Fraudulent Financial Reporting and …Fraudulent Financial Reporting and Litigation/Regulatory Action SEC Allegations of Auditor Deficiencies in Connection with Alleged Fraud Have

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


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











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



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.



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











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











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.











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



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.











Appendix



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



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.



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)





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)





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.


Documents

Fraudulent Financial Reporting and …Fraudulent Financial Reporting and Litigation/Regulatory Action SEC Allegations of Auditor Deficiencies in Connection with Alleged Fraud Have