Financial Statement Frauds Presentation at UNC - Charlotte Fraud Examination Class March 2, 2010 Cory Rogers, CPA Tina

1. Financial Statement Frauds Presentation at UNC - CharlotteFraud Examination Class March 2, 2010Cory Rogers, CPATina Whitmire, CPA, CFE, CFF

2. Forensic, investigative and litigation Information technology Valuation Governance risk and compliance Advisory Services Business strategy Performance improvement Restructuring and turnaround Transaction support Advisory Services Practice

3. What do we do? Investigations • financial statement fraud • embezzlement • third-party fraud (vendors/customers)

4. What do we do? (cont’d) • Litigation • calculate damages in commercial litigation cases (lost profits, liquidated damages, diminution of value) • electronic discovery consulting • expert testimony/reports • consult in post-acquisition (purchase price) disputes • serve as an arbitrator

5. What do we do? (cont’d) • Forensics • royalty audits/vendor audits • insurance claims • business interruption • property claims • assess distressed business for lenders/investors • fraud risk assessments • support audit teams (both internal and external)

6. What is financial statement fraud? The deliberate misrepresentation of the financial condition of an enterprise accomplished through the intentional misstatement or omission of amounts or disclosures in the financial statements to deceive financial statement users. Source: 2009 Fraud Examiners Manual

7. Financialpressure Rationalization Perception ofopportunity Fraud Triangle • Why do people commit fraud? • financial pressure • perception of opportunity • rationalization

8. Fraud triangle defined – Financial pressure • Management/employees have an incentive or are under pressure, which provides the underlying reason to commit fraud • profitability is threatened by economic, industry, or entity operating conditions • pressure to meet expectations of third parties • management’s or the board of directors’ personal financial situation is threatened by the entity’s financial performance

9. Fraud triangle defined – Opportunity • Absence of controls, ineffective controls and/or ability for management to override controls • nature of industry or the entity’s operations provides opportunities to engage in fraudulent financial reporting • ineffective monitoring of management • complex or unstable organizational structure • internal control components are deficient

10. Fraud triangle defined – Rationalization • Attitude, character or set of unethical values that allow them to knowingly and intentionally commit dishonest act • It is ok because the company needs to: • meet their loan covenants • meet a lender’s criteria for granting/extending loan facilities • make earnings to trigger performance-related compensation or earn-out payments • have a certain stock price in anticipation of a merger, acquisition or sale of personal stockholding

11. What is occupational fraud? The term “occupational fraud and abuse” may be defined as: • "The use of one's occupation for personal enrichment through the deliberate misuse or misapplication of the employing organization's resources or assets." Or more simply stated: • “occupational frauds are those in which an employee, manager, officer, or owner of an organization commits fraud to the detriment of that organization.” Source: 2009 Fraud Examiners Manual

12. Types of occupational fraud • Asset Misappropriation • Corruption • Fraudulent Statements This presentation focuses on Fraudulent Financial Statements

13. Asset Misappropriation Schemes • Cash receipts schemes • skimming (e.g. lapping) • larceny (e.g. theft of cash from the register) • Fraud disbursement • payroll schemes (e.g. ghost employees) • billing schemes (e.g. false vendors) • Inventory and other assets • larceny (e.g. stealing inventory)

14. Corruption Schemes • Paying or receiving bribes • Engaging in conflicts of interest • Extorting illegal payments • Accepting illegal gratuities

15. Current trends for occupational fraud • Asset misappropriations were by far the most common type of occupational fraud in our study, occurring in over 88% of all cases. Meanwhile, cases involving financial statement fraud were the least common at 10% of all cases, but had the largest impact when they did occur. • The median loss of $2 million in schemes involving financial statement frauds was 14 times greater than the median loss for schemes involving asset misappropriations and over four times greater than the median loss in cases that involved corruption. Source: 2009 Report to the Nation on Occupational Fraud and Abuse

16. Financial Statement Fraud Schemes • Fictitious revenues • Timing differences • Improper asset valuations • Concealed liabilities and expenses • Improper disclosures

17. Why is financial statement fraud committed? • To encourage investment through the sale of stock • To demonstrate increased earnings per share • To cover inability to generate cash flow • To dispel negative market perceptions • To obtain financing, or to obtain more favorable terms on existing financing • To receive higher purchase prices for acquisitions • To demonstrate compliance with financing covenants • To meet company goals and objectives • To receive performance-related bonuses Source: 2009 Fraud Examiners Manual

18. Trivia question • Staff Accounting Bulletin (SAB) 104 Revenue Recognition • GAAP requires that revenue be realized or realizable and earned before it can be recognized. • What are the four criteria that must be met before revenue can be recognized?

19. Trivia answer • Persuasive evidence of an arrangement exists • Delivery has occurred or services have been rendered • The price is fixed or determinable • Collectability is reasonably assured

20. Fictitious revenueFraudulent practices • Most popular method of committing financial statement fraud • Recording of sales of goods or services that did not occur • Accounts Receivable XX Revenues XX (Income Assets )

21. Fictitious revenue (cont’d) Fraudulent practices Ways perpetrator may record fictitious revenues: • False journal entries • creating journal entries debiting accounts receivable and crediting sales • false supporting documents may or may not be created • Sales with conditions • sales that have terms that have not been completed and the rights and risks of ownership have not passed to the purchaser • do not qualify for recording as revenue

22. Fictitious revenue (cont’d)Red flags • Rapid growth or unusual profitability • Recurring negative cash flows from operations • Significant transactions with related parties or special purpose entities not in the ordinary course of business • Significant, unusual or highly complex transactions, especially close to period end • Unusual growth in the days’ sales in receivables ratio (receivables/average daily sales) • Large volume of sales to entities whose substance and ownership is unknown • Unusual surge in sales by a majority of units within a company or in sales recorded by corporate headquarters

23. Timing differences • Recording of revenues or expenses in improper periods • Objective is to shift revenues or expenses between one period and the next, increasing or decreasing earnings

24. Timing differences (cont’d)Scheme 1: Premature revenue recognition • Revenue should not be recognized until the four criteria have been satisfied as presented in SAB 104 • Persuasive evidence of an arrangement exists • Delivery has occurred or services have been rendered • The price is fixed or determinable • Collectability is reasonably assured

25. Timing differences (cont’d)Scheme 1: Premature revenue recognition • Persuasive evidence of an arrangement does not exist: • no written or verbal agreement exists • verbal agreement exists but a written agreement is customary • a written order exists but is conditional upon sale to end users (consignment sales) • a written order exists but contains a right of return • a written order exists but a side letter alters the terms in ways that eliminate the required elements for an agreement • transaction is with an undisclosed related party

26. Timing differences (cont’d)Scheme 1: Premature revenue recognition • Delivery has not occurred or services have not been rendered: • shipment has not been made and the criteria for recognizing revenue on “bill and hold” transactions set out in SAB 104 have not been met • shipment has been made to the seller’s agent, an installer, or to a public warehouse, not the customer • items of the wrong specification were shipped • delivery is not complete until the installation, customer testing, and customer acceptance has occurred • services have not been provided at all • services are being performed over an extended period and only a portion of the service revenues should have been recognized in the current period

27. Timing differences (cont’d)Scheme 1: Premature revenue recognition Sunbeam • SEC complaint alleged: • Sunbeam offered financial incentives to customers to issue purchase orders approximately six months in advance of their actual need for the product • Sunbeam offered to hold the merchandise in 3rd party warehouses until the customers requested them • Sunbeam's customers had not requested bill and hold arrangement • Customer retained right to return product • To make up for a shortfall in revenue, Sunbeam changed its quarter end date from March 29 to March 31 allowing Sunbeam to record another $5 million is sales from its operations and $15 million from the newly acquired Coleman. Result: CEO and CFO paid civil penalties of $500K and $200K respectively; permanently barred from serving as officer/director of a public company

28. Timing differences (cont’d)Scheme 1: Premature revenue recognition • The seller’s price to the buyer is not fixed or determinable: • the price is contingent upon some future events • a service or membership fee is subject to unpredictable cancellation during the contract period • the transaction includes an option to exchange the product for others • payment terms are extended for a substantial period and additional discounts or upgrades may be required to induce continued use and payment instead of switching to alternative products

29. Timing differences (cont’d)Scheme 1: Premature revenue recognition • Collectability is not reasonably assured: • collection is contingent upon a future event, such as resale of the product, receipt of additional funding or litigation • the customer does not have the ability to pay, e.g., it is financially troubled, it has purchased far more than it can afford, or it is a shell company with minimal assets

30. Timing differences (cont’d)Scheme 2: Long term contracts • Examples are: percentage-of-completion and completed contract method • easily manipulated due to estimated costs to complete the project • easy to recognize revenue prematurely and conceal contract overruns

31. Timing differences (cont’d)Scheme 3: Channel stuffing • Defined as the sale of an unusually large quantity of a product to distributors who are encouraged to overbuy through the use of deep discounts or extended payment terms. • stealing from future periods’ sales makes it harder to achieve sales goals in those future periods. • raises questions about the collectability of the accounts receivable, and any existing side agreements that grant a right of return • greater risk of returns for certain products if they cannot be sold before their shelf life ends

32. Timing differences (cont’d)Scheme 3: Channel stuffing Coca-Cola Inc. • SEC complaint alleged: • Between 1997 and 1999, Coke implemented an undisclosed channel stuffing practice by • Asking bottlers in Japan to purchase additional quantities of cola concentrate in order to boost the company's revenues and help it meet profit goals • Offering extended credit terms to Japanese bottlers to induce them to purchase quantities the bottlers otherwise would not have purchased until a following period Result: April 2005 settlement with SEC includes cease and desist changes to corporate compliance Sources: SEC Accounting and Auditing Enforcement Release No. 2232, April 18, 2005

33. Timing differences (cont’d)Scheme 4: Recording expenses in the wrong period • As the expensing of certain costs is pushed into periods other than the ones in which they actually occur, they are not properly matched against the income that they help produce • This may cause the sales revenue from the transaction to be almost pure profit, inflating earnings in the current period and deflating earnings by a similar amount in the next period

34. Timing differences (cont’d)Red flags • Deep discounts, extended payment terms or other concessions to customers to inducing the sale of products in the current period • Increase in quantity of products shipped/sold at or near period end • Increased shipping cost at or near period end • Significant returns of inventory after period end • Entity outperforms industry • Deterioration of accounts receivable aging to certain accounts

35. Improper asset valuations • Improper asset valuations usually take the form of the following classifications: • Inventory valuation • Accounts receivable • Business combinations • Fixed assets • Inventory valuation and accounts receivable are the most commonly misstated asset accounts

36. Improper asset valuations (cont’d)Scheme 1: Inventory valuations • False Quantity • falsification of inventory count sheets or receiving reports • falsely reporting large values of inventory in transit knowing the auditors will have a difficult time observing it • bill and hold included in inventory counts that has already been recorded as sales. • pallets of inventory with hollow centers • Indentify False Quantity • attend the inventory count • do not give advance notice of what locations are to be counted • observe or confirm inventory

37. Improper asset valuations (cont’d)Scheme 1: Inventory valuations • False Quality • lower of cost or market issues • Under the “lower of cost or market value” rule, where an asset’s cost exceeds its current market value, the asset must be written down to market value • unusual increases in the inventory balances • obsolete inventory (i.e. Excessive inventory on hand) • Fraudulent or Improper Capitalization • amounts that are actually expenses are capitalized to inventory • overestimate of direct labor and overhead included in manufacturing inventory value

38. Improper asset valuations (cont’d)Scheme 2: Accounts receivable • Fictitious accounts receivable • most common around the end of the accounting period • concealed by providing false confirmations of balances to auditors • mailing address confirmations are sent to are either a mailbox under the fraudsters control, a home address, or the business address of a co-conspirator • Failure to write down • FASB Statement No. 5, Accounting for Contingencies requires companies to accrue losses on uncollectable receivables • companies may omit the recognition of such losses due to the negative impact on the income statement

39. Improper asset valuations (cont’d)Scheme 3: Business combinations & Fixed assets • Business combinations • create excessive reserves for expenses at time of acquisition • bootstrapping earnings – warning sign • growth through acquisition – warning sign • Fixed assets • booking fictitious assets • capitalizing nonasset costs • finance and Interest charges • misclassifying assets • reclassify as fixed assets as current assets

40. Improper asset valuations (cont’d)Red Flags • Reduction in allowances for bad debts, excess inventory, obsolete inventory, etc • Unusual growth in the number of days’ purchases in inventory ratio • Unusual growth in the number of days’ sales in receivables ratio • Non-financial management’s excessive participation in or preoccupation with the selection of accounting principles or the determination of significant estimates • Assets, liabilities, revenues, or expenses based on significant estimates that involve subjective judgments or uncertainties that are difficult to support

41. Concealed or manipulated liabilities and expenses • Understating liabilities and expenses makes a company appear to be more profitable • Much easier to commit than falsifying sales transactions • Common Methods: • Liability / Expense Omission • Capitalized Expenses • Adjusting Reserves

42. Concealed liabilities and expenses (cont’d)Scheme 1: Liability and/or expense omissions • Understated liabilities/expenses • it is often necessary to use estimates in accounting • using estimates increases the likelihood of fraud by manipulation of those estimates • Omission of liabilities/expenses • easy to conceal and hard to detect • Failure to record “contingent liabilities” • litigation

43. Concealed liabilities and expenses (cont’d)Scheme 2: Capitalized expenses • Capitalized expenses • overstatement of income and assets in current period • understatement of income in subsequent periods • Expensing capital expenditures • allows minimization of net income due to tax considerations • increase earnings in future periods

44. Manipulation of liabilities and expensesScheme 3: Adjusting of reserves • Schemes • “Rainy day” or “Cookie Jar” reserves • inadequate reserves • Overstating Reserves • done is profitable years • management reverses the reserve in future periods to boost earnings • Understating Reserves • do not record enough of a liability for warranty reserves, allowance for doubtful accounts, etc.

45. Concealed liabilities and expensesRed flags • Reducing accounts payable while competitors are stretching out payments to vendors • Allowances for sales returns, warranty claims, etc., that are shrinking in percentage terms or are otherwise out of line with industry peers • Recurring negative cash flows from operations or inability to generate cash flows from operations while reporting earnings and earnings growth

46. Improper disclosures • Accounting principles require that financial statements include all information necessary to prevent a reasonably discerning user of the financial statements from being misled • The notes should include narrative disclosures, supporting schedules, and any other information required to avoid misleading potential investors, creditors, or any other users of the financial statements

47. Examples of Improper disclosures • Liability omissions • Subsequent events • Related party transactions • Management fraud • Legal and regulatory compliance violations • Changes in accounting policy and estimates • False statements • Contingencies

48. Improper disclosures Red flags • Ineffective board of directors or audit committee oversight over the financial reporting process and internal control • Domination of management by a single person or small group without compensating controls • Rapid growth or profitability • Significant, unusual or highly complex transactions, especially those close to a period’s end that pose difficult “substance over form” questions • Significant related party transactions not in the ordinary course of business • Overly complex organizational structure • Known history of violations of securities laws or other laws and regulations

49. Preventative controls • Internal auditors – primary responsibility for establishing and maintaining internal control rests with management • Management’s responsibility to set the ethical tone at the top • Employee support programs • Fraud training for employees and managers • Segregation of duties • Publish a disciplinary policy (message must come from senior management through comments, commitment, and mission statement) • Assign high-level personnel to oversee the compliance program implementation and operations. Boards may wish to establish a compliance committee or other subset of the Board to monitor compliance program operations and regularly report to the Board • Establish communication systems (including hotlines and help lines, complaint boxes)

50. Questions?