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The Accounting Cycle
Freddie Mac's Scandal and the SEC's Judgment
Op/Ed

November 2007The financial reporting lies in the statements of Federal Home Loan Mortgage Corporation (Freddie Mac) came to light in 2003. The Securities and Exchange Commission recently issued a litigation release that attempts to put the affair behind us. Unfortunately, the SEC still cannot meet its goal of meting out punishment against the bad guys and only the bad guys.



The SEC issued Litigation Release No. 20304 on Sept. 27. The SEC alleges that the corporation engaged in an accounting fraud from 2000 to 2002. The manipulation of earnings occurred by incorrectly accounting for various derivative instruments of the firm as well as manipulating the accounting for loan origination costs and reserves for losses. Freddie Mac will pay a $50 million fine. The four executives who conceived and executed this fraud were also punished. Their fines ranged from $65,000 to $250,000; they paid out disgorgement amounts that ranged from $29,227 to $150,000. More details are laid out in the SEC complaint in this matter.

The fascinating thing about this accounting scandal is that it involved the understating of net income. In particular, the SEC contrasts the reported income with the restated net income (in billions of dollars):

Year

Reported Net Income

Restated Net Income

Difference

2000

$2.547

$3.666 

$ 1.119

2001

4.147 

3.158

(0.989)

2002

5.764

10.090 

4.326

This fraud creates three problems for investors and creditors:

The first consequence of the fraud is that it misleads capital providers with respect to the firm; the investment community will not think it as deserving as other organizations. The economy suffers a misallocation of resources.

The second consequence of the fraud is that it supplies the corporate executives with incentives to engage in insider trading. The market thinks the business entity has the lower income and may bid down the stock price and the bond prices. The managers who are partaking in the fraud know that the earnings stream is actually higher and can profit from this knowledge illegally.

The third consequence is that the market may misestimate the risk of the corporation and, in this case, that seems to provide the motivation for the accounting fraud. Corporate managers wanted to portray a picture of a steady, reliable company that was ever growing in resources and income. That picture was phony inasmuch as the true income stream is far more volatile than the reported earnings would indicate.

This case is fascinating for another reason. The SEC continues to give miscreants a slap on the wrist while hitting the innocents with a massive fine. Yes, I said that the SEC continues to dote on the bad guys by only slapping their wrist. The largest fine plus disgorgement is only $400,000. For the salaries and stock options and perquisites that these guys got while working at Freddie Mac, the fines plus disgorgement amounts to a speeding ticket for those mortals with at most six-digit incomes. The fines are trivial. If the SEC wants to dissuade managers from committing accounting frauds, then they must impose meaningful and enormous fines and prison sentences. Petty and insubstantial fines imply that the SEC no longer cares for investors and creditors. And managers at other entities surely take notice.

Worse, the SEC fined Freddie Mac $50 million; interestingly, this is the same amount the SEC fined Tyco for its shenanigans. But, who is really paying this $50 million fine? That's right, it is the investors of Freddie Mac -- those who were defrauded by the management team!

(We could analyze this more deeply by stating that the current investors are not necessarily the same investors who lost their shirts when the prices tumbled. Even so, assuming an efficient market, the current investors subtracted out the estimated fines to be paid by the corporation for this fine. Assuming an unbiased estimate, we are then back where we started: the investors at the time of the scandal are paying this $50 million fine.)

The SEC apparently does not understand the purpose of civil penalties and criminal sentences in our society. While they satisfy our collective sense of justice, more importantly, society issues civil penalties and criminal sentences to deter future crimes. If the disincentives are sufficiently repugnant and if the probability of enforcement is sufficiently high, then future managers are less likely to commit accounting frauds.

If the SEC hopes to deter future accounting frauds, it must align its punishment with the thieves who carry out these misdeeds instead of punishing the shareholders. Next time the SEC ought to fine the executives $50 million each. That would send the right message to Wall Street. And it would alleviate the pain and suffering by the shareholders.

This essay reflects the opinion of the author and not necessarily the opinion of The Pennsylvania State University.

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J. EDWARD KETZ is accounting professor at The Pennsylvania State University. Dr. Ketz's teaching and research interests focus on financial accounting, accounting information systems, and accounting ethics. He is the author of Hidden Financial Risk, which explores the causes of recent accounting scandals. He also has edited Accounting Ethics, a four-volume set that explores ethical thought in accounting since the Great Depression and across several countries. He is the co-author of a monograph, Fair Value Measurements: Valuation Principles and Auditing Techniques (with Mark Zyla, Managing Director, Acuitas, Inc.) to be published by BNA.

2007 SmartPros Ltd. All Rights Reserved.

Editorial and opinion content does not represent the opinions or beliefs of SmartPros Ltd.

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