Fraudulent Financial Reporting and Litigation/Regulatory Action

Transcription

1 Fraudulent Financial Reporting and Litigation/Regulatory Action Russell Duncan, Esq. Partner; Shulman, Rogers, Gandal, Pordy & Ecker Cindy Fornelli Executive Director; Center for Audit Quality Zoe-Vonna Palmrose Hanson Professor in Business Administration; University of Washington at Seattle Elaine Harwood Vice President; Cornerstone Research CARE Conference August 5, 2016

2 Topics for Discussion Navigating the litigation and regulatory enforcement landscape Proxies for fraudulent financial reporting The frequency of fraudulent financial reporting and litigation/regulatory action Common fraud schemes Issues to consider in connection with research CARE Conference 8/05/16 Page 2

3 Topics for Discussion Navigating the litigation and regulatory enforcement landscape Proxies for fraudulent financial reporting The frequency of fraudulent financial reporting and litigation/regulatory action Common fraud schemes Issues to consider in connection with research CARE Conference 8/05/16 Page 3

4 Fraudulent Financial Reporting A material misrepresentation resulting from an intentional failure to report financial information in accordance with generally accepted accounting principles. Center for Audit Quality, Deterring and Detecting Financial Reporting Fraud A Platform for Action, October 2010 Intentional deception through a material misrepresentation or omission in connection with the purchase or sale of a security. SEC Rule 10b-5 Intentional acts, misstatements or omissions, that result in a material misstatement in financial statements, designed to deceive users and where the effect causes financial statements not to be presented in conformity with GAAP. AU and.06 Fraud is a crime of extraordinary variety, limited only by human imagination, that is as old as falsehood and as versable as human ingenuity. Courts throughout the United States CARE Conference 8/05/16 Page 4

5 Shared Responsibility to the Investing Public for Mitigating the Risk of Financial Reporting Fraud Source: Deterring and Detecting Financial Reporting Fraud: A Platform for Action, Center for Audit Quality, CARE Conference 8/05/16 Page 5

6 Navigating the Landscape Fraudulent Financial Reporting and Litigation/Regulatory Action Company Board Audit Committee Management Auditor (Firm & Individuals) SEC PCAOB AICPA / State Board of Accountancy * State Regulators DOJ Shareholders * Only subject to enforcement if a CPA and/or AICPA member CARE Conference 8/05/16 Page 6

7 Topics for Discussion Navigating the litigation and regulatory enforcement landscape Proxies for fraudulent financial reporting The frequency of fraudulent financial reporting and litigation/regulatory action Common fraud schemes Issues to consider in connection with research CARE Conference 8/05/16 Page 7

8 Proxies for Fraudulent Financial Reporting? Allegation Academic Models Earnings Management/ Manipulation Fraud Prediction Restatement Private securities litigation Regulatory Investigation Filing of an action Settlement Private securities litigation Regulatory enforcement Finding Investigative conclusion Judge / jury Admission CARE Conference 8/05/16 Page 8

9 Topics for Discussion Navigating the litigation and regulatory enforcement landscape Proxies for fraudulent financial reporting The frequency of fraudulent financial reporting and litigation/regulatory action Common fraud schemes Issues to consider in connection with research CARE Conference 8/05/16 Page 9

10 SEC Allegations of Auditor Deficiencies in Connection with Alleged Fraud Have Been Rare During , approximately 9,500 entities filed financial statements with the SEC on an annual basis There were 87 instances where the SEC leveled sanctions against an auditor in connection with alleged fraud during that period, 35 of which involved national firms The most common deficiencies noted were: Failure to exercise due professional care Insufficient levels of professional skepticism Inadequate identification and assessment of risks Failure to respond to identified risks with appropriate audit responses to gather sufficient competent evidence Source: Beasley, Carcello, Hermanson, and Neal, An Analysis of Alleged Auditor Deficiencies in SEC Fraud Investigations: , May CARE Conference 8/05/16 Page 10

11 Topics for Discussion Navigating the litigation and regulatory enforcement landscape Proxies for fraudulent financial reporting The frequency of fraudulent financial reporting and litigation/regulatory action Common fraud schemes Issues to consider in connection with research CARE Conference 8/05/16 Page 11

12 Fraud Taxonomy TOP FRAUD CATEGORIES Premature Revenue Recognition Fictitious Revenues Omitted or Improper Disclosures Related Party Transactions Overvalued Assets and Undervalued Expenses/Liabilities OTHER CATEGORIES Fictitious Assets and/or Reductions of Expenses/Liabilities Omitted or Undervalued Liabilities Misclassifications Wrong Way Frauds Equity Frauds Illegal Acts Source: Bonner, Sarah E., Zoe-Vonna Palmrose, and Susan M. Young, Fraud Type and Auditor Litigation: An Analysis of SEC Accounting and Auditing Enforcement Releases, The Accounting Review Vol. 73, No. 4, October 1998, pp Note: Full taxonomy reprinted as Appendix C in Education and Training in Fraud and Forensic Accounting: A Guide for Educational Institutions, Stakeholder Organizations, Faculty and Students (DOJ Program, National Institute of Justice, March 2007), pp CARE Conference 8/05/16 Page 12

13 Illustrative Fraud Schemes Fictitious Revenues Not Based on Firm Orders 19% Fraud Schemes Overvalued Assets and Undervalued Expenses/Liabilities Undervalued Allowance for Bad Debts or Loan Losses Omitted or Improper Disclosures On Accounting Policy 17% 18% Related Party Transactions Disclosure Problems 16% Percentage of AAERs Source: Bonner, Sarah E., Zoe-Vonna Palmrose, and Susan M. Young, Fraud Type and Auditor Litigation: An Analysis of SEC Accounting and Auditing Enforcement Releases, The Accounting Review Vol. 73, No. 4, October 1998, pp Note: Full taxonomy reprinted as Appendix C in Education and Training in Fraud and Forensic Accounting: A Guide for Educational Institutions, Stakeholder Organizations, Faculty and Students (DOJ Program, National Institute of Justice, March 2007): pp CARE Conference 8/05/16 Page 13

14 Topics for Discussion Navigating the litigation and regulatory enforcement landscape Proxies for fraudulent financial reporting The frequency of fraudulent financial reporting and litigation/regulatory action Common fraud schemes Issues to consider in connection with research CARE Conference 8/05/16 Page 14

15 Appendix CARE Conference 8/05/16 Page 15

16 SEC Enforcement Actions Increased in the Past Two Years Financial Fraud/Issuer Disclosure Other Enforcement Actions Source: SEC 2016 Cornerstone Research. All rights reserved. Note: The Division of Enforcement adjusted its definition of Enforcement Actions starting in 2013 so as to exclude 21(a) Reports and certain civil contempt matters. Under the prior definition, the total for Fiscal Year 2013 is 686. CARE Conference 8/05/16 Page 16

17 Accounting Class Action Filings Increased in Recent Years Average Number of Accounting Cases (67) Non-Accounting Cases Accounting Cases 126 (57%) 51 (42%) 100 (56%) 104 (63%) 116 (66%) 108 (57%) 106 (70%) 119 (72%) 101 (59%) 118 (62%) 69 (58%) 77 (44%) 97 (43%) 61 (37%) 59 (34%) 80 (43%) 45 (30%) 47 (28%) 69 (41%) 71 (38%) 2006 N= N= N= N= N= N= N= N= N= N= Cornerstone Research. All rights reserved. Source: Accounting Class Action Filings and Settlements 2015 Review and Analysis, Cornerstone Research, CARE Conference 8/05/16 Page 17

18 Few Accounting Class Action Filings Involve Restatements Restatement Case Annual Average (24) Non-Restatement Cases Restatement Cases 28 (41%) 48 (62%) 75 (77%) 45 (74%) 43 (73%) 53 (66%) 28 (62%) 28 (60%) 40 (58%) 50 (70%) 41 (59%) 29 (38%) 22 (23%) 16 (26%) 16 (27%) 27 (34%) 17 (38%) 19 (40%) 29 (42%) 21 (30%) 2006 N= N= N= N= N= N= N= N= N= N= Cornerstone Research. All rights reserved. Source: Accounting Class Action Filings and Settlements 2015 Review and Analysis, Cornerstone Research, CARE Conference 8/05/16 Page 18

19 Accounting Class Actions Comprise the Majority of Settlements Average Number of Accounting Cases (54) Non-Accounting Cases Accounting Cases 32 (36%) 58 (64%) 41 (38%) 68 (62%) 24 (25%) 73 (75%) 33 (33%) 66 (67%) 24 (28%) 61 (72%) 31 (48%) 34 (52%) 19 (34%) 37 (66%) 22 (33%) 44 (67%) 19 (30%) 44 (70%) 30 (38%) 50 (62%) 2006 N= N= N= N= N= N= N= N= N= N= Cornerstone Research. All rights reserved. Source: Accounting Class Action Filings and Settlements 2015 Review and Analysis, Cornerstone Research, CARE Conference 8/05/16 Page 19

20 Accounting Class Actions Represent a Significant Portion of Settlement Dollars $20.2 Non-Accounting Cases Accounting Cases Accounting Case Annual Average ($4.7) 97% $8.3 94% $3.0 $4.1 $3.3 $3.3 $4.9 $3.0 91% 74% 91% $1.4 74% 89% 25% $1.1 85% 87% 2006 N= N= N= N= N= N= N= N= N= N=80 Note: Dollars in Billions. Settlement dollars are adjusted for inflation; 2015 dollar equivalent figures are used Cornerstone Research. All rights reserved. Source: Accounting Class Action Filings and Settlements 2015 Review and Analysis, Cornerstone Research, CARE Conference 8/05/16 Page 20