The age of Ponzi Scheme financial reporting

A Ponzi Scheme is a hidden pyramid business scheme, and therefore illegal. Ponzi Schemes are named after Charles Ponzi who ran a famous hidden pyramid scheme in the 1920s. However, Ponzi Schemes had been around much longer than Charles Ponzi. Examples include the South Seas Bubble of the 1720s in the U.K., the Mississippi Bubble in the early 1800s, and the Tulip Mania in Holland in the 1630s. Many of these manias and bubbles in the market were greatly facilitated by the corporate form of organization which limited the liability of the promoters of such schemes.

To be clear, an economic case can be made for Ponzi Scheme business models and this has been done in the marketing literature (Coughlan 2015). This modeling assumes some economic activity is generated with the business model beyond just recruiting more investors to provide capital to pay dividends to earlier investors. Here we are concerned with how the Ponzi Scheme reporting can mislead investors when the nature of the pyramid scheme is hidden from investors, thereby making the pyramid scheme illegal, and how the accounting facilitates the hiding of the pyramid business model.

An example of a legal pyramid scheme is the Ontario Lottery Corporation, fully owned by the Government of Ontario. An Ontario lottery winner is under no illusions that their gains come from other “investors” in lottery tickets and not from any other business activities. Lotteries are very lucrative because a small proportion of the population likes to gamble, no matter how small the odds. In fact, this kind of business is so lucrative that governments around the world like to take over and monopolize this type of gambling activity. Lotteries can be viewed as a form of voluntary taxation.

Pyramid business schemes such as lotteries can be viewed as a type of business model that involves participant investors recruiting more and more later participants where the earliest investors and promoters of the schemes profit and later investors lose out. Recruitment of new investors to provide capital to pay dividends to existing investors is the sole business in a pure pyramid business model. Only some investors can be expected to come out ahead in a pyramid business model, i.e., not all investors are treated equally, and if this treatment is hidden (only the insider early investors come out ahead), then this creates resentment and lack of trust from the pool of potential investors in society.

Pure pyramid schemes must eventually fail as the number of new exploited investors is limited by the size of the population. For example, it can be shown that when one person recruits six people to make further investments, who each recruit six other people, and so on, the scheme would require double the world’s population in 13 steps. The nature of the pyramid schemes is that they are unsustainable. Pyramid schemes are not illegal, but if the nature of the pyramid model is hidden from the new investors, then it becomes an illegal Ponzi Scheme because investors are misled as to the source of their returns that can be expected in the future; for example, if the returns are reported as regular dividends from fictitious earnings instead of as a liquidating dividends from contributed capital.

A corporate Ponzi Scheme can be implemented through accounting and its fundamental equation of assets (A) minus liabilities (L) equals owners’ equity (A — L = OE). In the 19th century corporate Ponzi Schemes were frequently implemented by failing railway companies in the form of not taking depreciation charges, thereby understating accumulated depreciation, overstating net assets, and paying dividends on the resultant inflated annual earnings. When it came to replace the rolling stock, the railroad company did not have sufficient capital to do so. Auditors learned the importance of recognizing realistic depreciation charges in order to keep a company solvent.

In the 1920s corporate Ponzi Schemes took the form of failing to record all proceeds from sale of stock as part of O.E., thereby inflating the assets from which future dividends could be paid. These dividend payments misled investors about prospects for future dividend payments from operating activities and therefore resulted in another form of Ponzi Scheme accounting (Previts and Merino 1998, 263—267). Variations on this theme continue to the present day, the latest version of which is to inflate the value of assets through fair value accounting. For example, this was accomplished at Enron. Interestingly, Enron’s accounting was considered to be “fully in compliance with GAAP,” yet many consider its accounting to not present fairly (DeFond et al. 2018). Another way to implement Ponzi accounting is to not record or otherwise understate liabilities. This is illustrated in the accounting of the Lehman Brothers bankruptcy that precipitated the 2008/2009 worldwide financial crisis, where, again, the accounting was argued to be “fully in compliance with GAAP” (ibid.). We summarize the problem from an audit perspective that looks at the unique risks associated with accounting estimates (i.e., the accounting risk concept or AccR).

These examples can be viewed as illustrations of social reality distortion of a firm’s economic performance that critical perspectives and social theory accounting researchers have been critical of. These problems largely arise through a compliance reporting mindset. To the extent that current GAAP allow misleading reporting in the sense of not being truthful according to commercial law of being materially truthful with at least 50% or higher probability, the accounting can facilitate fraudulent or misleading reporting. In such situations the firm’s reported social reality is a distortion of its actual economic reality. This is further discussed in the next section as part of auditor responsibilities to detect fraud due to misreporting of ISA 240.