Fraudulent Financial Statements Could Your Client Be Perpetrating A Scam [On You]? Robert H. Barr, Jr., CPA, CFE, CFF Harper & Pearson Company, P.C.
Financial Statement Fraud Defined Deliberate misstatements or omissions of amounts or disclosures of financial statements to deceive financial statement users, particularly investors and creditors.
Defining Financial Statement Fraud Falsification, alteration, or manipulation of material financial records, supporting documents, or business transactions Material intentional omissions or misrepresentations of events, transactions, accounts, or other significant information from which financial statements are prepared Deliberate misapplication of accounting principles, policies, and procedures used to measure, recognize, report, and disclose economic events and business transactions Intentional omissions of disclosures or presentation of inadequate disclosures regarding accounting principles and policies and related financial amounts
Costs of Financial Statement Fraud More than 50% of U.S. corporations are victims of fraud with losses of more than $500,000 (Albrecht & Searcy 2001) Enron lost about $70 billion in market capitalization to investors, employees, and pensioners Enron, WorldCom, Quest,Global Crossing, and Tyco s loss to shareholders was $460 billion (Cotton 2002) Other costs of fraud include legal costs, increased insurance costs, loss of productivity, adverse impacts on employee morale, customers goodwill, suppliers trust, and negative stock market reactions
Costs of Financial Statement Fraud Undermines the reliability, quality, transparency, and integrity of the financial reporting process Jeopardizes the integrity and objectivity of the auditing profession, especially auditors and auditing firms Diminishes the confidence of the capital markets, as well as market participants, in the reliability of financial information Makes the capital markets less efficient
Costs of Financial Statement Fraud Adversely affects the nation s economic growth and prosperity Results in huge litigation costs Destroys careers of individuals involved Causes bankruptcy or substantial economic losses by the company engaged in financial statement fraud
Methods of Financial Statement Fraud Fictitious Revenues Timing Differences Improper Asset Valuations Concealed Liabilities and Expenses Improper Disclosures 43.9% 28.3% 40.0% 45.0% 37.5%
Fictitious Revenues Recording of goods or services that did not occur Fake or phantom customers Legitimate customers Sales with conditions Pressures to boost revenues
Sales with Conditions MiniScribe Corporation New CEO had put pressure to meet the goals to keep the stock price high Competition had declining sales MiniScribe continued to record increasing revenues
Sales with Conditions MiniScribe Corporation Recorded Sales to Customers where Customers Had A Right to Return for up to 6 months Had never had this in the past GAAP Requires a History with this policy to record this as revenues, then with an allowance for returns
Sales with Conditions Auditors Missed The Recording of These Revenues Partner said in deposition that they had determined that the difference was immaterial to MiniScribe Amount of Adjustment was 147 times the Proposed Adjustment Scope for the Audit Cost the audit firm millions in settlement
Fictitious Revenues Case Study 1985, 1986 & 1987 Houston-based Publicly Traded Company Sold close out electronics merchandise Would purchase large lots of merchandise from manufacturers when they were closing out a line of product Purchased at substantial discounts from normal distribution chain prices
Fictitious Revenues Fiscal Year End January 31 Large Year-end end Sales to Retailers Sold large numbers of computer monitors to retailers in January 1987 (in last 3 days) Lack s Stores $1,452,000 Silo 3,350,750 Joske s (now Dillard s) 3,562,500 Total $8,365,250 Total Company Sales for 87 - $87,831,141 Total Company Sales for 87 Over 9.5% of annual sales
Fictitious Revenues Average price on these computer monitors was just under $200 Lack s Stores 7,260 monitors Silo 16,754 monitors Joske s 17,815 monitors Total = 41,829 monitors sold Monitor Boxes = Approx. 9 cubic feet If stacked 5 boxes high Would require almost 76,000 square feet of warehouse space (about 2 acres)
Fictitious Revenues Normal company sales terms were Net 30 days and this was on the invoices Terms on these sales were Net 90 days and Net 120 days according to the CEO Addresses on the invoices were to the home addresses of certain company officers All of these sales were reversed in December 1987 and January 1988
Fictitious Revenues Allegedly, all of these monitors were delivered by company trucks The company had 6 delivery trucks, very similar to UPS trucks The deliveries were to locations throughout Texas, Oklahoma, Louisiana, Arkansas, and Missouri Not at all realistic
Fictitious Revenues Recording the sales Accounting system required inventory in stock to create an invoice This inventory never existed Created transfers The transfers debited inventory and credited inventory suspense Other journal entries debited inventory suspense and credited cost of sales Net - $8.3 million in sales with $-0- cost of sales
Fictitious Revenues Channel Stuffing Refers to the sale of an unusually large quantity of product to distributors Distributors encouraged to overbuy through the use of Deep Discounts Extended Payment Terms Although orders are received, the terms may raise questions about the collectability of A/R
Fictitious Revenues Channel Stuffing Often, there are side deals Right of return Additional discounts if not sold within a certain period of time Etc. MiniScribe Company offered products at substantial discounts for purchases right at yearend All had a right to return if not used/sold within 6 months Company offered products at substantial
Red Flags Fictitious Revenues Significant, unusual, or highly complex transactions, especially those close to period end that pose difficult substance over form questions Unusual growth in the number of days sales in receivables A significant volume of sales to entities whose substance and ownership is not known An unusual surge in sales by a minority of units within a company, or of sales recorded by corporate headquarters
Fictitious Revenues Countermeasures ALWAYS look for large or unusual sales that happen very near yearend Test any unusual invoices found Consider looking at the entire invoice log for the last month of the year, and possibly for longer Confirm terms of unusual sales with the customer Check the addresses they may be fraudulent
Fictitious Revenues Countermeasures Trace unusual sales to actual purchase order If only a verbal purchase order, consider confirming with the customer Ask the customer about any extended terms, rights to return, etc. Test for subsequent collection If no collection, confirm (verbally) with the customer
Timing Differences Recording revenue and/or expenses in improper periods Shifts revenues or expenses between one period and the next, increasing or decreasing earnings as desired
Timing Differences Matching revenues with expenses Premature revenue recognition Long-term contracts Channel stuffing Recording expenses in the wrong period
Timing Differences One Area to Watch is Sales with Multiple Deliverables Sale of a product along with installation Sale of a product along with maintenance service There is a need to evaluate whether revenues and expenses are matched Premature revenue recognition is common
Timing Differences Xerox Corporation In 2001, restated consolidated financial statements for years ended December 31, 1997, 1998, 1999 and 2000 Revenues with contracts with multiple deliverables copiers with long-term maintenance contracts (5-year)
Timing Differences Revenue for sale of copier had been properly recorded Revenue for the maintenance portion of the contract had been recognized on a straight-line basis over the maintenance period Revenue recognition did not match the expense Maintenance costs tend to be back-end loaded)
Timing Differences Reductions in recognized revenues: 1997 - $768 million 1998 - $816 million 1999 - $572 million SEC alleged accelerated recognition of revenues of over $3 billion and increased earnings of over $1.5 billion
Timing Differences Understand your clients, and how they account for transactions Understand the expenses that are related to the revenue production, and ensure that there is a good matching
Timing Differences Always look for expenses that are recorded in the wrong period It is very easy to wait until the next year to record expenses Consider the period used for subsequent disbursement testing If average days purchases in Accounts Payable is 45 days, you likely need to extend subsequent disbursement testing beyond 45 days to find incorrectly recorded expenses
Timing Differences Countermeasures Test subsequent disbursements for enough time subsequent to yearend Channel stuffing be sure to consider the terms of large, unusual sales near yearend for unusual terms that might violate the recording of revenues Consider the recording of revenues from long- term contracts to ensure proper recording
Concealed Liabilities Liability/Expense omissions Capitalized expenses Failure to accrue warranty costs and liabilities
Concealed Liabilities Liability/Expense Omissions Easy to do simply hide invoices and fail to record them Record cash received from bank loans as reduction of receivables from related parties Put the debt in off-balance sheet entities Adelphia Communications Corporation Fraudulently excluded >$2.3 billion in bank debt by putting it in off-balance sheet and unconsolidated entities
Concealed Liabilities Capitalized Expenses Capitalizing revenue-based expenses increases income and assets WorldCom, Inc. Capitalized operating expenses as capitalized network access Improperly capitalized >$11 billion
Concealed Liabilities Capitalized Expenses Generally done by journal entry, often without any documentation or support Often done in round numbers Often done in post-closing journal entries that are prepared as the financial statements are being prepared
Concealed Liabilities Capitalized Expenses WorldCom, Inc. The journal entries were made at the instruction of the CFO First journal entry: Capitalized network capacity $639,000,000 Operating expenses $639,000,000 Per instructions of Scott Sullivan (the CFO) The journal entries are often this simple
Concealed Liabilities Warranty Costs and Liabilities A company may simply not record sales returns when received The company should estimate warranty costs on its products Needs to be based on what is reasonably expected to occur Old percentages and calculations may not be correct anymore if there have been changes in the product line
Concealed Liabilities Warranty Costs and Liabilities Regina Vacuum Cleaner Company After Don Sheehan had purchased a controlling interest, the company totally changed the product line Sheehan had replaced metal parts with plastic parts because they were cheaper Unfortunately, they did not work Some of the plastic parts actually melted
Concealed Liabilities Regina Vacuum Cleaner Company Returns of products were enormous due to the problems with the plastic parts Sheehan had the returns sent to an offsite storage facility and did not record the returns on the books Used the prior years percentages of sales to accrue warranty expense and warranty liabilities Liability and expense substantially understated
Concealed Liabilities Countermeasures Test subsequent disbursements same as discussed for Timing Differences Consider all transactions with unconsolidated entities Is the shifting of liabilities proper reporting? Look at journal entries Look at all large or unusual journal entries Ensure that there is sufficient supporting documentation
Concealed Liabilities Countermeasures Consider whether product changes could have a significant impact on warranty expenses and liabilities Ask receiving personnel about the quantity of product returns Ask receiving personnel for receiving logs for product returns and determine that the returns have been properly recorded
Improper Disclosures Liability omissions Subsequent events Management fraud Related-party transactions Accounting changes
Improper Disclosures Liability Omissions Failure to disclose loan covenants Failure to disclose contingent liabilities Loan Covenants Important to the users of the financial statements How close is the company to default?
Improper Disclosures Contingent Liabilities Corporate guarantees of loans of officers Potential liabilities from litigation against the company Countermeasures Always obtain and read loan agreements, and all amendments to ensure proper disclosure of covenants Always obtain legal letter from counsel Don t just take the client s word on it
Improper Disclosures Subsequent Events Events occurring or becoming known after yearend may have a significant effect on the financial statement disclosures Countermeasures Always ask about subsequent events Consider public record searches
Improper Disclosures Management Fraud Must disclose to the shareholders fraud committed by officers, executives and others in positions of trust At management level, there is NO immaterial fraud
Improper Disclosures Related-Party Transactions Nothing inherently wrong with related-party transactions As long as they are fully disclosed Tyco Failed to disclose hundreds of millions in low- interest and interest free loans to top executives, including CEO Dennis Kozlowski
Improper Disclosures Accounting Changes SFAS No. 154 describes three types of accounting changes that must be disclosed: Accounting principles Estimates Reporting entities Common changes Useful life changes Other changes
Improper Disclosures Crazy Eddie, Inc. Made a change in how purchase discounts were recorded Year 1 Purchase discounts are recorded when received. Year 2 Purchase discounts are recorded when earned. Impact of change was > 10% of net income, but the change in the wording was not otherwise disclosed
Improper Asset Valuation Inventory valuation Accounts receivable Business combinations Fixed assets
Improper Asset Valuation Inventory valuation Fictitious (phantom) inventory Lower of cost or market Obsolete inventory
Improper Asset Valuation Phantom Inventory Common to stack empty boxes with the rest of the inventory to give the appearance of more inventory than actually exists Crazy Eddie, Inc. Stacked boxes in such a way that it was impossible to see all of the boxes Counted the number of boxes high, number of boxes wide and number of boxes deep to determine the quantity
Improper Asset Valuation Crazy Eddie, Inc. Company officials also changed the auditors work papers to increase count quantities Auditors left the key to the audit work paper trunk in the box of paper clips on the desk The company had overstated inventory by over $50 million
Improper Asset Valuation Accounts Receivable Fictitious receivables Failure to establish a sufficient allowance for doubtful accounts Fictitious Receivables Generally, from fictitious revenues Addresses sometimes are addresses the perpetrator controls Check the address against the name and usual business address of the customer vs. business credit reports
Improper Asset Valuation Inadequate Allowance for Doubtful Accounts Companies struggling for profits and income may be tempted to omit the recognition of these losses because of the negative impact on net income
Improper Asset Valuation Business Combinations Excess of purchase price over the value of acquired assets is treated as goodwill Goodwill must be written-down when value is impaired Sometimes companies will allocate an excessive amount to purchased assets to reduce the amount of goodwill Need to test the allocation of purchase price to appraisals
Improper Asset Valuation Fixed Assets Booking fictitious assets Misrepresenting asset valuation Improperly capitalizing costs Booking fictitious assets An easy method to increase fixed assets, particularly if done in relatively small amounts Consider vouching a sample of additions that are less than the normal testing scope
Improper Asset Valuation Misrepresenting asset value Recording assets at market value rather than lower of cost or market Over-valuing valuing assets Enron Enron bought and sold a wide variety of things electricity, gas, futures contracts, coal, paper, water, and other commodities When values declines, Enron transferred the assets to SPE s to hide the losses
How Do We Respond? Personnel Be sure that we have the right personnel assigned to engagements Engage specialists when needed Understand the client s business Do not be afraid to carefully study and understand the business in which the client is involved The auditor needs to understand the business as well as the client does
How Do We Respond? Be observant Look for changes in how the client operates Look for that one word change in the description of accounting policies Compare results of your client s operations to others in the same industry Investigate any significant differences MiniScribe was the only hard disk manufacturer that had a profit in 1985, and they had record profits
How Do We Respond? Inventory counts Make sure that the boxes actually have products in them Actually open boxes on a random basis This could be one of the unpredictable procedures MiniScribe Had relabeled boxes 10 mb disks relabeled to 40 mb disks Had put bricks in boxes
How Do We Respond? Secure audit work papers Lock up all work papers whenever the auditors leave the office Lunch Evenings Do NOT hide the key in the audit room Take it with you If a high risk client, take work papers with you when you go home
How Do We Respond? Personnel Be sure that we have the right personnel assigned to engagements Engage specialists when needed Understand the client s business Do not be afraid to carefully study and understand the business in which the client is involved The auditor needs to understand the business as well as the client does
How Do We Respond? Be observant Look for changes in how the client operates Look for that one word change in the description of accounting policies Compare results of your client s operations to others in the same industry Investigate any significant differences MiniScribe was the only hard disk manufacturer that had a profit in 1985, and they had record profits
How Do We Respond? Inventory counts Make sure that the boxes actually have products in them Actually open boxes on a random basis This could be one of the unpredictable procedures MiniScribe Had relabeled boxes 10 mb disks relabeled to 40 mb disks Had put bricks in boxes
How Do We Respond? Make it as difficult as possible for a client to be able to perpetrate a fraud and you not catch it Do not accept easy answers to tough questions Make the client give you enough information to thoroughly evaluate the transaction at question
Any Questions?