Understanding Voodoo Accounting: Risks and Red Flags

“Voodoo accounting” is a slang term that describes a system through which profits for a company can be inflated. Unscrupulous and/or flat-out illegal methods of financial record-keeping are used to bolster a company’s bottom line, in large part, to make current investors happy and to attract new investors.

Voodoo accounting may be used to hide a company’s losses or, in some other way, provide a misrepresentation of a company’s actual financial status. The term is a reference to the magical practice of voodoo. With voodoo accounting, money and/or money issues are magically made to appear or disappear.

Voodoo accounting first garnered true, critical attention and focus when the nefarious accounting tactics of companies such as EnronEnron ScandalThe Enron scandal is likely the largest, most complicated, and most notorious accounting scandal of all time. Through deceiving accounting tricks, Enron came to light in the early 2000s.

Summary

• Voodoo accounting is the misuse of accounting techniques to bolster a company’s bottom line.
• Voodoo accounting manipulates how investors view a company, potentially misleading them to believe they will reap better returns on their investment; such a false perception of a company may also lead new investors to buy into a company.
• The Sarbanes-Oxley Act of 2002 required companies to be more transparent with their accounting tactics.

How It Works

To get a better sense of how voodoo accounting works, let us look at an example.

Let’s say that Company X employs a team of accountantsAccounting Salary GuideIn this accounting salary guide, we give you the midpoint compensation figures for those employed both in public and private accounting. Accountants are responsible for examining financial statements to ensure accuracy and compliance with existing laws and regulations, handling tax-related tasks such as calculating the collectively looking to submit the best possible profit report for the current quarter. They realize that they can report a $2 million profit for the quarter, but only if they cover up a $750,000 expense to settle a lawsuit and $250,000 for supplies expenses. If they don’t make the expenses disappear, the company can only report $1 million in earnings for the quarter.

Clearly, investors will be happier with $2 million in profits, and new investors would be more likely to invest in a company that brings in $2 million per quarter. An accountant can utilize various unethical or illegal tricks to make unwanted expenses disappear from the quarter’s accounting figures.

Auditors will likely inevitably look through Company X’s report. Companies with significantly high profit margins or unusual profits per quarter tend to be scrutinized extremely closely.

Once auditors discover the discrepancies, the fact that all the proper expenses for the quarter are still unreported, then the $2 million profit vanishes. The individuals responsible for the fraudulent accounting practice will suffer the consequences.

Significance of Voodoo Accounting

While it may seem obvious, it’s important to grasp the significance of voodoo accounting fully. Unethically or illegally manipulating a company’s financial figures significantly can affect a number of different elements. Primarily, false profit numbers make a company look substantially better than it is. It tricks investors into believing the company is performing much better than it actually is.

If reported profits are high enough, an investor may invest in a company that isn’t as financially successful as it appears. This leaves the investor open to significant financial losses.

The company reporting inaccurate profits is hurt as well. When its lies are discovered, it is subjected to scrutiny by regulators, which may only be aware of one instance of voodoo accounting tactics.

All of the company’s records will be scrutinized. All parties who participated will be held accountable. The company and management will not be viewed as credible and will scare away investors, customers, and suppliers.

The Sarbanes-Oxley Act of 2002

The Sarbanes-Oxley Act of 2002Sarbanes Oxley ActThe Sarbanes-Oxley Act is a U.S. federal law that aimed to protect investors by making corporate disclosures more reliable and accurate. was passed not long after voodoo accounting fell into the spotlight when Enron was caught fraudulently reporting its earnings. The act was passed so that accounting practices were required to be more transparent. It also led to the creation of the Public Company Accounting Oversight Board (PCAOB), which regulates accounting firms that offer auditing services.

Companies – regardless of their size – serve the public and the individuals who invest in them. Using unethical and unfair accounting tactics to report inaccurate financial figures can significantly impact investors and the company itself.

Additional Resources

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