Chapter 7

Cooked Books: Finding Financial Statement Fraud

In This Chapter

Identifying motives behind financial statement frauds

Realizing how such frauds are committed

Playing sleuth: Finding the fraud

Acompany records all its business transactions, culminating in the preparation of financial reports that provide information about the company's financial position and performance. Financial reports consist of the following: principal statements (the income statement, balance sheet, and statement of cash flows), notes to these statements, and management discussion and analysis (MD&A) of results. Financial statements provide a snapshot of the business at a given point in time: the results of its financial performance and its generation of cash flows during a given period.

Auditors conduct financial statement analysis, which involves evaluating a company's financial position and its ability to generate profits and cash flow both now and in the future. Such analysis may also include valuing the company itself. Financial statements provide the information to do so.

Financial statement fraud, commonly referred to as “cooking the books” or “fudging the numbers,” usually involves manipulating one or more elements of the financial statements. Assets, revenues, and profits could be overstated, and liabilities, expenses, and losses could be understated. This type of fraud involves the deliberate misrepresentation or manipulation of the financial condition of a business, and it's accomplished through the intentional misstatement or omission of amounts or disclosures in the financial statements to deceive the people who use those statements.

According to the Association of Certified Fraud Examiners (ACFE), losses due to issuing a fraudulent statement can total millions of dollars. When you take into account penalties and fines, legal costs, the loss of investor confidence, and reputational damage, the total costs of this type of fraud can be enormous.

Exploring the Financial Statement Fraud Triangle

The Committee of Sponsoring Organizations (COSO) of the Treadway Commission has studied financial statement fraud. Their studies indicate that senior management is often the most likely group to commit financial statement fraud. This section discusses incentives and opportunities to commit financial statement fraud.

Management has many incentives to perpetrate financial statement fraud. Managers trying to meet any number of legitimate corporate goals (such as sales targets, cost targets, analysts’ earnings expectations, and bonus plan targets) or who are trying to make critical investment and financing decisions to achieve these targets can find accounting rules and systems a hindrance. Therefore, they may be tempted to compromise the fundamental informational role of accounting to manage the company's earnings.

One of the main reasons to manage earnings is to keep Wall Street happy, at least in the short run. Information about a company's current status and prospects affect its share values. The company can get punished if it doesn't meet its earnings targets. Sometimes the drop in share value may be large.

Chapter 3 explains that the fraud triangle represents three conditions that are always present for fraud to occur: incentive, opportunity, and rationalization. This section examines the fraud triangle as it relates to financial statement fraud.

Understanding the incentive behind financial statement fraud

The following risk factors related to incentive or motivation can lead to financial statement fraud:

• The company is facing tough economic conditions, such as a high degree of competition, rapid technological changes, the threat of bankruptcy, declines in consumer demand, or new regulatory changes that threaten profitability.
• Management is faced with pressure to meet the expectations of third parties, including analysts, investors, or creditors, in terms of raising financing. Pending merger or acquisition activity can also create third-party pressure.
• Management and the board members’ personal financial situations are affected by the prospects of lower compensation or by owning shares in the company, which are tied to the company's financial performance.

Seeing the fraud opportunity

Here's how a company can create the opportunity for financial statement fraud:

• Internal control deficiencies exist as a result of inadequate accounting systems or the inadequate monitoring of controls.
• The organizational structure is complex, with multiple lines of reporting for managers and/or unusual legal entities, or senior management turnover is high.
• Management and board oversight is deficient as evidenced by the domination by a small group of people.
• The company operates within an industry that uses significant related-party transactions or operates in foreign jurisdictions.
• The company may have entered into complex transactions (for example, derivatives) that could present risks. Only a few people truly understand the mechanics of the transactions.

Coming up with a rationalization for the fraud

Risk factors associated with the rationalization of financial statement fraud include the following:

• The company has violated securities laws in the past or has been accused of fraud.
• The company suffers from ineffective communication or poor enforcement of ethical values and standards.
• Management fails to correct internal control weaknesses in a timely manner.
• The relationship between management and the auditor is strained.

Spotting the Common Methods of Fraud

An accountant's role in investigating financial fraud is to look for red flags or accounting warning signs. It's akin to a doctor who initially examines a patient by taking the patient's blood pressure, testing his reflexes, listening to his heart, and looking in his eyes, ears, and throat. Accounting red flags include:

• Aggressive revenue recognition practices, such as recognizing revenue in earlier periods than when the product was sold or the service was delivered
• Unusually high revenues and low expenses at period end that can't be attributed to seasonality
• Growth in inventory that doesn't match growth in sales
• Improper capitalization of expenses in excess of industry norms
• Reported earnings that are positive and growing accompanied by operating cash flow that's declining
• Growth in revenues that is far greater than growth in other companies in the same industry or peer group
• Gross margin or operating margins out of line with peer companies
• Extensive use of off–balance sheet entities based on relationships that aren't normal in the industry

This section explains four of the most common methods used to commit financial statement fraud: hidden liabilities, cookie jar reserves, off–balance sheet transactions, and notes that no one can comprehend.

Hidden liabilities

In the accrual method of accounting (which is required for all public companies), expenses must be recorded in the period in which they're incurred, regardless of when they're paid. Capitalization refers to recording expenditures as assets rather than expenses because the expenditures add to the value of an asset, which provides benefits into the future. Improper capitalization occurs when companies capitalize current costs that don't benefit future periods. Improperly capitalizing or deferring expenses generally causes a company to understate reported expenses and overstate net income in the period of capitalization or deferral.

Take the case of WorldCom in the early 2000s. WorldCom was alleged to have overstated its cash flow by booking $3.8 billion of operating expenses as additions to capital. This transfer resulted in WorldCom materially understating expenses and overstating net income. It also enabled the company to report earnings that met analyst estimates. WorldCom's CEO was sentenced to 25 years in prison for orchestrating the fraud.

Cookie jar reserves

Reserves are provisions for liabilities that are set up for a wide variety of future expenditures, including restructuring charges, environmental cleanup costs, or expected litigation costs. Recording a reserve on a company's books generally involves recognizing an expense and a related liability. From a fraud perspective, this may be done in good years when the company makes profits so that it's able to incur larger expenses. These provisions are called cookie jar reserves because management can reach into the jar and reverse it in future years when the company deems it necessary to boost earnings.

Symbol Technologies is a case in point. From 1998 until early 2003, Symbol engaged in numerous fraudulent accounting practices and other misconduct that had a cumulative net impact of more than $230 million on Symbol's reported revenue and more than $530 million on its pretax earnings. Symbol created cookie jar reserves by fabricating restructuring and other charges to artificially reduce operating expenses in order to manage earnings.

Off–balance sheet transactions

Off–balance sheet arrangements are used to raise additional financing and liquidity. These arrangements may involve the use of complex structures, including special purpose entities (SPEs), to facilitate a company's transfer of, or access to, assets. In many cases, the transferor of assets has some liability or continuing involvement with the transferred assets.

Depending on the nature of the obligations and the related accounting treatment, the company's financial statements may not fully reflect the company's obligations with respect to the SPE or its arrangements. Transactions with SPEs commonly are structured so that the company that establishes or sponsors the SPE and engages in transactions with it isn't required to consolidate the SPE into its financial statements.

Enron provides a great example of the improper use of off–balance sheet transactions for fraudulent purposes. The company's former CFO and another high-ranking Enron official were convicted of engaging in a complex scheme to create an appearance that certain entities they funded and controlled were independent of the company. This allowed Enron to incorrectly move its interest in these companies off its balance sheet. The U.S. Securities and Exchange Commission (SEC) alleged that these entities were designed to improve the company's financial results and to misappropriate millions of dollars representing undisclosed fees and other illegal profits.

In response to the Enron off–balance sheet transactions, the AICPA issued an interpretation — FIN46 — regarding entities that need to be consolidated for financial statement purposes. FIN46, which was later amended to FIN46R, is now referred to as the Consolidation Topic under the FASB Codification.

Notes no one can comprehend

Companies can also commit financial statement fraud by misrepresenting their financial condition through misstatements and omissions of facts and circumstances in their public filings, such as the management and discussion analysis, nonfinancial sections of annual reports, or footnotes to the financial statements. In this situation, management doesn't provide sufficient information to the users of financial statements. As a result, the users can't make informed decisions about the financial condition of the company.

Companies must disclose related party transactions in accordance with securities laws and accounting rules. Moreover, transactions with board members, certain officers, relatives, or beneficial owners holding 5 percent or more of a company's voting securities that exceed $60,000 must be disclosed in the management section of the annual report. Failure to disclose related party transactions hides material information from shareholders and may be an indicator of fraudulent financial reporting.

In 2002, the SEC alleged that Adelphia engaged in numerous undisclosed related party transactions with board members, executive officers, and entities it controlled. One of these transactions involved the construction of a golf course on land owned or controlled by senior management. The SEC alleged that Adelphia failed to disclose the existence of these transactions or misrepresented their terms in its financial statements. More than $300 million of company funds were diverted to senior management without adequate disclosure to investors.

The SEC alleged that three top executives — the CEO, CFO, and Chief Legal Officer — failed to disclose to shareholders the multimillion dollar loans from the company they used for personal business ventures and investments, and to purchase yachts, fine art, estate jewelry, luxury apartments, and vacation estates. These senior officials also allegedly failed to disclose benefits such as a rent-free $31 million Fifth Avenue apartment in New York City, the personal use of corporate jets, and charitable contributions made in their names.

Uncovering Financial Statement Fraud

Financial analysis techniques can help accountants and investigators discover and examine unexpected relationships in financial information. These analytical procedures are based on the premise that relatively stable relationships exist among financial accounts. If the relationships among those accounts become unstable, especially in a public company, the financial statements should offer full disclosure of the facts to explain what happened.

Unexpected deviations in relationships most likely indicate errors, but they may indicate illegal acts or fraud. Therefore, deviations in expected relationships warrant further investigation to determine the exact cause. As a fraud investigator, you can use several methods of analysis to examine the parts of financial statements that are most likely to be tainted by fraud. This section explores those analytical methods. To find out more about any of these methods, check out A Guide to Forensic Accounting Investigation, 2nd Edition, by Steven L. Skalak, Thomas Golden, Mona Clayton, and Jessica Pill (Wiley).

Comparative techniques

As an accountant, you could use the following techniques to identify the relationships among any financial data that present red flags:

• Comparison of current period information with similar information from prior periods: Prior period amounts are used as the basis for analyzing current period information. This time series analysis can show unusual changes that may be indicative of fraud.
• Comparison of accounting information with budgets or forecasts: Pressures on management to meet budget estimates may result in financial fraud. This comparison should include adjustments for unusual transactions and events.
• Study of relationships of financial information with the appropriate nonfinancial information: Nonfinancial measures are normally generated from an outside source. For example, retail store sales is a common measure of the performance of retail companies, where sales are expected to vary with the number of square feet of shelf space.
• Comparison of information with similar information from the industry in which the organization operates: Studying a company's financial metrics and comparing them to other industry participants for unusual trends may indicate discrepancies. These discrepancies need further analysis to investigate financial fraud.
• Comparison of information with similar information from other organizational units: This technique involves comparing the financial performance of various subunits. For instance, a company with several stores may compare one store with another store.

Ratio analysis

Ratio analysis is a comparative technique that you can use to study data on a time series basis (meaning year over year or over a period of time) so that different trends can be identified. You should perform these analyses at the company level and at the business-unit levels (meaning within each department or unit of the company). See Book V, Chapter 3, to get up to speed on using ratios to assess the financial health of a company. The following list looks at some of these ratios from a forensic perspective to help you understand how financial fraud can be detected from this analysis.

• Current ratio: This ratio measures the ability of the company to pay its current obligations from its current assets, such as cash, inventories, and receivables. The current ratio decreases when cash is embezzled, because less cash would decrease the numerator of the formula (current assets). The formula for calculating this ratio is as follows:

  Current ratio = Current assets ÷ Current liabilities

• Debt-to-equity ratio: This ratio measures the degree of debt a company has in relation to its equity (ownership resources). In other words, it shows the use of borrowed funds (debt) as compared with resources from the owners. The debt to equity ratio can be expressed as follows:

  Debt to equity ratio = Total liabilities ÷ Total equity

• Profit margin ratio: This ratio measures the margins earned by a company from selling its products or services. It helps you understand the company's pricing structure, cost structure, and profit levels. You should look at profit margin trends because this ratio is expected to be consistent over time. Management can play around either with manipulating revenues or costs in order to maximize this ratio. Thus:

  Profit margin ratio = Net income ÷ Net sales

• Asset turnover ratio: This one measures the effectiveness of the usage of assets in terms of generating sales. This ratio can be manipulated by booking fictitious sales, thereby increasing the numerator in the asset turnover ratio, which is expressed as follows:

  Asset turnover ratio = Net sales ÷ Average assets

Beneish model

The Beneish model is a mathematical model used to predict the likelihood of a company cooking its books. To use this model, you calculate indexes based on changes in account balances between the current and prior year. Professor Messod Beneish developed the model after finding that on average, companies that manipulate their financial statements have significantly larger increases in days sales in receivables, greater deterioration of gross margins and asset quality, higher sales growth, and larger accruals than companies that don't manipulate their financial statements.

Here are several important indexes used in the Beneish model:

• Days sales in receivables index: The ratio of days sales in receivables in the current year to the corresponding measure in the prior year. Days sales in receivables compares how much you typically sell in one day to your total receivable balance. If you sell $100 in sales per day, for example, and your receivable balance is $2,000, you have 20 days sales tied up in receivables ($2,000 ÷ $100). This index indicates whether your total receivable balance is growing or declining, as compared with daily sales. This variable gauges whether receivables and revenues are in or out of balance in two consecutive years. A large increase in days’ sales in receivables could be the result of a change in credit policy to spur sales.
• Gross margin index: The ratio of the gross margin in the prior year to the gross margin in the current year. When this index is greater than 1, it indicates that gross margins have deteriorated, which increases the probability of earnings manipulation.
• Asset quality index: The ratio of noncurrent assets other than property plant and equipment (PP&E) to total assets. This ratio measures the proportion of total assets for which future benefits are potentially less certain. This ratio compares asset quality in the current year to asset quality in the previous year. An increase in this index indicates an increased propensity to capitalize expenses and thus defer costs (red flags for an accountant).
• Sales growth index: The ratio of sales in the current year to sales in the prior year. Growth doesn't imply manipulation, but growth firms are viewed as more likely to commit financial statement fraud because their financial position and capital needs put pressure on managers to achieve earnings targets.
• Total accruals to total assets: Total accruals are calculated as the change in working capital accounts other than cash less depreciation. This ratio is used to gauge the extent to which cash underlies reported earnings. Higher positive accruals are associated with a higher likelihood of earnings manipulation.

By calculating these ratios, you create a score that you can compare with the scores of other companies. The following table shows the average scores for each index for nonmanipulators (companies that don't mess around with their financial statements) and manipulators (companies that do). If your calculations show that a company's scores are close to those of a manipulator, you have reason to keep investigating.

Data mining

Whereas all the analytical methods introduced so far in this chapter involve analyzing aggregated financial statements, data mining uses queries or searches within financial accounts to identify anomalies — large and unusual items that call for further review. For instance, a query can be performed on payment amounts to identify double payments. Other examples of data mining techniques include:

• Identifying gaps in document numbers such as invoices, checks, and purchase orders
• Identifying duplicate vendors or duplicate payments to vendors or employees
• Finding fictitious customers, vendors, or employees
• Noting unusually high or above market payments of commissions to agents