FINANCIAL STATEMENT FRAUD: IT S NOT JUST FOR BIG BUSINESS

Transcription

1 Financial statement fraud is not limited to big business. It is more widespread than you may think. Explore the motivations behind and methods of manipulating reported financial results. From the landmark cases of WorldCom and Livent to real-life examples of smaller schemes, hear how financial statements have been altered for personal gain. Learn tips and techniques to detect schemes and reduce the risk of being a victim of financial statement fraud. CHERYL E. SHEARER, CFE, CA Associate Blair Mackay Mynett Valuations Inc. Vancouver, British Columbia Practicing as a Chartered Accountant for more than 25 years, Cheryl Shearer has a broad range of experience in the areas of forensic accounting investigations, litigation support and financial accounting matters. She has conducted investigations into allegations of financial statement fraud, misappropriation of trust funds, employee theft, securities violations, shareholder, commercial and matrimonial disputes and performed numerous asset tracing assignments. Ms. Shearer has assisted the Vancouver Police Department and the Royal Canadian Mounted Police in criminal investigations and produced forensic accounting reports for evidentiary purposes. In addition, she has investigated allegations of professional misconduct and prepared comprehensive reports for use in disciplinary proceedings conducted by the Institute of Chartered Accountants of British Columbia. Ms. Shearer has given expert witness testimony in the Supreme Court of British Columbia and at the Institute of Chartered Accountants of British Columbia Discipline Tribunal proceedings. She has assisted legal counsel in their understanding and presentation of accounting issues, and with the preparation of affidavits, evidence binders and hearings briefs. Ms. Shearer works as an independent contractor primarily with Blair Mackay Mynett Valuations Inc. in Vancouver, British Columbia. Association of Certified Fraud Examiners, Certified Fraud Examiner, CFE, ACFE, and the ACFE Logo are trademarks owned by the Association of Certified Fraud Examiners, Inc. The contents of this paper may not be transmitted, re-published, modified, reproduced, distributed, copied, or sold without the prior consent of the author. 2011

2 Introduction During the past ten years, financial statement fraud has gained widespread media attention. The magnitude of the loss to investors in companies such as WorldCom and Enron was unprecedented. More recently here in Toronto, the Livent financial statement fraud captured the public s attention when Garth Drabinsky and Myron Gottlieb lost their appeal and were sentenced to jail for their involvement in the manipulation of Livent s financial statements. The effects of these and other large financial statement frauds were, and continue to be, far reaching. They have permanently changed the accounting profession and how business is conducted. Financial statement fraud is not limited to big business. Executives at many small and medium companies are motivated to manipulate financial results for various purposes. In this presentation we will explore: The motives behind committing financial statement fraud Who participates in these frauds Who uses the financial statements Who is affected by financial statement fraud Methods used to manipulate reported financial information We will briefly review the landmark fraud cases of WorldCom and Livent, as well as hear about how many small to medium businesses, as well as individuals, have become victims of financial statement fraud. Finally, we will cover some tips and techniques to detect and reduce the risk of becoming a victim of financial statement fraud. Motive Cynthia Cooper, the former Vice President of Internal Audit for WorldCom, was the whistleblower in the

3 WorldCom fraud. In her book Extraordinary Circumstances, she makes the statement: People don t wake up and say, I think I ll become a criminal today. Instead, it s often a slippery slope and we lose our footing one step at time. In my experience, I have found this statement to be very true. Often, people start off thinking that the fraud will only be temporary. They believe they will pay the money back or correct the entries later when things get better. All too often, however, things don t improve and they start their descent on the slippery slope. In some cases, as their involvement in the fraud escalates, they feel trapped and are no longer able to extract themselves for fear of prosecution. Alternatively, others may determine that no one has noticed the fraud and as such, they rationalize that their behaviour can continue. Often the fraud escalates and eventually spirals out of control. There are a number of factors that cause individuals to manipulate a company s financial results. A nonexhaustive list includes: Pressures from outside sources for example, shareholders and investors making investment decisions based on the company s financial performance or a need for the company to maintain its financial performance within the provisions of their financial institution s lending covenants Pressures from inside sources for example, meeting the expectations of the company s management, owners, and directors. Often meeting these internal expectations directly affects the remuneration of those individuals ultimately responsible for the company s financial reporting

4 Personal circumstances for example, covering funds stolen to enable a gambling addiction or substance abuse problem Rationalization for example, thinking that the fraud is justified if it can save the company Desire not to fail the personalities of many individuals in positions of power can be described as high ego. This can create a mindset where achieving financial success is justified by any means and failure is not an option Greed a human trait that, when coupled with a lack of ethical conscience, can lead to manipulation of financial information for personal gain Pathological sense of entitlement although this may appear on the surface to be just another name for greed, it has actually been described as a psychological condition where an individual sees what is available to others and feels justified and entitled to take some (or all) for themselves This non-exhaustive list of motives is ever present in our society and, given the right circumstances and opportunity, may cause a person to commit financial statement fraud. There are numerous outcomes an individual and/or company might be trying to achieve when manipulating a company s reported financial information. Some of these outcomes include: Concealing the actual financial results of the company for example, entries that inflate or understate the company s profitability Concealing financial transactions for example, concealing from the minority shareholder the amount of funds the majority shareholder has withdrawn from the company during the year

5 Complying with bank loan covenants for example, manipulating the financial results to fall within an acceptable range determined by certain key lending ratios Concealing personal benefits for example, burying personal expenses in company expense accounts Concealing assets or liabilities for example, incomplete disclosure of the company s current financial position or future financial obligations Participants Who are the participants in financial statement fraud? In my experience, it can be anyone who has the ability to influence or alter the financial information. It does not have to be a person directly responsible for processing a company s day-to-day accounting entries or for preparing the financial statements, but it can also include those individuals in a position of power who can influence the behaviour of others. Potential participants in financial statement fraud include most everyone: Owners Officers and directors Senior management Employees Spouses (in matrimonial matters) IT MAY BE SOMEONE YOU KNOW AND TRUST Each of these individuals might have their own motivation or motivations, as discussed in the above section, to commit financial statement fraud. When motive and opportunity present themselves together in a particular situation, this may lead to inappropriate decisions and behaviour on the part of one or more of these potential

6 participants and could ultimately lead to a financial statement fraud being perpetrated. Impact Financial statements are used for a variety of purposes by a variety of stakeholders, such as: Public company shareholders Private company shareholders, including minority shareholders who often do not have access to any other financial information from the company Investors Bank and other debt holders Tax authorities Spouses (often financial statements filed in a matrimonial divorce action are falsified to hide assets from a spouse) Obviously, relying on falsified information by decision makers in any capacity can lead to inappropriate decisions and costly mistakes. These decisions can have long-term personal, social, and economic impact. In the past, white-collar crime was often thought of as a nameless, faceless crime that did not impact the general public, but rather only affected the company, not the individuals. Since the financial statement frauds of WorldCom and Enron, financial statement fraud is now acknowledged to have far reaching consequences. In her Reasons for Sentence in the Livent case, the Honourable Madame Justice Mary Lou Benotto recognised and identified the effect of corporate fraud, describing its resulting outcomes as: A tangible loss to employees, investors, and creditors A less tangible but equally significant loss to society A fostering of cynicism

7 An eroding of public confidence in the financial markets As such, the Courts have been looking to more severe penalties for individuals involved in financial statement manipulation. Methods For someone to be able to manipulate a company s financial reporting, one or more of the following situations is generally present: Insufficient or no internal controls more often found in a small business where there are a limited number of employees or an unsophisticated accounting system. However, many mid- to large-size companies have internal control weaknesses that also leave them vulnerable. Someone in a position to override the controls these individuals are frequently described by victims of a financial statement fraud as the trusted employee or someone whom no one would have ever expected would take advantage of their position in the company. Collusion a company s internal controls are compromised in the presence of collusion. Often it is not willing collusion on the part of employees, but they feel bullied or threatened into participating. Once involved, they fear that they will be prosecuted or lose their job; therefore, they continue to do their part to facilitate the fraud. Lack of oversight by owner, manager, board of directors, audit committee in some instances, warning signs were present. Had the supervisors in the company been more attentive, these warning signs would have led to the discovery of the fraud in the early stages. In other cases, the corporate culture is such that employees know no one is watching. Therefore, they

8 may be motivated to engage in fraudulent behaviours for personal financial gain, which results in financial loss to the company. There are a number of methods used to manipulate a company s financial results. A non-exhaustive list includes: Manipulating the timing of revenue and expense recognition a company s profitability can be manipulated by cut-off errors that occur when the recorded revenue has not been matched in the same accounting period with the related expenses incurred to earn that revenue. For example, in the case of Livent, expenses were being rolled forward to subsequent reporting periods to artificially inflate the current period s reported profit (or, in some cases, to hide a current period s operating loss). Not recording or misrepresenting financial transactions unrecorded revenue (e.g., skimming), unrecorded expenses, capitalization of expenses as fixed assets, and not recording liabilities or contingent liabilities are all ways that a company s financial results may be manipulated. As well, revenue and expenses can be transferred to related companies. Falsifying financial transactions a common example is an employee falsifying entries on a company s bank statement or bank reconciliation to conceal the fraudulent removal of funds from the company. Another example is an employee creating false supplier invoices that were processed though the company s accounts payable system. This had the effect of overstating the company s expenses while creating cheques that were then intercepted by the employee and used to pay for personal expenditures. Misrepresentation for personal benefit a common example is a company s owners or employees filing

9 expense reports to be reimbursed for personal expenses such as travel, meals and entertainment and auto. In matrimonial divorce proceedings, a too-frequent occurrence is a spouse not recording all their assets on their personal financial statement (e.g., Form 8 in British Columbia Supreme Court Rules). Misapplying accounting principles accounting is not black and white as some believe. Preparing a company s financial statements require estimates and judgments be made concerning matters such as the useful life of a company s asset or the amount of income that has been earned on an ongoing contract. A company s income may be materially under or overstated, depending upon what estimates and policies are adopted. As well, if a company s contingent liabilities are not fully disclosed on the financial statements, this may materially misstate the company s financial position at the financial statement date. Landmark Cases WorldCom In the 1990s, WorldCom had grown to one of the largest telecommunication companies in the world. This growth had been achieved largely through acquisitions and debt offerings. However, in June 2002, WorldCom s success was shattered when it announced that it had misstated its financial statements over the past five quarters by $3.8 billion. When investigations were completed and the fraud was unraveled, the misstatements were found to be worth $11 billion. Faced with pressures from analysts and investors and the realization that the company s financial results were not meeting published expectations, the senior management at WorldCom set out to falsify the

10 company s reported earnings. Employees, who became unwilling participants in the fraud, were initially told that the losses were likely an error somewhere in the company s accounting records and that the mistake would correct itself in the next quarter. When things did not improve, they were persuaded that the company needed more time to turn things around. Meanwhile, on the market, investors were making inappropriate decisions based on fraudulent financial information. The WorldCom fraud initially involved reducing liability accounts and offsetting these amounts against higher than predicted expenses. Later, the fraud involved overstating the company s income by capitalizing line expenses (what the company paid to lease telecommunication lines) and recording these expenses as assets on the company s balance sheet. WorldCom s former CEO, Bernie Ebbers was found guilty of all fraud charges and sentenced to 25 years in jail. He relinquished $6.13 billion in assets in a civil settlement. WorldCom s former CFO, the Controller and three accounting staff members agreed to cooperate with the prosecution in hope of receiving reduced sentences. The sentences for these and other individuals involved in the fraud ranged from 5 years imprisonment for the CFO to three years probation for one of the employees who was identified by the court as being at the bottom of the chain of involvement. Livent Livent was a Toronto-based theatre production company that rose to prominence in the 1990s. Cofounded by Garth Drabinsky and Myron Gottlieb, the company gained notoriety for, among other things, for its theatre production of the Phantom of the Opera

11 The Livent fraud involved artificially inflating income to attract investor capital. The company s profits were overstated and, in some periods, operating losses were concealed by a system of adjusting or otherwise understating expenses. This was achieved by various methods, including: Asking suppliers to falsify invoices Failing to record some expenses Rolling forward some expenses into subsequent periods Transferring expenses among theatre productions Manipulating computer software to eliminate the trail As a result of this fraud, it is estimated that investors lost approximately $500 million. Garth Drabinsky and Myron Gottlieb were originally sentenced to seven years and six years respectively for their involvement in this fraud. On appeal, these sentences were reduced to five years and four years respectively. Another senior executive who was the head of Livent s accounting group was also charged with fraud for his involvement. He made a plea bargain to testify against Drabinsky and Gottlieb in return for a conditional sentence of two years less one day. Detection Review of Financial Statements The following are some things to consider when you are reviewing a company s financial statement or an individual s statement of net worth: 1. What would I expect to see on the financial statements given my knowledge of the individual or

12 the company and my knowledge of other companies operating the same or similar business? 2. What is missing from the financial statements may be as or more important than what is reported on the statements. For example, dividend income may be recorded by the company (on the income statement) or by the individual (on the income tax return) but no investments are recorded on the balance sheet or no gain or loss has been recorded during the year when the investment appears to have been disposed of. 3. Does anything look unusual? Look to see if anything stands out on the balance sheet or income statement as being unusual. For example, consider if the expenses recorded in any given category appear unusually high or low or nonexistent in a year when compared to other years. If so, further enquiries may be required to determine the reason for these variances. 4. Does what I am seeing make business sense? For example, is it reasonable that an owner/manager would continue to operate a company that was consistently recording huge annual operating losses when there did not appear to be any reasonable expectation of profitability in the future? Consider what other motivations there may be when business activity does not appear to be prudent. 5. It is appropriate in certain situations for a company to defer the recognition of income or expenses or to maintain reserves with respect to certain asset or liability accounts. However, these are also accounts that can be easily used to manipulate a company s reported assets, liabilities, and income. When looking at a financial statement, take a close look at any items recorded as deferred or a reserve. If the business purpose for these entries is not clear or

13 they appear unusual given your knowledge of the business, further information may be required to determine if the deferral or reserve is bona fide entry. Management/Employee Fraud The following are questions to consider when monitoring the employees in your organization who have the responsibilities related to the company s day-to-day accounting and financial statement preparation: 1. Do all employees in the accounting department take annual vacations for at least two consecutive weeks? 2. Is there adequate segregation of duties among the employees? 3. Are the lifestyles of the employees consistent with what you know their income to be? 4. Do the bank statements agree (after reconciliation) to what is reported as cash on the company s financial statements. Search for Hidden Assets Often in matters involving the division of matrimonial assets, one of the parties does not fully disclose their assets on their personal financial statement filed in the divorce proceedings. When reviewing these personal net worth financial statements, it is often useful to compare the information disclosed in these statements to other sources of information that may confirm the existence of undisclosed assets. A non-exhaustive list of records and other sources of information to review includes: Personal income tax returns Bank accounts (unexplained deposits and/or disbursements) Credit card statements Property tax notices Travel documents and passport stamps

14 Telephone records and other information stored on personal computers and devices