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
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
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
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 316.05 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
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, 2010. CARE Conference 8/05/16 Page 5
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
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
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
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
SEC Allegations of Auditor Deficiencies in Connection with Alleged Fraud Have Been Rare During 1998 2010, 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: 1998-2010, May 2013. CARE Conference 8/05/16 Page 10
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
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. 503 532. 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. 53 59. CARE Conference 8/05/16 Page 12
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. 503 532. 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. 53-59. CARE Conference 8/05/16 Page 13
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
Appendix CARE Conference 8/05/16 Page 15
SEC Enforcement Actions Increased in the Past Two Years Financial Fraud/Issuer Disclosure Other Enforcement Actions 735 734 755 807 630 656 671 664 681 676 574 445 436 437 514 521 555 626 640 603 649 659 185 138 219 157 143 126 109 94 73 106 148 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 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
Accounting Class Action Filings Increased in Recent Years 2006 2014 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=120 2007 N=177 2008 N=223 2009 N=165 2010 N=175 2011 N=188 2012 N=151 2013 N=166 2014 N=170 2015 N=189 2016 Cornerstone Research. All rights reserved. Source: Accounting Class Action Filings and Settlements 2015 Review and Analysis, Cornerstone Research, 2016. CARE Conference 8/05/16 Page 17
Few Accounting Class Action Filings Involve Restatements 2006 2014 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=69 2007 N=77 2008 N=97 2009 N=61 2010 N=59 2011 N=80 2012 N=45 2013 N=47 2014 N=69 2015 N=71 2016 Cornerstone Research. All rights reserved. Source: Accounting Class Action Filings and Settlements 2015 Review and Analysis, Cornerstone Research, 2016. CARE Conference 8/05/16 Page 18
Accounting Class Actions Comprise the Majority of Settlements 2006 2014 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=90 2007 N=109 2008 N=97 2009 N=99 2010 N=85 2011 N=65 2012 N=56 2013 N=66 2014 N=63 2015 N=80 2016 Cornerstone Research. All rights reserved. Source: Accounting Class Action Filings and Settlements 2015 Review and Analysis, Cornerstone Research, 2016. CARE Conference 8/05/16 Page 19
Accounting Class Actions Represent a Significant Portion of Settlement Dollars $20.2 Non-Accounting Cases Accounting Cases 2006 2014 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=90 2007 N=109 2008 N=97 2009 N=99 2010 N=85 2011 N=65 2012 N=56 2013 N=66 2014 N=63 2015 N=80 Note: Dollars in Billions. Settlement dollars are adjusted for inflation; 2015 dollar equivalent figures are used. 2016 Cornerstone Research. All rights reserved. Source: Accounting Class Action Filings and Settlements 2015 Review and Analysis, Cornerstone Research, 2016. CARE Conference 8/05/16 Page 20