Corporate Scandals – Lessons Learnt

1. Corporate Scandals – Lessons Learnt Professor Gillian Yeo Executive Vice Dean & Dean (Degree Programs) Nanyang Business School Nanyang Technological University Singapore

2. Corporate Scandals – Lessons Learnt • Responsibility for detecting and preventing corporate scandals • Expectation gap and auditors’ role • Positive approach vs negative approach • Professional Skepticism

3. A Better Audit Lens • Traditional risk assessments – links risks to company’s • business strategy, process & operations • Risk of material misstatements in financial statements • resulting from fraud or error (SSA 240) Complements Suppliers – Facilities Customers Other Information Providers Culture Competitors Suppliers – Inventory Core Brand & Image Delivery Strategic Partners Strategic Suppliers – Labor Business Processes Product - Service Delivery Customer Service Delivery Management Resource Management Processes Human Resources Property Management Regulatory Management Regulators Suppliers – Capital Information Management Financial/Treasury Management Process Objectives & Tactics Structure & Activities Capital Markets Financial Statements Accounting Transactions Generally Accepted Acctg. Principles External Auditor External Auditor SSA Audit

4. The Fraud Triangle Three conditions are present when fraud occurs • Incentive/ Pressure • Reduce earnings volatility • Support or increase stock price • Increase earnings-based incentive compensation • Meet analysts forecasts • Opportunity • Absence of controls • Ineffective controls • Ability of management to override controls • Rationalization/ Attitude • Consistent with personal code of ethics to commit dishonest act Adapted from SAS99

5. Earnings Management to Avoid Losses No. of Firms Change in EPS (1974-1996) (cents)

6. Fraudulent Financial Reporting • Recognition of premature or fictitious revenue • Aggressive capitalization and extended amortization policies • Misreported assets and liabilities

7. Premature or Fictitious Revenue • Goods ordered but not shipped • P. Inc - ambitious sales targets, predating packing lists, shipping records, invoices • Goods shipped but not ordered • BS. Corp – meet or exceed sales targets, commercial warehouses leased and unsold goods shipped there – credits later issued and goods resold to different customers

8. Premature or Fictitious Revenue • Cover-up activities – CB Corp 1991 Bought $975k goods Paid $975k CB Corp. $975k goods shipped back Sold $975k goods Paid $975k to Cambridge Third Company $975k to Distributor to pay Cambridge Distributor

9. Detecting Premature or Fictitious Revenue • Understand the policy for revenue recognition • Is revenue really earned? – Informatics and recognition of international student revenue • Is there right of return or price protection? • Sales agreement side letters

10. Detecting Premature or Fictitious Revenue • Service revenue – finance-related income • Y Corp – sales type lease accounting • Gross Profit = PV of lease payments – cost to manufacture • Used low interest rates to obtain high PV of lease payments • But Latin American sales – high inflation – high interest rates should be used

11. Detecting Premature or Fictitious Revenue • Watch accounts receivable or other accounts used to offset premature or fictitious revenue

12. Detecting Premature or Fictitious Revenue • Watch for steps taken to thwart detection • Transfer from accounts receivable to plant, property and equipment or other assets • Evaluate relationships, rate of change in account relative to rate of change in revenue • Compare with industry norms and competitors

13. Detecting Premature or Fictitious Revenue • Consider physical capacity • Fictitious warranty repair claims of mobile phones • Sales increased significantly • Volume of handphones serviced - significant increase - unrealistic compared to company’s capacity

14. Detecting Aggressive Cost Capitalization Policies • Software development costs

15. Detecting Aggressive Cost Capitalization Policies and Extended Amortization Periods • Z com – manipulated E/R ratio (line cost expense to revenue) to maintain at previous reported rate • Industry-wide declines in telecommunications • Z com had notably better E/R ratio than its peers • Competitors had taken impairment charges but Z com did not write down business goodwill

16. Detecting Misreported Assets and Liabilities • Overvalued assets/Undervalued liabilities

17. Detecting Misreported Assets and Liabilities • Undervalued liabilities – off balance sheet and contingent liabilities • Speculative trading in options in 3Q ‘03 • Put options that mature in 1Q ‘04 • High risk exposure of open positions • Oil price moved in opposite direction in 4Q ‘03 and 1Q ‘04 and MTM value of company’s options trades deteriorated significantly • Hugh liability for open positions at year end and subsequent to year end

18. Detecting Misappropriation of Assets • Using technology and data mining techniques to detect fraud • Fictitious vendors – matches between vendor and employee addresses/phone numbers, more than one vendor with same address/phone number, post office boxes in residential areas • Vendor kickbacks – exclusive dealing with a limited number of vendors, prices charged higher than market average, accelerated payment of invoices, purchasing agents’ lifestyle

19. Concluding Remarks – Fraud Deterrence • Professional skepticism • Think like the fraudster • Understand the organization, motivation of people to commit fraud and conditions in which fraud occurs • Ask direct/polite questions – eg. “Do you think this company has any problems with fraud? Why or Why not? • Education • Interview skills - Understand and interpret human behaviour • Antifraud specialist on teamif needed

20. Will the Future be like the past? White collar – crime of the older and better-educated and our society is aging Warren Buffet:You don’t know who is swimming without any shorts on until the tide runs out!