AP & P2P 2017 Las Vegas 10/25/2017

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1 November 12-14, 2017 Bellagio Resort & Casino, Las Vegas November 13 & 14, 2017 Concealing Fraud in Financial Statements Allan Bachman, CFE Education Manager [retired] Association of Certified Fraud Examiners Austin, Texas Agenda Overview and Definitions What Constitutes Financial Statement Fraud? Magnitude of the Problem Committee of Sponsoring Organizations of the Treadway Commission (COSO) ACFE 2016 Report to the Nations Types of Financial Statement Fraud Gunning Fog Index (time permitting) But first in their own words Financial Statement Types Balance sheet Assets. Liabilities and Capital) Statement of income (Revenues and Expenses) Statement of retained earnings or statement of changes in owners equity Statement of cash flows Notes to financial statements 1

2 What is Financial Statement Fraud? The deliberate misrepresentation of the organization s financial condition Accomplished through the intentional misstatement or omission of amounts or disclosures To deceive financial statement readers and users Misleading Financial Statements Financial statements are materially misleading (fraudulent) when the presentation contains: fictions, improper valuations, inappropriate transaction timing, omissions, or false statements that are important enough to affect decisions made by users of the statements. What is Fraud? Wrongful or criminal deception intended to result in financial or personal gain. 6 2

3 The Fraud Triangle Opportunity The chance to take advantage of an organization Motivation Perceived un-shareable financial need Rationalization The explanation as to why? 7 Fraud is Hidden Its very nature makes it difficult to measure actual fraud losses. Until a fraud is discovered, there is no way to know magnitude. A tip of the iceberg potential to all fraud statistics. 8 Financial Statement Fraud Typically involves one or more of the following: Overstating assets, revenues, and profits Understating liabilities, expenses, and losses 3

4 Why Financial Statement Fraud Occurs Meet financial analysts expectations. Encourage investment in company stock. Demonstrate increased earnings, allowing increased dividend or distribution payouts. Cover inability to generate positive cash flows. Dispel negative market perceptions. Obtain financing or more favorable terms. Receive higher purchase prices for acquisitions. Motivation Make the organization appear more profitable. Understate assets and revenues for more funding (i.e., government contracts). Revenues might be understated to avoid taxes or to create a cushion for the future. Often does not involve personal gain. Opportunity The absence of, or improper oversight by, the board of directors or audit committee Weak or nonexistent internal controls Unusual or complex transactions Financial estimates requiring significant subjective judgments 4

5 Rationalization Keep up with competitors. Demonstrate compliance with loan covenants. Meet internal company goals and objectives. Receive performance-related bonuses or otherwise inflate executive compensation. Increase stock value for acquisitions involving stock swaps. Smooth reported earnings. Outcomes of Financial Statement Fraud Stock price decline Impact on reputation of entity and those involved Lost jobs Lost pensions Lawsuits against company and auditors Potential corporate deathblow Agenda Overview and Definitions Overview of Financial Statement Fraud Magnitude of the Problem Committee of Sponsoring Organizations of the Treadway Commission (COSO) ACFE 2016 Report to the Nations Financial Statement Fraud (FSF) 5

6 The COSO Study Examination of 347 financial statement frauds totaling nearly $120 billion from Average fraud involved $ million; median fraud involved $12.05 million Average fraud period was 31.4 months; median fraud period was 24 months Most common misstatement techniques: Improper revenue recognition Asset overstatements The COSO Study CEO was involved in 72% of the frauds. CFO was involved in 65% of the frauds. Together, CEO and CFO were involved in 89% of the frauds. 6

7 RTTN Executive Summary Typical organization loses 5% of revenues as a result of fraud. Total losses by cases examined exceeded $6.3 billion. The average loss per case was $2.7 million Due to the nature of fraud and the issue of voluntary reporting, It cannot be determined what the actual global losses due to fraud actually are. 19 How Occupational Fraud Is Committed Most frauds (16.6%) originated in the accounting department. 75% of frauds were committed in one of these departments: Accounting, Operations, Sales, Customer Service, Purchasing, Finance, Executive/Upper Management 20 How Occupational Fraud Is Committed 21 7

8 How Occupational Fraud Is Committed 9.6% 22 Duration of Fraud Schemes The longer a fraud went undiscovered, the greater the loss. Financial Statement Fraud Duration 24 Months Median loss $975, Duration of Fraud Schemes 24 months 24 8

9 How Occupational Fraud Is Committed $975, How the Financial Statement Fraud Schemes Were Concealed Created fraudulent physical documents (50.7%) Altered physical documents (49.3%) Created fraudulent transactions in the accounting system (38.4%) Altered transactions in the accounting system (37.9%) Created fraudulent electronic documents or files (32.4%) Altered electronic documents or files (33.8%) Created fraudulent journal entries (30.6%) Altered account balances in the accounting system (31.5%) Concealment of Fraud Schemes 49.3% 50.7% 37.9% 38.4% 33.8% 32.4% 30.6% 31.5% 27 9

10 Initial Detection of Occupational Frauds Most common detection method was tips (39.1%) Organizations with hotlines were more likely to have fraud detected. Organizations with hotlines were more likely to get tips (47.3%) compared to those without (28.2%). Active detection reduced the median loss and duration more than passive detection. 28 Initial Detection of Occupational Frauds 16.5% 13.4% 39.1% 29 Source of Tips 51.5% 30 10

11 Methods of Fraud in Small Businesses 8.8% 12.1% 31 ACFE 2016 Report to the Nations FSF more likely to be perpetrated by executives or upper management than by line employees Perpetrators often display behavioral red flags: Living beyond means (49%) Wheeler-dealer attitude (24%) Financial difficulties (24%) Excessive pressure from within the organization (18%) Control issues or unwillingness to share duties (18%) Irritability, suspiciousness, or defensiveness (18%) Prosecuting Financial Statement Fraud 18 U.S.C Knowing and willful falsification Overvaluation of land, property, or security Violators can be fined up to $1 million and/or imprisoned for up to 30 years 11

12 Types of Financial Statement Fraud Revenue-Based Schemes Asset-Based Schemes Expense and Liability Schemes Other Schemes Revenue-Based Schemes Timing Schemes Improper estimates Bill and hold schemes Pushing current revenue to future periods Improper use of reserves Fictitious or Inflated Revenues Misclassification Schemes Gross-Up Schemes Phony revenue and expenses Asset-Based Schemes Improper Capitalization of Costs R&D costs Property and equipment Development and acquisition costs Deferrals and prepaid expenses Inventory capitalization schemes Asset Valuation Schemes Fictitious assets Inventory valuation 12

13 Expense and Liability Schemes Shifting Expenses to Future Periods Timing schemes involving liabilities Accounts payable Omissions and Underreporting of Liabilities Other Schemes FSF to Conceal Asset Misappropriation FSF to Conceal Illegal Acts Disclosure Fraud Gunning Fog Index: What is It? In linguistics, the Gunning Fog Index (GFI) measures the readability of English writing. Estimates the years of formal education needed to understand the text on a first reading. For Example: A fog index of 12 requires the reading level of a U.S. high school senior (around 18 years old). Texts for a wide audience generally need a fog index less than 12. Texts requiring near-universal understanding generally need an index less than 8. 13

14 Calculating the Gunning Fog Index It is a weighted average of: the number of words per sentence, and the number of long words per word. An interpretation is that the text can be understood by someone who left full-time education at a later age than the index. What Does the Score Mean? The ideal score for readability with the Fog index is 7 or 8. Anything above 12 is too hard for most people to read. For instance, The Bible, Shakespeare and Mark Twain have Fog Indexes of around 6. The leading magazines, like Time, Newsweek, and the Wall Street Journal average around 11. Source: The Gunning Fog Index is Calculated with the Following Algorithm Select a passage (such as one or more full paragraphs) of around 100 words. Do not omit any sentences; Determine the average sentence length. (Divide the number of words by the number of sentences.); Count the "complex" words: those with three or more syllables. Do not include proper nouns, familiar jargon, or compound words. Do not include common suffixes (such as -es, -ed, or - ing) as a syllable; Add the average sentence length and the percentage of complex words; and Multiply the result by

15 Examples: Newsweek = 10 Time Magazine = 11 Atlantic Monthly = 12 Audited Financial Statements =?? Bible Psalm 23 The LORD is my shepherd; I shall not want. He maketh me to lie down in green pastures; He leadeth me beside the still waters. He restoreth my soul; He leadeth me in the paths of righteousness for His name s sake. Yea, though I walk through the valley of the shadow of death, I will fear no evil; for Thou art with me; Thy rod and Thy staff, they comfort me. Thou preparest a table before me in the presence of mine enemies; Thou anointest my head with oil; my cup runneth over. Surely goodness and mercy shall follow me all the days of my life; and I will dwell in the house of the LORD for ever. GUNNING FOG INDEX IS Mark Twain Life on the Mississippi [extract] Very well, this growing swarm of new pilots presently began to undermine the wages, in order to get berths. Too late apparently the knights of the tiller perceived their mistake. Plainly, something had to be done, and quickly; but what was to be the needful thing. A close organization. Nothing else would answer. To compass this seemed an impossibility; so it was talked, and talked, and then dropped. It was too likely to ruin whoever ventured to move in the matter. But at last about a dozen of the boldest and some of them the best pilots on the river launched themselves into the enterprise and took all the chances. They got a special charter from the legislature, with large powers, under the name of the Pilots' Benevolent Association; elected their officers, completed their organization, contributed capital, put 'association' wages up to two hundred and fifty dollars at once and then retired to their homes, for they were promptly discharged from employment. But there were two or three unnoticed trifles in their by-laws which had the seeds of propagation in them. For instance, all idle members of the association, in good standing, were entitled to a pension of twenty-five dollars per month. This began to bring in one straggler after another from the ranks of the new-fledged pilots, in the dull (summer) season. Better have twentyfive dollars than starve; the initiation fee was only twelve dollars, and no dues required from the unemployed. GUNNING FOG INDEX IS

16 Martin Luther King I have a dream [extract] But there is something that I must say to my people, who stand on the warm threshold which leads into the palace of justice: In the process of gaining our rightful place, we must not be guilty of wrongful deeds. Let us not seek to satisfy our thirst for freedom by drinking from the cup of bitterness and hatred. We must forever conduct our struggle on the high plane of dignity and discipline. We must not allow our creative protest to degenerate into physical violence. Again and again, we must rise to the majestic heights of meeting physical force with soul force. GUNNING FOG INDEX IS Abraham Lincoln Gettysburg Address Four score and seven years ago our fathers brought forth on this continent a new nation, conceived in liberty, and dedicated to the proposition that all men are created equal. Now we are engaged in a great civil war, testing whether that nation, or any nation so conceived and so dedicated, can long endure. We are met on a great battlefield of that war. We have come to dedicate a portion of that field, as a final resting place for those who here gave their lives that that nation might live. It is altogether fitting and proper that we should do this. But, in a larger sense, we can not dedicate, we can not consecrate, we can not hallow this ground. The brave men, living and dead, who struggled here, have consecrated it, far above our poor power to add or detract. The world will little note, nor long remember what we say here, but it can never forget what they did here. It is for us the living, rather, to be dedicated here to the unfinished work which they who fought here have thus far so nobly advanced. It is rather for us to be here dedicated to the great task remaining before us that from these honored dead we take increased devotion to that cause for which they gave the last full measure of devotion that we here highly resolve that these dead shall not have died in vain that this nation, under God, shall have a new birth of freedom and that government of the people, by the people, for the people, shall not perish from the earth. GUNNING FOG INDEX IS Enron Notes to Financial Statements 1 SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Consolidation Policy and Use of Estimates The accounting and financial reporting policies of Enron Corp. and its subsidiaries conform to generally accepted accounting principles and prevailing industry practices. The consolidated financial statements include the accounts of all subsidiaries controlled by Enron Corp. after the elimination of significant intercompany accounts and transactions. The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. GUNNING FOG INDEX IS

17 Enron Notes to Financial Statements Financial Instruments Enron uses the following methods and assumptions in estimating fair values: (a) short- and long-term debt - the carrying amount of variable-rate debt approximates fair value, the fair value of marketable debt is based on quoted market prices and the fair value of other debt is based on the discounted present value of cash flows using Enron s current borrowing rates; (b) company-obligated preferred securities of subsidiaries the fair value is based on quoted market prices, where available, or based on the discounted present value of cash flows using Enron s current borrowing rates if not publicly traded; and (c) energy commodity price swaps, interest rate swaps, foreign currency contracts and equity contracts - estimated fair values have been determined using available market data and valuation methodologies. Judgment is necessarily required in interpreting market data and the use of different market assumptions or estimation methodologies may affect the estimated fair value amounts GUNNING FOG INDEX IS Note 16 Continued In 2000, Enron entered into transactions with the Related Party to hedge certain merchant investments and other assets. As part of the transactions, Enron (i) contributed to newly-formed entities (the Entities) assets valued at approximately $1.2 billion, including $150 million in Enron notes payable, 3.7 million restricted shares of outstanding Enron common stock and the right to receive up to 18.0 million shares of outstanding Enron common stock in March 2003 (subject to certain conditions) and (ii) transferred to the Entities assets valued at approximately $309 million, including a $50 million note payable and an investment in an entity that indirectly holds warrants convertible into common stock of an Enron equity method investee. In return, Enron received economic interests in the Entities, $309 million in notes receivable, of which $259 million is recorded at Enron's carryover basis of zero, and a special distribution from the Entities in the form of $1.2 billion in notes receivable, subject to changes in the principal for amounts payable by Enron in connection with the execution of additional derivative instruments. Cash in these Entities of $172.6 million is invested in Enron demand notes. In addition, Enron paid $123 million to purchase share-settled options from the Entities on 21.7 million shares of Enron common stock. The Entities paid Enron $10.7 million to terminate the share-settled options on 14.5 million shares of Enron common stock outstanding. In late 2000, Enron entered into share-settled collar arrangements with the Entities on 15.4 million shares of Enron common stock. Such arrangements will be accounted for as equity transactions when settled. GUNNING FOG INDEX IS 31.8 In Closing In its early stages fraud and stupidity look a lot alike. Fraud indicators can often be explained away by claiming oh, that was a stupid mistake. Further investigation of stupid mistakes is always warranted. Follow-up is also critical. If you suspect something, say something

18 Download Your Own Report to the Nations Copy Want a PDF of the entire report? Go to: Click Resources then Downloads Created fraudulent electronic documents or files (32.4%) nations.pdf 52 November 12-14, 2017 Bellagio Resort & Casino, Las Vegas November 13 & 14, 2017 Concealing Fraud in Financial Statements Questions? Allan Bachman, CFE ABachmanCFE@gmail.com 18