WILLIAM I. ESKIN, CPA. Presentation to : Southeastern Accounting Show FINANCIAL STATEMENT ANALYSIS/FRAUD. August 18, 2011.

Transcription

1 WILLIAM I. ESKIN, CPA Presentation to : Southeastern Accounting Show FINANCIAL STATEMENT ANALYSIS/FRAUD August 18, 2011 Introduction What is Fraud? SAS No. 99 defines fraud as: an intentional act that results in a material misstatement in financial statements that are the subject of an audit 1

2 Introduction Our profession continues to respond to the ever present perplexity created by fraudulent activity in a business environment We continue to be faced with the dilemma of identifying fraud and answering the question: How can I efficiently search for fraudulent activity Introduction Before we jump into preventing and detecting financial statement fraud, a few words of Caution: It s just not possible to prevent all fraud enough said Every fraud incident is unique finding the fraud requires creativity; NOT a fraud audit program Nothing said here is legal advice the head coach of all fraud response teams is the attorney; NOT the CPA 2

3 Introduction When fraud occurs, emotions must be managed (especially our own) when fraud hits, disbelief, anger, and empathy are common reactions. All decisions should be made in a clear, mature manner, not with heavy emotions! *There are usually many parties involved and hurt by the fraud (employees, lenders, vendors, officers, etc.) You want to be very careful not to allow the accused to become the accuser. And most importantly, innocent parties MUST be protected Financial Statement Fraud Financial Statement Fraud is a term we have all heard thrown around as one of the causes of our current economic mess. What do we mean by Financial Statement Fraud? Intentional deceit Intentional concealment Forgery Collusion 3

4 Financial Statement Fraud Therefore, rarely if ever will you be able to simply pick up a financial statement and see a smoking ggun that indicates financial statement fraud Financial Statement Fraud Instead of the smoking gun, what we look for are known as fraud symptoms; indicators or red flags that you observe upon reading the financial statements that causes that icky feeling in your belly 4

5 Financial Statement Fraud By their nature, fraud symptoms cannot easily be ranked in order of importance or combined into effective predictive models In addition to fraud symptoms, we also have the issue of red flag indicators of fraud Financial Statement Fraud There are times when the red flag indicators are all there, but absolutely no fraud involving the financial statements has occurred Oth ti j fi i l t t t f d Other times, a major financial statement fraud occurs and none of the red flags were present 5

6 Motivations to Commit Financial Statement Fraud Why do entities commit financial statement fraud? To support a high stock price To support a bond or stock offering To increase executive compensation (if tied into performance) To meet board of director and shareholder expectations To meet 3 rd party (bank, regulator, etc.) expectations Introduction We will now discuss the difficulty of detecting financial statement fraud and the mandate that our profession has to deal with this difficulty We must look for something (fraud) that may be well hidden and generally beyond the level of the traditional audit procedures 6

7 Introduction However, it is essential that we as CPA professionals be on the lookout for financial statement fraud when performing our audits The purpose of this presentation is to make the search for fraud more productive and meaningful. While some of the points we discuss will not apply to all situations, experience shows that under the proper set of circumstances, they will point to indicators of fraud or deception. Determining Fraud Exposures Identifying fraud exposures is one of the most difficult steps in detecting financial statement fraud. The act of identifying exposures means that the CPA must clearly understand: The operations and nature of the organization that he/she is studying The nature of the organization s industry and competition. 7

8 Determining Fraud Exposures The nature the organization s management and what motivates them The organizational structure of the company Its relationship with other parties, in particular, related parties Determining Fraud Exposures Fraudulent financial statements are rarely, if ever, discovered by just analyzing the statements. The fraud is most often discovered in conjunction with the various items we detailed on the previous slides 8

9 Determining Fraud Exposures In other words, financial statement fraud is often discovered by comparing what is reported in those statements and what one would expect to see based on his/her global understanding of the entity Determining Fraud Exposures In addition, financial statement fraud is often discovered analytically by comparing current year s income statement and balance sheet amounts to what was recorded in the prior year Any unexplained difference could be an indication of possible financial statement fraud 9

10 Management and the Board of Directors In the vast majority of situations when financial statement occurs, top management is actively involved Unlike embezzlement and misappropriation of assets which is often done by lower level employees, fraud involving the financial statements more often than not involves the highest levels within the organization Management and the Board of Directors Therefore, it is imperative for the CPA to obtain a thorough understanding of what makes management tick. In particular, the CPA should examine: The background of the various members of management What is management s motivations g What is management s influence in making decisions for the organization What is the turnover rate within management 10

11 Management and the Board of Directors Background This first one is quite obvious but often overlooked by many auditors. If there is a skeleton in their closets from the past, it could resurface again with your client. Management and the Board of Directors Motivation The auditor must gain an understanding on what makes management tick Is their personal wealth tied up in the organization Are they required to deliver unrealistic financial results Is their compensation tied into financial results 11

12 Management and the Board of Directors Many financial statement frauds have occurred because of these negative motivations exhibited by management and/or the board of directors Management and the Board of Directors Influence Management s ability to influence decisions for the organization is important for the auditor to understand because it is much easier to perpetrate management fraud when 1 or 2 individuals have primary decision-making power than it is with a more democratic leadership 12

13 Management and the Board of Directors When the decision-making function is spread among several individuals, or when there is an actively functioning board of directors (and audit committee where applicable), fraud is much more difficult to perpetuate Management and the Board of Directors When evaluating management, auditors should be sure that there is a proper tone at the top. How they deal with fraud Are its feelings towards fraud properly communicated to the organization Any attempts by management to limit the scope of audit work performed by the outside CPA 13

14 Management and the Board of Directors Turnover Last, but not least, the auditor must get his/her finger on the pulse of management turnover The correlation of lack of management integrity and management turnover is really undeniable. The proof of this may be Enron where 7 key executives left the company in the year before its collapse Relationship with Others Financial Statement Fraud is often perpetrated with the help of other entities (both real and fictitious) Therefore, the auditor must develop a solid understanding of the various relationships between their client and various other entities. We will now take a few minutes and look at some of these others 14

15 Relationship with Others Related Parties Our client s relationship with related parties must be examined because of the very nature of the business and sometimes personal relationships Relationship with Others Most business transactions result from bargained dealing. When the parties to a transaction are related, the objectivity expected in related bargaining i may be lost. 15

16 Relationship with Others Because of the loss of objectivity, knowledge of the nature and volume of transactions with related parties may be necessary for financial statement users to properly evaluate the company's financial position and results of operations. Consequently, material related party transactions must be disclosed. Organization and Industry It is always necessary to obtain an understanding of the industry, operations, and controls that your client operates in. In regards to a particular industry, it is quite obvious that there may be different fraud opportunities i in a banking environment as compared to a construction contractor 16

17 Organization and Industry What is gained by acquiring this understanding of your client s industry? Will help you determine whether certain observed conditions or transactions do not make business sense and indicate the possibility that fraud exists Will help you understand where there may be opportunities for financial i statement t t fraud to occur Will provide you with insight that will be helpful in determining truthfulness during the interview phase of the inquiry concerning financial statement fraud Organization and Industry A COSO-sponsored study concerning financial statement fraud came up with the following conclusions: The inability and unwillingness of small companies to implement cost-effective internals may be a factor affecting the likelihood of financial statement fraud (override of controls is easier to do with smaller entities) The importance of a well-established control environment 17

18 Organization and Industry Investors should always be aware of the possible complications arising from family relationships and from individuals (officers, board of directors, etc) who hold significant power within the company Organization and Industry In addition to the client s organization, in order to be on the look out for possible financial statement fraud, the CPA must understand the industry the client operates in. Why? To determine if observed financial results either To determine if observed financial results either make analytical sense or are possible fraud indicators as compared to other types of entities operating in the same industry 18

19 Financial Results and Operating Characteristics As we noted earlier, when attempting to identify fraud in the financial statements, one thing we look for is significant changes in account balances For instance, a large increase in the accounts receivable balance this year over last year could be a fraud symptom of receivable and/or revenue fraud Financial Results and Operating Characteristics Not only can the financial statements themselves be an indication of fraud, but the footnotes can also serve in the same manner The Standards require that disclosures be written clearly so the users of the financial statement can understand what is being communicated. In many of the major frauds (Enron), this just was not the case 19

20 Financial Results and Operating Characteristics Another financial statement red flag is when your client dramatically changes the nature of their business especially moving from a more conservative line of business into a more aggressive line Financial Results and Operating Characteristics When assessing fraud exposures through financial statements and operating characteristics, it is important to compare the balances and amounts with those of similar organizations in the same industry to help determine if the numbers presented are reasonable as compared to others and the financial statements taken as a whole 20

21 Financial Results and Operating Characteristics For example, included in your client s financial statements is $2,000,000 of inventory. Obviously to be reasonable, the inventory must be located somewhere, and depending on the type of inventory, it could require a certain amount of space to store it. So the question must be raised: Are the financial statement numbers realistic given the actual inventory that appears to be on hand? Red Flags When utilizing red flags to detect fraud, it is critical to understand context. While we previously presented everyone with lists of questions for the 4 categories (management, relationships, organization, and operating results), the CPA should understand that simply answering a fraud checklist with a YES, NO, or N/A just won t cut it 21

22 A Note on Identifying Fraud Exposures To summarize what we have just been discussing, the 1 st step in detecting financial statement fraud is to identify fraud exposures A Note on Identifying Fraud Exposures While our discussion i has been on fraud exposures, most fraud symptoms, especially those relating to financial results and operating characteristic are scheme-specific Therefore, for the remainder of the presentation, we will be looking at 1 specific fraud that can result in fraudulent financial statements: REVENUE 22

23 Introduction Why are we spending some time discussing REVENUE RECOGNITION? Remember those headlines from the Wall Street Journal! Scandals were announced on what seemed to be a daily basis and many of those scandals revolved around: IMPROPER REVENUE RECOGNITION Introduction As this section continues, we will provide other examples Nothing is new! Every scheme for fraudulently recognizing revenues has been used before! 23

24 Introduction Well-Known Schemes Recognizing revenue too soon Booking the proceeds of sale of assets as revenue Booking revenue too late (Freddie Mac) Bill and hold Inadequate allowances (if any) for returns, etc. SAB 101 & 104 Revenue Recognition Criteria 1) Persuasive evidence of arrangement exists 2) Delivery has occurred or services have been rendered 3) Selling price is fixed or determinable 4) Collection of receivable is reasonably assured 24

25 Introduction As a result of Enron and a number of other highly publicized cases, revenue recognition has now become the enforcement topic de jour. As a result, companies (as well as the CPA auditing them) must always be aware of the real possibility of overstating revenues. When is Revenue Considered Earned? Revenues are recognized when earned. This revenueearning activity involves delivering or producing goods rendering services, or other activities that are the entity s ongoing major or central operation. Revenues are earned when the entity has substantially accomplished what it must do to be entitled to the benefits represented by the revenues 25

26 When is Revenue Considered Earned? Hey Bill, how about some real-life examples Most industries When the product is delivered or the services rendered d to the customer. Revenues from manufacturing and selling activities, and gains and losses from sales of other assets are usually recognized at the time of the sale When is Revenue Considered Earned? Magazine Subscriptions This is a case where the sale and/or the cash receipt occurs before production and delivery. In this situation, revenue is not recognized until it is earned via production or delivery 26

27 When is Revenue Considered Earned? Construction Contractors Revenue must be recognized by the percentage-of-completion ti method When is Revenue Considered Earned? Maintenance Agreements and Extended Warranties When many entities sell their product, they include a maintenance agreement or extended warranty. How does GAAP allow revenue recognition from these transactions? 27

28 When is Revenue Considered Earned? GAAP instructs that revenue recognition from these 2 types of agreements be deferred and recognized in income on a straight-line basis over the contract period The only exception to this rule is if there is sufficient historical evidence that indicates that the costs of performing services under these agreements are incurred on other than a straight-line basis When is Revenue Considered Earned? Doubtful Receivables If the collectibility of the receivable is doubtful (especially in today s troubled economy), then revenues and gains are recognized on the basis of cash received. Such recognition depends on the provision that the fair values involved can be determined within reasonable limits 28

29 Earnings Management vs. Fraud When does one cross the line between managing the company s earnings and reporting fraudulent financial information? Legitimate earnings management year- end tax planning to accelerate income or deductions postponing certain expenditures due to lower than expected revenue, etc. Earnings Management vs. Fraud Fraud intentionally recognizing or measuring transactions and other events and circumstances in the wrong accounting period or recording fictitious transactions. Both of these activities constitute fraud! 29

30 Earnings Management vs. Fraud Sometimes, it may be a very fine line between earnings management and fraud. Sometimes it takes all of the CPAs brainpower to distinguish between the two Fraud Symptoms We noted earlier in this presentation that in order for financial statement fraud to be detected, fraud symptoms must be observed and recognized In regards to revenue, probably the #1 fraud symptom may be an unexplained increase in revenues from 1 year to the next 30

31 Fraud Symptoms But in order to identify financial statement fraud involving revenue, we just can t look at the revenue numbers themselves in a vacuum; other numbers could be additional indicators. These include: Gross profit ratios (Sales minus cost of sales) Sales return percentages too low a % could be a fraud indicator Sales discount percentages a lowering number could indicate uncollectibility of receivables Fraud Symptoms Accounts receivable turnover excellent analytical tool to discover fraudulent sales # days in receivables the lower the better. An increase in this ratio could be an indicator of fraudulent receivables and related revenue Allowance for doubtful accounts very obvious; not establishing a sufficient allowance for uncollectible accounts receivable is a fast and easy way to fraudulently overstate receivables and underreport bad debt expense 31

32 Fraud Symptoms Asset Turnover unusually large increases in this ratio might indicate some kind of revenue-related fraud is occurring Working capital turnover dittos as previous comment Operating performance ratio dividing net income by net sales. When revenue goes up, expenses generally go up too. Therefore, an unexplained significant increase in this ratio could indicate revenue-related fraud Limitations Leaders in every organization want the same thing a business environment that is hostile to fraud. What they need from us (inside and outside CPAs and auditors) are the ideas, tools, and action steps that can make this desire a reality 32

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