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2. The Acquisition. Purchaserprivately held companysophisticated managementnational and international presenceSellersmall business in the transportation industryowned principally by an investor groupmanaged by minority owners. 3. Cast of Characters. PurchaserSeller's CFOSeller's ControllerInvestors in SellerPlaintiff's ExpertArbitratorSeller's Attorney.
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1. 1 Uncovering Financial Statement Fraud: A Case Study
An Acquisition in Wonderland?
Presented by Beth Junell, FTI Consulting, Inc.
Objectives:
1) Background on the case
2) How fraud was perpetrated
3) How fraud was discovered
4) Lessons learnedObjectives:
1) Background on the case
2) How fraud was perpetrated
3) How fraud was discovered
4) Lessons learned
2. 2 Companies introduced December 1999
Acquisition occurred May 2000
Fraud discovered October 2001 (18 months later)
Companies introduced December 1999
Acquisition occurred May 2000
Fraud discovered October 2001 (18 months later)
3. 3 Cast of Characters Purchaser
Sellers CFO
Sellers Controller
Investors in Seller
Plaintiffs Expert
Arbitrator
Sellers Attorney Alice
Mad Hatter
March Hare
Cheshire Cat
White Rabbit
King of Hearts
Queen of Hearts National Accounting Firm = 1 of Big 4
National Banks = well known, large institutions
Plaintiffs Expert (and forensic accountant) partner at former firm;
My role: 2nd chair, so-to-speakNational Accounting Firm = 1 of Big 4
National Banks = well known, large institutions
Plaintiffs Expert (and forensic accountant) partner at former firm;
My role: 2nd chair, so-to-speak
4. 4 Games at the Tea Party:Fraud Schemes to Overstate Revenue Use of unsupported topside entries to manipulate the general ledger and financial statements
Manipulation of accounts receivable
Use of formulas to artificially inflate customers accounts
Rebucketing of the age of customers accounts
Credit-to-clear process to secretly write off uncollectible accounts receivable
Understatement of liabilities
False statements to everyone who inquired
5. 5 How Did Alice Discover the Tea Party?
Uncovering the Fraud
6. 6 Events Leading to Discovery Alice has a lot of questions about A/R
Mad Hatter & March Hare are terminated
Accounting staff inform Alice that certain accounts can not be reconciled
$10 million suspense account is created
White Rabbit is engaged to take a look
National Accounting Firm called in to re-audit financial statements for several periods
A/R subledgers (not MS Excel) can not be produced for a variety of reasons (all lies)
Suspect collections are a problem (hidden)
March Hare terminated for cause (lying to Alice)
Mad Hatter requests severance (believes all evidence is destroyed or hidden so well it will not be discovered)
White Rabbit uncovers the mechanics of how the fraud was perpetrated
National Accounting firm:
- declares massive financial statement fraud
- records $18 million loss
- deems goodwill in acquired company worthless ($10 million asset)
A/R subledgers (not MS Excel) can not be produced for a variety of reasons (all lies)
Suspect collections are a problem (hidden)
March Hare terminated for cause (lying to Alice)
Mad Hatter requests severance (believes all evidence is destroyed or hidden so well it will not be discovered)
White Rabbit uncovers the mechanics of how the fraud was perpetrated
National Accounting firm:
- declares massive financial statement fraud
- records $18 million loss
- deems goodwill in acquired company worthless ($10 million asset)
7. 7 Fraud Investigation Tools Uncovering the Mechanics of the Fraud
8. 8 Accounting Staff Interviews Topside entries
Falsification of supporting documentation
Altering bank reconciliations to achieve pre-determined cash balances
3rd Re-Bucketing
9. 9 Comparison of Documents Accounts receivable reports given to Alice, National Bank and National Accounting Firm with actual sub-ledgers
Bank reconciliations given to National Accounting Firm with actual bank reconciliations kept by accounting staff Saw this in earlier slides:
- Showed re-bucketing and inflation of AR
- Showed reduction of O/S checks and addition of held checksSaw this in earlier slides:
- Showed re-bucketing and inflation of AR
- Showed reduction of O/S checks and addition of held checks
10. 10 A Little Luck Recovery of an allegedly crashed database:
Credit-to-clear
2nd re-bucketing scheme
True amount and age of current accounts
Discovery of the garage tapes
Specific mechanics of using formulas and re-bucketing in MS Excel to create A/R detail
Early evidence of the collections problems Garage tapes:
- statement that paralegal created the List
- angered employee of Alice
- set out to find proof of creation
- talked to a friend (ex-employee)
- had old back-up tapes in garage
- contents on tapes not found on hard drivesGarage tapes:
- statement that paralegal created the List
- angered employee of Alice
- set out to find proof of creation
- talked to a friend (ex-employee)
- had old back-up tapes in garage
- contents on tapes not found on hard drives
11. 11 Mr. Experts Findings Detected method of manipulation for the 9/30/99 accounts receivable
Provided exhibits documenting the method
Dismissed the apparent fraud as correcting the detail for system problems and human error
12. 12 Pattern Detected Pattern of manipulation for all periods readily detectible:
After discovery of the Lists creation; and
After Mr. Expert laid out his findings on the 9/30/99 accounts receivable manipulation
13. 13 Data Mining From transactional/accounting databases
Used to extract evidence of claims made during staff interviews:
Existence and magnitude of topside entries
1st, 2nd and 3rd Re-bucketings made within the accounting systems
Credit-to-clear transactions
Age of actual invoices written off through credit-to-clear
14. 14 Application of the Fraud Triangle
Pressure, Opportunity and Rationalization of Defrauding Alice Donald Cressey
Doctorate in criminology during the 1940s
Focused on embezzlers
Interviewed about 200 inmates in the Midwest
Developed hypothesis (read from book)
Hypothesis has become better known as the Fraud TriangleDonald Cressey
Doctorate in criminology during the 1940s
Focused on embezzlers
Interviewed about 200 inmates in the Midwest
Developed hypothesis (read from book)
Hypothesis has become better known as the Fraud Triangle
15. 15 Lessons Learned Internal (Validating SOX) Dont put all the eggs in one basket
Dont allow personal guarantees to minimize due diligence work
If it sounds like an excuse, it probably is
Dont minimize oversight based on financial performance
An internal audit function is crucial; dont expect external audit to replace the need for good governance and internal controls
Use computer assisted audit techniques Excuses
continual excuses should raise a white flag
- in this case: systems errors, human error, etc.
- after a while, investigate
Incentive to commit fraud (especially if something is already being hidden)
Audit failures do occur
Excuses
continual excuses should raise a white flag
- in this case: systems errors, human error, etc.
- after a while, investigate
Incentive to commit fraud (especially if something is already being hidden)
Audit failures do occur
16. 16 Lessons Learned External (Validating SAS 99) If it looks like an Excel document, it probably is
Dont let immateriality override fraud indicators
Understand how numbers end up in the financial statements
Talk to the accounting staff, not just the CFO and Controller
Perform basic audit procedures effectively
Use computer assisted audit techniques
Do not rely on management representations test them Acquired company was immaterial to Alice on a consolidated basis
Statements audited were clearly MS Excel documents
Confirmations:
- accounting firm told confirmation process would not work
- mom & pop customers would not respond
- firm based decision not to send confirmations based on this statement
- audit workpapers of the prior auditors included confirmation testing (albeit with exceptions which were cleared)
Management representations I believe you, but show me!Acquired company was immaterial to Alice on a consolidated basis
Statements audited were clearly MS Excel documents
Confirmations:
- accounting firm told confirmation process would not work
- mom & pop customers would not respond
- firm based decision not to send confirmations based on this statement
- audit workpapers of the prior auditors included confirmation testing (albeit with exceptions which were cleared)
Management representations I believe you, but show me!