession evolved and regulators became more serious in enforcing laws, voodoo accounting came under greater scrutiny. This was especially true following the Enron scandal. The failing energy and utility company used off-the-book accounting practices to fool shareholders and regulators into believing it was profitable. Enron used special purpose vehicles (SPVs) to hide losses, toxic assets, and volumes of debt, thereby deceiving both its creditors and shareholders. The company filed for Chapter 11 and the scandal resulted in fines and charges for a number of company executives.
The Enron scandal rocked the financial world because of the tricks that the company used to hide copious amounts of debt and toxic assets it was dealing with for years. Regulators took notice of Enron's actions along with other cases of financial misconduct from the likes of Tyco and WorldCom by passing the Sarbanes-Oxley Act of 2002. The law required reforms to regulations and also set in stricter penalties to those who committed financial fraud.
The Sarbanes-Oxley Act of 2002 was passed to ensure companies are truthful and transparent in their financial reporting.
Example of Voodoo Accounting
Here's a hypothetical example of how voodoo accounting works. A company may employ voodoo accounting to prematurely recognize $5 billion of revenue while concealing $1 billion in unexpected expenses during a quarter. These tactics enable it to report net income that is $6 million higher than the true figure for the quarter. This may have significant implications on the stock price upon release of the quarterly earnings report. However, the discovery that these additional profits for the period were not real would quickly erase a positive share price reaction and call into question management credibility.