FINANCIAL STATEMENT FRAUD · THREE TYPES OF FS FRAUD Manipulation: falsification or alteration of accounting records upon which FS is based Misrepresentation: intentional omission

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FINANCIAL STATEMENT FRAUD ISSUES & EXAMPLES

Angela Morelock, PartnerForensics & Valuation [email protected]

Blog: www.BKDForensics.com Twitter: @Angela Morelock

FINANCIAL STATEMENT FRAUD

Def. Deliberate fraud committed by management that injures investors & creditors through materially misleading financial statements

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THREE TYPES OF FS FRAUD

Manipulation: falsification or alteration of accounting records upon which FS is basedMisrepresentation: intentional omission of significant events, transactions, etc.Misapplication of accounting principles relating to amounts, classification, manner of presentation or disclosure

FREQUENCY OF FINANCIAL STATEMENT FRAUD

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©2016 by the Association of Certified Fraud Examiners, Inc.

LOSSES FROM FINANCIAL STATEMENT FRAUD


WHY COMMITTED?Demonstrate increased EPS so that dividends will be paidDispel negative market perceptionsObtain financingMeet company goalsReceive performance-related bonusesIncrease purchase price for acquisitionMeet regulatory requirementsHide asset misappropriation

TYPICAL FS FRAUDSImproper revenue recognitionInadequate disclosureImproper asset valuationImproper deferral of expensesManipulation of accruals, reserves & estimatesUnderstatement of liabilitiesCapitalizing expensesTop-side entriesRelated-party transactions

LIABILITY FOR FINANCIAL STATEMENT FRAUD

Negligence fail to exercise professional careGross negligence intentional failure to perform dutyFraud active participation


MEET CAROLINE BEMBRY

� Medical Manager Corporation Assistant Corporate Controller

� Participated in a financial statement fraud two years into her career

� Key witness at trial


SOME TRIAL EXHIBITS


ETHICS


MEET A HOSPITAL CFO

� Fired for smoothing earnings using contractual account as cookie jar

� Product of his environment� Believed this was proper� Failed to recognize ethical dilemma


MANIPULATION OF NON-PROFIT HOSPITAL FINANCIALS

� Subsidiary hospital of large non-profit system� CFO thought revenue seemed low� One quarter booked approx. $5 mil revenue to make same as last year� Another quarter, earnings were great

• Booked a $1 million liability against contractuals• Created a reserve for smoothing earnings


IS SMOOTHING EARNINGS AN ACCEPTABLE PRACTICE?

SEC on Smoothing


Is it OK to be over accrued?

Is it better to be over accrued than under accrued?


� An accounting principle?� GAAP?� Encouraged by any accounting standard or guidance?

What basis exists for conservatism?

Is conservatism:


FASB CONCEPTS STATEMENT NO. 2 (AS AMENDED)QUALITATIVE CHARACTERISTICS OF ACCOUNTING INFORMATIONISSUED: MAY 1980

�conservatism tends to conflict with significant qualitative characteristics, such as representational faithfulness, neutrality, and comparability (including consistency)� (para. 92)

�if two amounts are not equally likely, conservatism does not necessarily dictate using the more pessimistic amount rather than the more likely one� (para. 95)

General reserve for the unknown acceptable?

ENRON�S SPECIAL PURPOSE ENTITIES


MEET WARREN SCHMIDGALL, CFO AIPC


SUMMARY OF PRESS RELEASE

� Delay in filing of 10-Q for Q3 2005� Audit committee investigation in process� $60.7 million in financial statement adjustments estimated

• Actual adjustments turn out to be $52.5 million� Stock price drops from $20.94 to $11.16� Stock delisted in April 2007



METHODS TO INFLATE EARNINGS

� Multiple round-trip transactions� Recording fictitious $1 million receivable� Capitalization of plant operating expenses� Capitalization of MIS expenses� Recognizing revenue on product not shipped� Not recording write down of spare parts inventory


US ATTORNEY�S OFFICE NEWS RELEASE 9/15/2008

SUMMARY OF LITIGATION

� Criminal charges against several, including• Warren Schmidgall, CFO• Timothy Webster, CEO

� Shareholder class action - $175 million• Company settled $25 million (14%)• E&Y settled $3.6 million

� SEC civil actions filed against numerous individuals including many accounting personnel & Dave Watson, COO


CAPITALIZATION OF PLANT EXPENSES

Multiple capital expansion projectsAdjusted plant expenses to budget & pushed excess expense into capital projectsCapitalized $9.4 million of plant operating expenses, thereby increasing earnings

CAPITALIZATION OF MIS EXPENSES

Multiple IT development implementation projectsAdjusted MIS expenses to budget & pushed excess expense into capitalized IT projectsCapitalized $5.23 million of plant operating expenses, thereby increasing earnings

DETECTING FS FRAUD

Horizontal & vertical analysis (3-5 years)Ratio analysisComparison to industryCareful examination of corporate culture & financial reporting controlsVouching to source documentsConfirmationsExamination of estimates

Nonroutine transactionsCareful examination of capitalization (operating expenses, IT projects, etc.)Scrutiny of manual journal entriesAdvanced data analytics

DETECTING FS FRAUD

Nonroutine transactionsCareful examination of capitalization (operating expenses, IT projects, etc.)Scrutiny of manual journal entries

• Rationalizing can be easy � we all do it• Grey areas can quickly turn black• Your gut often tells you right from wrong

�I knew it was wrong�.I knew that what I was doing was misleading. But I didn't think it was illegal. I thought: That's how the game is played. You have a complex set of rules, and the objective is to use the rules to your advantage. And that was the mistake I made.�

Andrew Fastow, Former Chief Financial Officer of Enron

SET A GOOD EXAMPLE

WHISTLEBLOWER RETALIATION


2013 National Business Ethics Survey

Source: AFCE Report to the Nations 2016


DETECTION OF FRAUD SCHEMES



RISKS & REWARDS OF FRAUD HOTLINES




www.IntegraReport.com

VICTIM ORGANIZATIONS





ACFE � ANTIFRAUD CONTROLS


• Presence of antifraud controls is notably correlated with significant decreases in the cost & duration of occupational fraud schemes. Victim organizations that had implemented any of 16 common antifraud controls experienced considerably lower losses & time-to-detection than organizations lacking these controls

• Perpetrators with higher levels of authority tend to cause much larger losses. Median loss among frauds committed by owner/executives was $573,000, median loss caused by managers was $180,000 & median loss caused by employees was $60,000

©2016 by the Association of Certified Fraud Examiners, Inc.

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Angela Morelock, CPA, CFE, CFF, ABV // [email protected] // 417.865.8701

910 E. St. Louis StreetSpringfield, MO 65801-1190

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FINANCIAL STATEMENT FRAUD · THREE TYPES OF FS FRAUD Manipulation: falsification or alteration of accounting records upon which FS is based Misrepresentation: intentional omission