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Fraudulent Financial Reporting and Litigation/Regulatory Action
CARE Conference
Russell Duncan, Esq.Partner; Shulman, Rogers, Gandal, Pordy & Ecker
Cindy FornelliExecutive Director; Center for Audit Quality
Zoe-Vonna PalmroseHanson Professor in Business Administration; University of Washington at Seattle
Elaine HarwoodVice President; Cornerstone Research
August 5, 2016
CARE Conference – 8/05/16 – Page 2
Fraudulent Financial Reporting and Litigation/Regulatory Action
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 and Litigation/Regulatory Action
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 4
Fraudulent Financial Reporting and Litigation/Regulatory Action
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 5
Fraudulent Financial Reporting and Litigation/Regulatory Action
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 6
Fraudulent Financial Reporting and Litigation/Regulatory Action
Navigating the Landscape
* Only subject to enforcement if a CPA and/or AICPA member
CompanyBoard
Audit CommitteeManagement
Auditor(Firm & Individuals)
SEC
PCAOB
AICPA / State Board of Accountancy
DOJ
Shareholders
*
State Regulators
CARE Conference – 8/05/16 – Page 7
Fraudulent Financial Reporting and Litigation/Regulatory Action
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 8
Fraudulent Financial Reporting and Litigation/Regulatory Action
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 9
Fraudulent Financial Reporting and Litigation/Regulatory Action
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 10
Fraudulent Financial Reporting and Litigation/Regulatory Action
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 11
Fraudulent Financial Reporting and Litigation/Regulatory Action
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 12
Fraudulent Financial Reporting and Litigation/Regulatory Action
Fraud Taxonomy
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.
TOP FRAUD CATEGORIES
• Premature Revenue Recognition
• Fictitious Revenues
• Overvalued Assets and Undervalued Expenses/Liabilities
• Omitted or Improper Disclosures
• Related Party Transactions
OTHER CATEGORIES
• Fictitious Assets and/or Reductions of Expenses/Liabilities
• Omitted or Undervalued Liabilities
• Misclassifications
• “Wrong Way” Frauds
• Equity Frauds
• Illegal Acts
CARE Conference – 8/05/16 – Page 13
Fraudulent Financial Reporting and Litigation/Regulatory Action
19%
18%
17%
16%
Percentage of AAERs
Frau
d Sc
hem
es
Illustrative Fraud Schemes
Fictitious RevenuesNot Based on Firm Orders
Overvalued Assets and Undervalued Expenses/Liabilities
Undervalued Allowance for Bad Debts or Loan Losses
Omitted or Improper DisclosuresOn Accounting Policy
Related Party TransactionsDisclosure Problems
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 14
Fraudulent Financial Reporting and Litigation/Regulatory Action
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 15
Fraudulent Financial Reporting and Litigation/Regulatory Action
Appendix
CARE Conference – 8/05/16 – Page 16
Fraudulent Financial Reporting and Litigation/Regulatory Action
185138
219157 143 126 109 94 73 106
148
445
436
437514 521 555 626 640
603
649659
630
574
656 671 664 681
735 734
676
755
807
2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015
Financial Fraud/Issuer Disclosure Other Enforcement Actions
SEC Enforcement ActionsIncreased in the Past Two Years
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.
© 2016 Cornerstone Research. All rights reserved.Source: SEC
CARE Conference – 8/05/16 – Page 17
Fraudulent Financial Reporting and Litigation/Regulatory Action
Accounting Class Action FilingsIncreased in Recent Years
© 2016 Cornerstone Research. All rights reserved.
69(58%)
77(44%)
97(43%)
61(37%)
59(34%)
80(43%)
45(30%)
47(28%)
69(41%)
71(38%)
51(42%)
100(56%)
126(57%)
104(63%)
116(66%)
108(57%)
106(70%)
119(72%)
101(59%)
118(62%)
2006N=120
2007N=177
2008N=223
2009N=165
2010N=175
2011N=188
2012N=151
2013N=166
2014N=170
2015N=189
Non-Accounting CasesAccounting Cases
2006–2014 Average Number of
Accounting Cases (67)
Source: Accounting Class Action Filings and Settlements –2015 Review and Analysis, Cornerstone Research, 2016.
CARE Conference – 8/05/16 – Page 18
Fraudulent Financial Reporting and Litigation/Regulatory Action
Few Accounting Class Action Filings Involve Restatements
41(59%) 29
(38%) 22(23%) 16
(26%)16
(27%)
27(34%) 17
(38%)19
(40%)
29(42%) 21
(30%)
28(41%) 48
(62%)
75(77%)
45(74%)
43(73%)
53(66%)
28(62%)
28(60%)
40(58%) 50
(70%)
2006N=69
2007N=77
2008N=97
2009N=61
2010N=59
2011N=80
2012N=45
2013N=47
2014N=69
2015N=71
Non-Restatement CasesRestatement Cases
2006–2014 Restatement Case
Annual Average (24)
© 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
Fraudulent Financial Reporting and Litigation/Regulatory Action
Accounting Class Actions Comprise the Majority of Settlements
50(62%)44
(70%)44
(67%)37(66%)
34(52%)
61(72%)
66(67%)
73(75%)68
(62%)58(64%)
30(38%)19
(30%)22
(33%)
19(34%)
31(48%)
24(28%)
33(33%)
24(25%)
41(38%)
32(36%)
2015N=80
2014N=63
2013N=66
2012N=56
2011N=65
2010N=85
2009N=99
2008N=97
2007N=109
2006N=90
Non-Accounting Cases
Accounting Cases
2006–2014Average Number of
Accounting Cases (54)
© 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
Fraudulent Financial Reporting and Litigation/Regulatory Action
87%85%25%
89%74%
91%74%91%
94%
97%
$3.0
$1.1
$4.9
$3.3
$1.4
$3.3 $4.1
$3.0
$8.3
$20.2
2015N=80
2014N=63
2013N=66
2012N=56
2011N=65
2010N=85
2009N=99
2008N=97
2007N=109
2006N=90
Non-Accounting CasesAccounting Cases
2006–2014Accounting Case
Annual Average ($4.7)
Accounting Class Actions Represent a Significant Portion of Settlement Dollars
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.
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