Introduction to Financial Statement Fraud - ACC...
Transcript of Introduction to Financial Statement Fraud - ACC...
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Introduction to Financial StatementFraud
Deloitte Financial Advisory Services LLP
September 18, 2008
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1Copyright © 2008 Deloitte Development LLC. All rights reserved.
Agenda
Financial Statement Reporting
Fraud Basics
Common Fraud Schemes
! Revenue Recognition
! Reserve Manipulation
! Improper Expense Capitalization
! Quality of Earnings & Level of Disclosure
FCPA
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Financial Statement Reporting
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Financial Statement Reporting:A Complete Set of Financial Statements
Set of FinancialStatements
Balance Sheet
Cash Flow Statement
Statement of Stockholders’Equity
Notes to the FinancialStatements
Income Statement
Description
Shows the financial position (assetsand liabilities) of the company at theend of the period.
Shows the results of the operations forthe period.
Shows cash inflows (receipts) andoutflows (uses) for the period.
Explains investments by anddistributions to owners during theperiod.
Provides qualitative data.
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Financial Statement Reporting:Inter–Relationships
Income Statement
Revenue $ 412,800
Cost of Sales 200,000
Depreciation and Amortization 6,400
Other Operating Expenses 100,000
Other Non-Operating Expenses 77,380
Net Income $ 22,620
Cash Flow Statement
Net Income $ 22,620
Depreciation and Amortization 6,400
Increase in Net Working Capital (10,220)
Cash Flow From Operations 18,800
Cash Flow From Investing (20,000)
Proceeds from Common Stock 4,000
Dividends Paid (1,000)
Cash Flow From Financing 3,000
Increase in Cash 1,800
Beginning Cash Balance 1,200
Ending Cash Balance $ 3,000
Balance Sheet
Assets
Cash $ 3,000
Other Current Assets 24,400
Property, Plant & Equipment 168,000
Accumulated Depreciation (32,000)
Other Non-Current Assets 1,600
Total Assets $ 165,000
Liabilities
Current Liabilities $ 32,000
Long-Term Liabilities 27,000
Total Liabilities 59,000
Stockholders’ Equity 106,000
Total Liabilities’ Equity $ 165,000
Statement of Stockholders’ Equity
Beginning Balance $ 80,380
Net Income 22,620
Common Stock Issued 4,000
Dividends Paid (1,000)
Total Stockholders’ Equity $ 106,000
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Financial Statement Reporting:Notes to the Financial Statements
! Provides further explanations or provides the onlyexplanations for significant transactions and containsrequired disclosures
! Overview of the business
! Significant accounting policies
– Revenue recognition
– Principles of consolidation
– Property, plant & equipment
– Intangible assets & goodwill
! Discontinued operations
! Business combinations
! Debt offerings and credit risk
– Income taxes
– Related party transactions
– Subsequent events
– Commitments
– Contingencies
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Financial Statement Reporting:Objective
! “…intended to provide information that is useful in makingbusiness and economic decisions.”
– Provide useful information in:
! Investment and credit decisions
! Assessing cash flow prospects
– Provide useful information about:
! Enterprise resources, claims to those resources, and changes in theresources
! Economic resources, obligations, and owners’ equity
! Enterprise performance and earnings
! Liquidity, solvency, and funds flows
Source: FASB Statement of Financial Accounting Concepts No. 1
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Financial Statement Reporting:Limitations on Financial Statements
! Information often results from approximate, rather thanexact measures
! Information is based upon historical data and does notmeasure or discuss management’s plans for the future
! Information is generally recorded at cost and may notreflect the current market value
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Fraud Basics
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Fraud Basics: Types of Fraud
Financial Fraud
Misappropriationof Assets
Corrupt BusinessPractices
FraudulentFinancialReporting
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Misappropriation of Assets
Source: AICPA Journal of Accountancy (12/01) and ACFE.
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Corrupt Business Practices
! Improper or unauthorized expenditures
! Self-dealings
! Violations of laws and regulations
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Corruption Perception Index
Source: http://www.transparency.org/policy_research/surveys_indices/cpi/2007
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Fraud Basics:Definition of Financial Statement Fraud
! Intentional acts by management designed to misstatefinancial performance in order to deceive financialstatement users.
– Manipulation of accounting records or supporting documents fromwhich financial statements are prepared
– Misrepresentation in, or intentional omission from, financialstatement events, transactions, or other significant information
– Intentional misapplication of accounting principles relating toamounts, classification, manner of presentation, or disclosure
Source: Statement on Auditing Standard No. 99
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Fraud Basics:The Fraud Triangle
Pressure/Incentive
Pressure to misappropriateassets and commit financial
statement fraud
Opportunity
Circumstances that allowthe misappropriation
assets
Rationalization
Frame of mind that allowsone to justify their
dishonesty
Source: Occupational Fraud Abuse, by Joseph T. Wells, CPA, CFE
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Fraud Basics:The Fraud Triangle – Pressure/Incentives
! Smoothing earnings/meeting Wall Street expectations
! Achieving compliance with contractual terms (e.g., debtcovenants)
! Facilitate the use of Non-GAAP earnings (e.g., EBITDA)
! Meet bonus targets
! Increase value of stock based compensation
! Personal financial pressures
! Corrupt corporate culture
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Fraud Detection
! Organizations lost 7% oftheir annual revenues tofraud
! The typical fraud schemelasts 24 months before it isdetected
! 9.1% of fraud schemes areinitially detected byexternal auditors
Source: 2008 ACFE Report to the Nation on Occupational Fraud & Abuse
Note: The sum of percentages in this chart exceeds 100% because insome cases respondents identified more than one detection method.
Initial Detection of Occupational Frauds
3.8%
12.0%
19.2%
20.2%
25.4%
34.2%
3.2%
9.1%
23.3%
19.4%
20.0%
46.2%
0.0% 10.0% 20.0% 30.0% 40.0% 50.0%
Notified by Police
External Audit
Internal Controls
Internal Audit
By Accident
Tip
Typ
e o
f D
ete
cti
on
Percent of Cases
2008
2006
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Fraud Frequency
! Revenue recognition fraudschemes are by far themost prevalent, at 41% ofthe total. This finding isconsistent with earlierstudies and reinforces theneed for focus on this area
! Other fraud schemesinvolving manipulation ofvarious financial statementitems account for morethan a third of all fraudschemes identified.
41%
12%
11%
8%
7%
7%
4%
3%
3%2%1%1%
Revenue Recognition 41% Improper Disclosures 12%
Manipulation of Expenses 11% Manipulation of Assests 8%
Manipulation of Liabilities 7% Manipulation of Reserves 7%
Asset Misappropriation 4% Bribery & Kickbacks 3%
Manipulation of A/R 3% Aiding and Abetting 2%
Good will 1% Investments 1%
Source: Deloitte’s Fraud Work Center – 10 Things on Fraud booklet
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Common Fraud Schemes
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Common Fraud SchemesRevenue Recognition
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Revenue Recognition
! Under SEC Staff Accounting Bulletin 101/104 (SAB101/104), revenue is generally “realizable and earned”when all of the following conditions are met:
– Persuasive evidence of an arrangement exists
– Delivery has occurred or services have been rendered
– The seller's price to the buyer is fixed or determinable
– Collectability is reasonably assured
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Common Types of Revenue RecognitionFrauds
The ‘top 6’ fraud schemes depicted above account for 70% of all revenuerecognition schemes identified.
123
35%
42
12%
46
13%
41
12%
43
12%
58
16%
Recording of fictitious revenue
From swaps, round-tripping or barter arrangements
Bill and hold transactions
Unresolved contingencies
Improper accounting/ failure to establish appropriate reserves
Recognition of revenue when products or services are not delivered,delivery is incomplete, or delivered without customer acceptance
Source: Deloitte’s Fraud Work Center – 10 Things on Fraud booklet
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Common Fraud Schemes:Revenue Recognition – Issues
! Channel Stuffing
! Side Agreements
! Backdated Agreements
! Bill & Hold Transactions
! Contingent Sales
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Possible Indicators and Detection Methods ofRevenue Recognition Fraud
! Absence of valid business purpose for transaction(s)
! Significant transactions at quarter-end
! Existence of side-letters, verbal agreements or emails thatappear to alter the standard terms of sale
! Product returns in excess of standard policies
! Changes in customer purchasing and payment trends
! Distributor inventory activity
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Common Fraud SchemesReserve Manipulation
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Common Fraud Schemes:Reserve Manipulation
! Reserves tend to be liability (credit) accounts on thebalance sheet. Reserves should be specific.
– “General,” “excess,” “rainy-day,” “cookie-jar,” “cushion” and“unallocated” reserves are not allowable under GAAP
! These improper reserve accounts often include excessreserves which can be reversed to inflate earnings inorder to:
– Meet profitability targets
– Avoid net losses
– “Smooth” operating results
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Common Fraud Schemes:Reserve Manipulation
! Smoothing Earnings:
– It was the best of times…
! Companies experiencing fantastic operating performance may seek todefer earnings into future periods
– To reduce market expectations of future performance, and
– To establish reserves for use in covering future period expenses
– It was the worst of times…
! Companies may decide to take a “Big Bath” during periods of poorfinancial performance. “If we’ve already missed expectations, let’sREALLY miss them and establish reserves so this doesn’t happen again.”
– To describe current year performance as “fluke”
– Reserves often established through “non-recurring” expenses
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Possible Indicators and Detection Methods ofReserve Manipulation
! “Big Bath” Indicators
! Upcoming acquisition or IPO
! Existence of new reserve accounts, “general” reserveaccounts, or increased activity in previously dormantaccounts
! Post-closing and “top-side” entries creating credits onbalance sheet
! Booking expenses “to budget”
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Common Fraud SchemesImproper Expense Capitalization
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Common Fraud Schemes:Improper Expense Capitalization
! Certain costs are allowed to be capitalized on the BalanceSheet as assets and expensed piecemeal over time ifthere is future economic benefit.
– These assets are expensed through the Income Statement over thecourse of their estimated useful lives using depreciation/amortizationexpense.
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Common Fraud Schemes –Improper Expense Capitalization
! Occurs when a company capitalizes certain costs which arenot permitted under GAAP (including no future economicbenefit)
! Expenses are effectively deferred over the “useful” life ofthe asset as opposed to being charged to the incomestatement immediately
! The objective is to lower expenses and increase earnings orprofit on the Income Statement by improperly capitalizingthe expense
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Possible Indicators and Detection Methods ofImproper Expense Capitalization
! Unexplained increase in “fixed assets” such as property,plant and equipment
! Lower than expected expenses
! Manual journal entries posting increases to capital assetaccounts where systematic process exists
! Unexplained significant variances between actual capitalexpenditures and budgeted amounts
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Common Fraud SchemesQuality of Earnings & Level of Disclosure
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Common Fraud Schemes:Quality of Earnings & Level of Disclosure
! Financial Statement Classification
– Non-recurring Items
! Disclosure of Trends
– Channel Stuffing
! Related Party Transactions
! Comparability and consistency
– Change in Estimates
– Changes in Accounting Principles
! Non-GAAP Measures
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Example: Non-GAAP Measure: Same StoreSales
! Common industry non-GAAP metric
! Determines the level of sales growth from existing storesversus sales growth from new store openings
– Definition varies between companies
! Yum! Brands Inc.
– Restaurants in operation for at least one year
! McDonald’s Corp.
– Restaurants open for at least thirteen months
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Foreign Corrupt Practices Act(“FCPA”)
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Background
! The FCPA Overview of Provisions: A company cannotcorruptly make an offer, promise, or payment of “anything ofvalue” to a “foreign government official” or politician for the“purpose of influencing his or her official actions” for theadvantage of the company.
! Main Provisions
– Anti-bribery provision: Prohibits the offer of payment or payments to agovernment official for the purpose of securing a businessadvantage. (Federal criminal offense)
– Books & Records provision: Requires “issuers” to maintainappropriate books and records and to maintain adequate internalaccounting controls.
! Applies only to SEC issuers, including those that trade ADRs
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Background (cont.)
! The FCPA requires U.S. companies to establish accountingand recordkeeping controls that will prevent the use of“slush” funds” and “off-the-books” accounts – used by somecompanies in the past to facilitate and conceal questionablepayments.
! Penalties include fines up to $2,000,000 per violation forcompanies and $100,000 and/or up to 5 yearsimprisonment for individuals.
! Individuals are subject to criminal liability under the FCPA,regardless of whether the company is found guilty or evenprosecuted.
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DOJ/SEC Investigations Peaking & Continuing
! Certain “new” markets are known for corrupt businesspractices – (China, India, Brazil, Africa/Transparency Int’lBribery Index)
! “Voluntary Disclosure” of potential violations – in “postEnron” environment
! Whistleblowers – new source of investigations
! World governmental attitudes – OECD Anti-BriberyConvention and national legislation
! Anti-terrorism financing scrutiny – cross bordergovernmental cooperation.
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DOJ/SEC Investigations Peaking & Continuing(cont.)
! Sarbanes-Oxley – certification and internal controls
! Board of Directors and Audit Committee expectations andinquiries
! Increase in mergers & acquisitions into new markets
! Decentralized operations in developing countries
! New and unknown business partners/ventures
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40Copyright © 2008 Deloitte Development LLC. All rights reserved.
Enforcement Trends
! Compliance Standards Rising
! Certain industries and countries are under scrutiny
! Prosecution of individual corporate officials as well ascorporate entities
! Source of allegations – whistleblower protections
! Source of the alleged bribe does not have to be in the U.S.
! The actions of an agent, consultant, representative and“business partners” acting “on behalf” of the companygenerally attributed to the company
! Successor Liability
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Questions & Answers
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42Copyright © 2008 Deloitte Development LLC. All rights reserved.
Speaker Contact Information
! Howard ScheckPartner
Deloitte Financial Advisory Services LLP202 378 [email protected]
! Paula TookeySenior ManagerDeloitte Financial Advisory Services LLP
202 378 [email protected]
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Copyright © 2008 Deloitte Development LLC. All rights reserved.