1/3/2012. Cooking the Books: Financial Statement Fraud Issues & Examples. Financial Statement Fraud

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1 Cooking the Books: Financial Statement Fraud Issues & Examples Presented by Angela Morelock, CPA, CFE, CFF, ABV, Certified Forensic Accountant Financial Statement Fraud Def. Deliberate fraud committed by management that injures investors & creditors through materially misleading financial statements 1

2 Three Types of FS Fraud Manipulation: falsification or alteration of accounting records upon which FS is based Misrepresentation: intentional omission of significant events, transactions, etc. Misapplication of accounting principles relating to amounts, classification, manner of presentation or disclosure How Occupational Fraud Is Committed Occupational Frauds by Category (U.S. only) Frequency 4 4 The sum of percentages in this chart exceeds 100% because several cases involved schemes from more than one category Association of Certified Fraud Examiners, Inc. How Occupational Fraud Is Committed Occupational Frauds by Category (U.S. only) Median Loss 2010 Association of Certified Fraud Examiners, Inc. 2

3 Why Committed? Demonstrate increased EPS so that dividends will be paid Dispel negative market perceptions Obtain financing Meet company goals Receive performance-related bonuses Increase purchase price for acquisition Meet regulatory requirements Hide asset misappropriation Typical FS Frauds Improper revenue recognition Inadequate disclosure Improper asset valuation Improper deferral of expenses Manipulation of accruals & reserves Understatement of liabilities Capitalizing expenses Top-side entries Related-party transactions Improper Recognition (Presumption) Improper treatment of certain transactions as revenue Bill & hold Cut-off problems (holding books open) Premature revenue recognition (sale not complete) 3

4 Investments Fictitious investments Overvaluing investments Improper classification to avoid recognizing losses Accumulating unrecognized losses Failure to write down for permanent decline in value Liability for Financial Statement Fraud Negligence fail to exercise professional care Gross negligence intentional failure to perform duty Fraud active participation Restatements SEC estimates 1% of submissions are subjected to restatement % of public companies restated corporate earnings reports Restatements frequently accompany financial statement fraud issues, but not every restatement is related to fraud Negative consequences to stock price 4

5 Some Trial Exhibits Circular Transaction (Round Trip) Acquisition Proceeds $5 million Medical Manager Acquisition Target Return of part of proceeds and recorded as revenue $1.5 million Same Day 5

6 Manipulation of Pre-Acquisition Deferral of s Let s record it later. Pre-Acquisition We need revenue. Income Statement Income Statement Balance Sheet Acquisition Balance Sheet Deferred Deferred Post- Acquisition Acquisition Target Medical Manager Manipulation of Pre-Acquisition An accrual is created, just in case earnings come up short. Pre- Acquisition Balance Sheet We need earnings. Income Statement Acquisition Balance Sheet Earnings Earnings Post- Acquisition Acquisition Target Medical Manager Same Concepts Taken Out of Acquisition Environment 6

7 Circular Transaction (Round Trip) Contract for Services $5 million Company Vendor Return of part of proceeds and recorded as revenue $1.5 million Around Same Time Manipulation of Deferred s Let s record it later. Good Quarter Bad Quarter We need revenue. Income Statement Balance Sheet Deferred Deferred Manipulation of Let s use extra earnings to set up a reserve. Good Quarter Bad Quarter We need earnings. Income Statement Earnings Balance Sheet Earnings Earnings 7

8 Summary of Press Release Delay in filing of 10-Q for Q Audit committee investigation in process $60.7 million in financial statement adjustments estimated o Actual adjustments turn out to be $52.5 million Stock price drops from $20.94 to $11.16 Stock delisted in April

9 Summary of Litigation Criminal charges against several, including o Warren Schmidgall, CFO o Timothy Webster, CEO Shareholder class action $25 million SEC civil actions filed against numerous individuals including accounting personnel & COO US Attorney s Office News Release 9/15/2008 9

10 Methods to Inflate Earnings Multiple round-trip transactions Recording fictitious $1 million receivable Capitalization of plant operating expenses Capitalization of MIS expenses Recognizing revenue on product not shipped Not recording write down of spare parts inventory Round Trip Transactions Mrs. Leeper s earnout/cost reimbursement o Previous owners reimburse AIPC for $1.28 million of costs (recorded expense offset) o AIPC provides earnout payment of $1.3 Termination of Mrs. Leeper s former owners Round Trip Transactions Termination of Mrs. Leeper s former owners o Negotiate buyout of $7 million o Increased to $7.5 million w/$500,000 to be paid back to AIPC for cost reimbursement o Then increased to $8 million w/$1 million to be paid back to AIPC for cost reimbursement o $1 million recorded as offset to expenses 10

11 Round Trip Transactions Smart & Final antidumping Determine sold product in Italy under cost to produce in violation of antidumping Will create Dept. of Commerce problem Set up retroactive price increase o Smart & Final pays AIPC $345,744 o AIPC pays Smart & Final $400,000 for promotional spending Fictitious Receivable Contract to produce Atkins low-carb pasta Problems in manufacturing drove up costs Booked $1 million receivable from Atkins & offset against expenses Represented to auditors had verbal agreement w/atkins & written agreement was in process No agreement ever happened Capitalization of Plant Expenses Multiple capital expansion projects Adjusted plant expenses to budget & pushed excess expense into capital projects Capitalized $9.4 million of plant operating expenses, thereby increasing earnings 11

12 Capitalization of MIS Expenses Multiple IT development implementation projects Adjusted MIS expenses to budget & pushed excess expense into capitalized IT projects Capitalized $5.23 million of plant operating expenses, thereby increasing earnings Recognition Only done at one fiscal year-end Recorded $1.2 million not yet shipped Spare Parts Inventory Conducted physical inventory $1.5 million of spare parts couldn t be located (likely used) Chose not to record write down, which would hit expense Spare parts overstated by $1.5 million 12

13 Detecting Financial Statement Fraud Horizontal & vertical analysis(3-5 years) Ratio analysis Comparison to industry Careful examination of corporate culture & financial reporting controls Vouching to source documents Confirmations Examination of estimates Detecting Financial Statement Fraud Nonroutine transactions Careful examination of capitalization (operating expenses, IT projects, etc.) Scrutiny of manual journal entries Resources Managing the Business Risk of Fraud: A Practical Guide (AICPA & IIA) Management Anti-Fraud Programs & Controls (exhibit to SAS 99) ACFE Fraud Prevention Check-Up ACFE Best Practices in Ethics Hotlines ACFE Sample Code of Conduct ACFE Sample Ethics Policy 13

14 Questions? Angela Morelock, CPA, CFE, CFF, ABV Certified Forensic Accountant E. St. Louis Street Springfield, MO