“Arresting Financial Fraud: The Inside Story From The FBI ”

1. The views expressed by the presenters do not necessarily represent the views, positions, or opinions of either the AICPA or the presenter’s respective organization “Arresting Financial Fraud:The Inside Story From The FBI”

2. Course Objectives This program is designed to help you: • Understand the U.S. Department of Justice’s three-part definition of corporate fraud; • Understand the scope of the problem; • Identify common accounting schemes; • Work effectively with law enforcement; and • Better understand the impact of recently enacted legislation Slide 2

3. Grant Ashley, CPA Assistant Director, Criminal Investigative Division Federal Bureau of Investigation --------  Gary Dagan, CPA Chief, Economic Crimes Unit Federal Bureau of Investigation Keith Slotter, CPA Chief, Financial Crimes Section Federal Bureau of Investigation -------- John F. Hudson, CPA Moderator Hudson Consulting Group, LLC Today’s Speakers Slide 3

4. Corporate Fraud - Background • Following the corporate scandals of 2002, the Department of Justice issued a three-part formal definition which describes the illegal activities that encompass corporate fraud. • These three parts are: • Accounting Fraud • Self-Dealing by Corporate Insiders • Obstructive Conduct Slide 4

5. Dept. of Justice Definition – Corporate Fraud • Part One – Accounting Fraud (“Cooking the Books”) • The falsification of financial information, including false accounting entries, bogus trades designed to inflate profits or hide losses, and false transactions designed to evade regulatory oversight. Slide 5

6. Restatements by Reason1997 - June 2002 Per GAO Report on Financial RestatementsFigure 3 Slide 6

7. In its October 2002 Report on Financial Statement Restatement, the GAO concluded that: Why is Revenue Recognition So Important? • Almost 38% of the 919 announced restatements between 1997 and June 30, 2002 involved revenue recognition. • Revenue recognition was the primary reason for restatements in each year. • Over 50% of the immediate market losses following restatements were attributable to revenue recognition related restatements. • Approximately 50% of the SEC’s enforcement cases have involved revenue recognition issues. Slide 7

8. Why is Revenue Recognition So Important? • Restatements for improper revenue recognition also result in larger drops in market capitalization than any other type of restatement: • 8 out of the top 10 market value losses in 2000 related to revenue problems. • Of the 10 companies, the top 3 lost US$20 billion in market value in just 3 days due to revenue recognition problems. Slide 8

9. Some Examples of Revenue Recognition Schemes • Phantom Sales • Parked Inventory Sales • Swap (i.e., “Round Trip”) Transactions • Channel Stuffing • Accelerated Revenue • Undisclosed Side Deals • Undisclosed Contingencies • Backdated Contracts Slide 9

10. Some Examples of Expense & Liability Recognition Schemes • Capitalizing Expenses • Deferring Expenses • Unrecorded Expenses • “Big Bath” Accounting • “Cookie Jar” Reserves • Creative Acquisition Accounting Slide 10

11. Cooking The Books– Selected Recipes • Parked Inventory Sales – Recording sales for goods shipped to a site (warehouse, parking lot) controlled by the seller to provide the appearance a valid sale occurred. • Swap Transactions – A scheme in which two conspiring companies exchange payments and services solely for the purpose of inflating revenues. • Channel Stuffing – Overselling products to customers with a hidden understanding that the customer will receive deep discounts on the full invoice price at a future date. Slide 11

12. Cooking The Books – Selected Recipes • Side Deals – An arrangement in which the buyer of goods is given the right to cancel the sales contract, return products or receive rebates in future periods. Although the sale is booked, the side deals are hidden from auditors. • Accelerated Revenue – Improperly recording revenues in the current fiscal period which are applicable to future periods. Examples are unshipped merchandise and percentage of completion contracts. Slide 12

13. Cooking The Books – Selected Recipes • Capitalizing Expenses – The improper reclassification of an expense to an asset. This scheme is typically conducted through a series of journal entries at the end of a fiscal period in order to inflate the financial statements. • Deferred Expenses – Recording expenses applicable to the current fiscal period at some date in the future. Typically, this scheme continues to perpetuate itself in future periods. Slide 13

14. Dept. of Justice Definition – Corporate Fraud • Part Two – Self-dealing by corporate insiders (“Me First”), including . . . • Insider trading • Kickbacks • Misuse of corporate property for personal gain • Individual tax violations related to self-dealing Slide 14

15. The Fundamentals of Corporate Governance • Lessons often forgotten . . . • A corporation is owned and controlled by the individual shareholders. • The corporation is NOT the personal property of the individual executives of the company. • Self-dealing places the greed of individual executives ahead of the shareholders. Slide 15

16. Examples of Self-Dealing • Executive loans with no intentions to ever repay. • Extraordinary personal expenses charged to the company. • Failure to report forgiven loans or reimbursed personal expenses as taxable income. Slide 16

17. Examples of Self-Dealing • Awarding business contracts in return for personal compensation. • Receiving shares of stock in other companies in return for business transactions (shares are often placed in the name of another family member to avoid detection). Slide 17

18. Examples of Self-Dealing • Insider Trading • Buying or selling personally owned shares of stock prior to a major announcement that is expected to affect the stock price (i.e., positive or negative earnings, new products, change in management, mergers & acquisitions). Slide 18

19. Dept. of Justice Definition – Corporate Fraud • Part Three – Obstruction of Justice (“The Cover-up”) • Obstruction of justice designed to conceal the previously noted criminal conduct (accounting fraud & self-dealing), particularly when that obstruction impedes the regulatory inquiries of the Securities and Exchange Commission or other agencies. Slide 19

20. Obstructive Conduct • Shredding documents • Erasing computer files • Creating or altering documents to justify illegal conduct • Purposely failing to provide all documents and files requested in a subpoena Slide 20

21. Obstructive Conduct • Providing false testimony in SEC depositions • Lying to criminal investigators • Influencing another witness • Threatening another witness • Failing to maintain records for a prescribed period of time Slide 21

22. Record RetentionExpectations of the CPA • In 2002, a new criminal law (title 18, section 1520) was enacted which requires any accountant who conducts an audit of a public company to maintain all audit workpapers from this engagement for a period of five years. Slide 22

23. Corporate Fraud Victims • Individual shareholders • Employee pension plans • Mutual funds • Financial institutions (lenders) • Market stability & reliance Slide 23

24. New York, NY Chicago Los Angeles San Francisco San Diego Boston Detroit Houston And … Locations of Corporate Fraud Investigations Slide 24

25. Birmingham Charleston (SC) Anchorage Columbus (OH) Honolulu Omaha Erie (PA) Johnson City (TN) Oklahoma City (Continued) Locations ofCorporate Fraud Investigations Slide 25

26. Corporate Fraud … Is A National Problem Slide 26

27. Energy Telecommunications Retail Medical Insurance Software Internet Banking Cable TV Charities Industry TrendsIn Current Investigations Slide 27

28. Typical Scenario • In far too many cases, accounting fraud began as a “one time act” to help meet the quarterly revenue targets. • However, the “just one time” syndrome perpetuates itself into future quarters until the fraud becomes out of control. Slide 28

29. Case Study Example Corporate Fraud: Walter Pavlo’s Insider Perspective . . . Slide 29

30. Case Study Example Let’s look at an interview with Walter Pavlo . . . Slide 30

31. Perspective • Some corporate executives have compared accounting fraud to a gambling or drug addiction. Although they believe it can be stopped at any time, their circumstances dictate otherwise. • Phony accounting from prior periods combined with current losses has a snowball effect. Slide 31

32. Motives For Corporate Fraud • Executive bonuses are tied to profits. • Executives maintain their prominent positions within the corporation. • Stock value remains artificially inflated based on phony financial performance indicators. • Personal greed is the underlying factor. Slide 32

33. Impact • Corporate fraud has negatively impacted the financial services sector. Its effect on the banking, insurance, and securities industries undermines the fundamental core of the United States economy. Slide 33

34. Overall Scope of Corporate Fraud • Not limited to any geographic area or market segment. • Despite media attention on several select companies, the FBI is currently pursuing 139 cases of corporate fraud. • Many companies are lesser known but effect on shareholders is the same. Slide 34

35. Corporate Fraud Investigations • At least 16 cases with losses > $1 Billion • 50 cases with losses > $100 Million • Since January 2002 – 187 executives charged with corporate fraud violations. • 3-6 new cases opened each month Slide 35

36. Participants In Corporate Fraud Vary But May Include . . . • Chief Executive Officer • Chief Financial Officer • Line Accountants • Sales Personnel • Shipping Personnel • Corporate Attorneys • Collusive Customers Slide 36

37. A Common Myth • I work in a small local CPA firm. Corporate fraud is only a concern for the big, national accounting firms. • I have very few (or no) publicly-traded audit clients. Therefore, the issue of corporate fraud has no effect on my practice. Slide 37

38. A Common Myth • Should You Be Concerned About Corporate Fraud . . . • Do you conduct audits? • Do your clients have employees? • Do you prepare tax returns? • Do you conduct forensic examinations? • Do outside parties rely on your client’s financial statements? • Do your clients transact business with other companies? Slide 38

39. A Common Myth If you answered “Yes” to any of these questions, you can be affected by corporate fraud. Because . . . Slide 39

40. Why You Should Be Concerned . . . • As you certainly know, audited financial statements have end users, like investors and creditors, who rely on them. • Employee theft and self-dealing is a corporate fraud violation. • Individual tax violations from self-dealing is corporate fraud. • One company may assist another company in committing accounting fraud if there’s an incentive. Slide 40

41. Role of the CPA • Independence remains a crucial element In conducting effective audits • Objectivity and professional skepticism are also important • CPAs must avoid placing themselves in the position of “protecting” a client under investigation. Slide 41

42. Role of the CPA • A major public misperception of the CPA is that if a CPA performs a financial statement audit, he or she will detect any fraud that may exist. • While an auditor does have responsibilities for detecting material fraud, audits are conducted to issue an opinion on the fairness of the financial statements. Slide 42

43. Statement on Auditing Standards No. 99: “Consideration of Fraud in a Financial Statement Audit”

44. Evolution of the Fraud Standard - Number of Paragraphs

45. What’s New in the Auditor’s Fraud Detection Responsibilities? • Evaluating how the entity responds to identified fraud risks • More emphasis on professional skepticism • Discussions among engagement personnel • Expanded inquiries of management and others within the entity. • Reorganized and modified fraud risk factor examples (the “Fraud Triangle”). • Expanded fraud risk assessment approach Slide 45

46. What’s New in the Auditor’s Fraud Detection Responsibilities? • Expanded guidance on revenue recognition as a likely risk. • Linkage between identified risks and the auditor’s response. • Responses to address the risk of management override of controls. • Documentation (expanded requirements). Slide 46

47. The Government’s Response To Corporate Fraud Slide 47

48. The Sarbanes-Oxley Act: Why & How • Focused on restoring investor confidence by: • Placing greater accountability on corporate officers; • Forcing timely flow of information (both good new and bad news); • Forcing greater separation of duties between auditors, consulting, and management; and • Limiting self-regulation of the accounting profession and standards-setting process. Slide 48

49. The Sarbanes-Oxley Act: Why & How • Pursues these goals by amending existing laws, or creating new ones, which: • Requires officers, under possible civil and/or criminal penalty, to certify accuracy and representation of its financial conditions, disclosure controls and procedures, and assess its effectiveness on internal control structure and procedures over financial reporting; • Requires quarterly review of internal controls; • Places limitations on audit firm’s ability to provide some services and requires board approval of all non-audit services; and • Brings PCAOB into existence. Slide 49

50. The Sarbanes-Oxley Act: Why & How In essence, it endeavors to restore investor confidence by changing the corporate mind-set and actions towards controls and disclosures. Slide 50