Voodoo Accounting What It is How It Works Example

Voodoo Accounting: Understanding the Concept and Its Impact

Ariel Courage, an experienced editor and researcher, has worked for reputable finance publications such as The Motley Fool and Passport to Wall Street.

What is Voodoo Accounting?

Voodoo accounting refers to an unethical method of inflating figures on a company’s financial statements. This manipulation involves accounting gimmicks that boost revenue and conceal expenses.

These maneuvers may be ignored as minor one-time tricks, but repeated offenses negatively affect a company’s market value and reputation.

Key Takeaways:

– Voodoo accounting involves illegal or unethical practices that artificially improve a company’s financial figures.

– Accounting scandals, such as those involving Enron, Tyco, and WorldCom, shed light on voodoo accounting.

– The Sarbanes-Oxley Act of 2002 was enacted to reform regulations and impose stricter penalties on those involved in fraudulent acts.

How Voodoo Accounting Works

Voodoo accounting refers to the deceptive tricks companies use to hide losses and inflate profits. This unethical technique deceives investors and analysts into believing companies are more profitable than they actually are.

Smaller, less scrutinized companies tend to engage in voodoo accounting more frequently.

Former SEC Chair Arthur Levitt identified voodoo accounting practices during the dotcom bubble in the late 1990s. Examples include:

– Improper reporting of one-time losses (big bath charges) to mask lower-than-expected earnings.

– Use of cookie jar reserves for income smoothing.

– Premature recognition of revenue before collection.

– Writing off acquisition prices as in-process research and development (merger magic).

Companies resort to voodoo accounting to maintain investor confidence and meet quarterly earnings expectations on Wall Street. However, the consequences can be severe, affecting executive compensation, jobs, reputation, and market value.

Special Considerations

Voodoo accounting was exposed to greater scrutiny after the Enron scandal. Enron used off-the-books accounting practices, including special purpose vehicles (SPVs), to deceive shareholders and regulators.

Enron’s deceitful actions, along with similar instances of financial misconduct by companies like Tyco and WorldCom, led to the passing of the Sarbanes-Oxley Act of 2002. This act aimed to enforce reforms, regulations, and stricter penalties for financial fraud.

The act ensures that companies are truthful and transparent in their financial reporting.

Example of Voodoo Accounting

Let’s consider a hypothetical example to understand voodoo accounting. A company might employ voodoo accounting in a quarter by prematurely recognizing $5 billion of revenue while concealing $1 billion in unexpected expenses.

This manipulation allows the company to report net income that is $6 million higher than the actual figure for the quarter. Upon the release of the quarterly earnings report, the stock price may initially react positively. However, the discovery that these additional profits were not real would quickly erase this positive response and raise doubts about management credibility.