Financial Shenanigans: How to Detect Accounting Gimmicks & Fraud in Financial Reports, 3rd Edition by Howard Schilit, Jeremy Perler Page A
Authors: Howard Schilit, Jeremy Perler
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at AIG, which AIG eventually refunded as purported “insurance claim payments.”
Accounting Capsule: Legitimate Insurance Contracts Require a Transfer of Risk
Just because two parties call an agreement an insurance contract does not mean that they can book it as such in their financial statements. In order to be considered an insurance policy for accounting purposes, an arrangement must involve a transfer of risk from the insured to the insurer. Without this transfer of risk, GAAP treats the arrangement as a financing transaction, with premium payments being treated like bank deposits and recoveries being treated like the return of principal.
The Regulators Considered This Scheme to Be a Scam . Brightpoint got into trouble with the Securities and Exchange Commission (SEC) for inappropriately masking its problems. AIG found itself in the SEC’s crosshairs as well for knowingly structuring the insurance policy in such a way that it allowed Brightpoint to misrepresent its actual losses as “insured losses.” In November 2004, AIG agreed to pay $126 million to settle litigation with the Department of Justice and the SEC on charges that it had sold products that helped companies inflate earnings via the use of finite insurance.
Charity Begins at Home—After Helping Its Clients, AIG Finds Time to Help Itself
After several years of helping its clients smooth out rough patches in their earnings, AIG decided to use its expertise to help rid itself of nasty questions raised by its own Wall Street analysts. AIG’s September 2000 earnings release did not go well. Many analysts were unsettled by an unexpected decline in AIG’s insurance liability reserve. They were asking questions about this decline, and some worried that AIG had released reserves to make its numbers for the quarter.
To help solve its “Wall Street problem” and boost the troubling anemic reserve balance, AIG sought the assistance of Gen Re to structure a sham reinsurance arrangement. Since AIG was one of Gen Re’s largest clients, Gen Re acquiesced and actively participated in the fraud, for which it would later pay dearly. Here’s how it went down. AIG received $500 million in purported insurance premiums from Gen Re, which it used to beef up its loss reserves. At the same time, AIG paid $500 million to Gen Re to reinsure a risk. As in the Brightpoint transaction, there was no real economic substance or transfer of risk behind this exchange—it was really just a round trip of cash. However, AIG did not account for it that way. It used the transaction to inappropriately prop up its loss reserves.
Beware: Bogus Reserves Will Often Lead to Bogus Revenue or Income. In its sham arrangement with Gen Re, AIG could just as easily have decided to record bogus revenue instead of propping up its reserves. However, AIG’s goal was to increase its reserve account, not to inflate revenue—at least not yet. If a reserve is bogus and no future payment exists, a company can easily make a bookkeeping entry that releases the reserve to report phony income.
So AIG actually improperly benefited twice from this shenanigan. First, when it created a bogus liability reserve, Wall Street analysts were mollified by the high reserve balance. Then, with the “reloaded” reserve, AIG gave itself an opportunity to “flip the switch” and release these reserves into income. The plan worked great for a while—or until the regulators started sniffing around. AIG Pays Big Time for Its Shenanigans in Its Settlement with the SEC. In May 2005, AIG announced a staggering $2.7 billion restatement, correcting misstatements for the previous five years. The following February, AIG paid another $1.6 billion to settle litigation as part of a global resolution of federal and state actions.
Peregrine Dupes Investors with Software Sales That Lack Economic Substance
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Accounting Capsule: Legitimate Insurance Contracts Require a Transfer of Risk
Just because two parties call an agreement an insurance contract does not mean that they can book it as such in their financial statements. In order to be considered an insurance policy for accounting purposes, an arrangement must involve a transfer of risk from the insured to the insurer. Without this transfer of risk, GAAP treats the arrangement as a financing transaction, with premium payments being treated like bank deposits and recoveries being treated like the return of principal.
The Regulators Considered This Scheme to Be a Scam . Brightpoint got into trouble with the Securities and Exchange Commission (SEC) for inappropriately masking its problems. AIG found itself in the SEC’s crosshairs as well for knowingly structuring the insurance policy in such a way that it allowed Brightpoint to misrepresent its actual losses as “insured losses.” In November 2004, AIG agreed to pay $126 million to settle litigation with the Department of Justice and the SEC on charges that it had sold products that helped companies inflate earnings via the use of finite insurance.
Charity Begins at Home—After Helping Its Clients, AIG Finds Time to Help Itself
After several years of helping its clients smooth out rough patches in their earnings, AIG decided to use its expertise to help rid itself of nasty questions raised by its own Wall Street analysts. AIG’s September 2000 earnings release did not go well. Many analysts were unsettled by an unexpected decline in AIG’s insurance liability reserve. They were asking questions about this decline, and some worried that AIG had released reserves to make its numbers for the quarter.
To help solve its “Wall Street problem” and boost the troubling anemic reserve balance, AIG sought the assistance of Gen Re to structure a sham reinsurance arrangement. Since AIG was one of Gen Re’s largest clients, Gen Re acquiesced and actively participated in the fraud, for which it would later pay dearly. Here’s how it went down. AIG received $500 million in purported insurance premiums from Gen Re, which it used to beef up its loss reserves. At the same time, AIG paid $500 million to Gen Re to reinsure a risk. As in the Brightpoint transaction, there was no real economic substance or transfer of risk behind this exchange—it was really just a round trip of cash. However, AIG did not account for it that way. It used the transaction to inappropriately prop up its loss reserves.
Beware: Bogus Reserves Will Often Lead to Bogus Revenue or Income. In its sham arrangement with Gen Re, AIG could just as easily have decided to record bogus revenue instead of propping up its reserves. However, AIG’s goal was to increase its reserve account, not to inflate revenue—at least not yet. If a reserve is bogus and no future payment exists, a company can easily make a bookkeeping entry that releases the reserve to report phony income.
So AIG actually improperly benefited twice from this shenanigan. First, when it created a bogus liability reserve, Wall Street analysts were mollified by the high reserve balance. Then, with the “reloaded” reserve, AIG gave itself an opportunity to “flip the switch” and release these reserves into income. The plan worked great for a while—or until the regulators started sniffing around. AIG Pays Big Time for Its Shenanigans in Its Settlement with the SEC. In May 2005, AIG announced a staggering $2.7 billion restatement, correcting misstatements for the previous five years. The following February, AIG paid another $1.6 billion to settle litigation as part of a global resolution of federal and state actions.
Peregrine Dupes Investors with Software Sales That Lack Economic Substance
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