Chapter 1 Copyright AICPA Unauthorized copying prohibited An Introduction to Financial Statement Fraud

Chapter Outline Importance of Accurate Financial Information Nature of Financial Statement Fraud Financial Statement Fraud Statistics An Example Motivations for Financial Statement Fraud Copyright AICPA Unauthorized copying prohibited

Importance of Accurate Financial Information Why is accurate financial information important? Financial statements provide meaningful disclosures of a company’s past, present, and future Most Financial Statements are prepared with integrity, but sometimes they are prepared in ways that misrepresent actual financial position Misstatement of financial statements can result from manipulation, falsification, or altering of accounting records or supporting documentation from which the statements are prepared, Misrepresentation or intentional omission of events, transactions, other significant information Intentional misapplication of accounting principles relating to amounts, classification, manner of presentation or disclosure Copyright AICPA Unauthorized copying prohibited

Accountants have been given a “watchdog” role by the SEC SEC and other parties rely on auditors to issue audit opinions that act like Good Housekeeping Seal of Approval Enron is only 1 of 600 financial statements frauds that have been investigated by the SEC Accountants must understand as much as possible about financial statements and financial statement fraud Allows auditors to be more discriminating in the kinds of audits they accept, give better advice to clients Copyright AICPA Unauthorized copying prohibited

Nature of Financial Statement Fraud Involves intentional deceit and concealment through falsified documentation, forgery, collusion among management, employees, and third parties Unlike fraud where employees and others take advantage of the organization, when financial statement fraud takes place management acts on behalf of the organization to make the organization appear more profitable than it actually is Copyright AICPA Unauthorized copying prohibited

Financial statement fraud is rarely seen When fraud does occur fraud symptoms, indicators, or red flags are usually observed Because these symptoms can be caused by other legitimate factors the presence of fraud symptoms does not always indicate that fraud exists for example a document may be missing, the GL may be out of balance, an analytical relationship may not make sense These may simply indicate errors, lost documents, or changes in the firm’s underlying economic condition

Even a tipster reporting fraud may be motivated to make false allegations Copyright AICPA Unauthorized copying prohibited

Red flags Fraud symptoms cannot be easily ranked in order of importance or combined into effective predictive models Some factors exist when no fraud is present A smaller number of red flags may exist when fraud is present It can be hard to predict fraud once it is suspected Without a confession, a number of repeated similar fraudulent acts (fraud can be inferred from a pattern) or obviously forged documents, it is very difficult to convict someone of fraudulent behavior Auditors must exercise extreme care when conducting audits, performing fraud examinations, trying to quantify fraud or performing other fraud related engagements Copyright AICPA Unauthorized copying prohibited

SEC AAERs The best measure of financial statement fraud is to look at the SEC enforcement releases (AAERs) One or more enforcement releases is issued when financial statement fraud occurs at a company whose stock is publicly traded Most comprehensive study of the AAERs was conducted by COSO, examining all financial statement frauds from 1998 to 2007 Copyright AICPA Unauthorized copying prohibited

Financial Statement Fraud Statistics A Few Interesting Facts Revealed in the COSO study of Financial Statement Frauds that occurred between 1998 and 2007: Of the 347 alleged cases of public company fraudulent financial reporting, the median financial statement fraud was $12.05 million The most common methods used to misstate financial statements were, in order, improper revenue recognition, overstatement of assets, and capitalization of expenses. Copyright AICPA Unauthorized copying prohibited

Financial Statement Fraud Statistics (Continued) Organizations involved in fraudulent financial reporting had assets and revenues of just under 100 million In 89% of the cases, the CEO and/or CFO was named in the AAER for some level of involvement Within 2 years of the completion of the investigation, 20 percent of the CEOs and CFOs were indicted and over 60 percent of those indicted were convicted 26 percent of the fraud firms in the study changed auditors between the last clean financial statement date and the fraudulent financial statement date, only 12% of no fraud firms switched auditors during the same period Copyright AICPA Unauthorized copying prohibited

Financial Statement Fraud Statistics (Continued) Once news of an alleged fraud reached the press, company stock declined on average 16.7% Consequences for the fraud firms were severe and often included bankruptcy, delisting from stock exchanges, and material assets sales following the discovery of the fraud These findings are consistent with other similar reports such as the Report Pursuant to Section 704 of the SOX 2002 Copyright AICPA Unauthorized copying prohibited

Section 704 of SOX 2002 Section 704 requires the SEC to review and analyze all enforcement actions by the SEC involving violations of reporting requirements, and restatements of financial statements, to identify areas of reporting that are most susceptible to fraud, inappropriate manipulation, or inappropriate earnings management, such as revenue recognition and the accounting treatment of off-balance-sheet special purpose entities. The Commission is required to report its findings to the Committee on Financial Services of the House of Representatives and the Committee on Banking, Housing and Urban Affairs of the Senate, not later than 180 days after the date of the enactment of the Act and to use its findings to revise its rules and regulations as necessary. Copyright AICPA Unauthorized copying prohibited

The Commission reviewed and analyzed 515 enforcement actions for financial reporting and disclosure violations These included 869 named parties, 164 entities and 705 individuals Copyright AICPA Unauthorized copying prohibited

Year Number of Financial Reporting Violations Copyright AICPA Unauthorized copying prohibited

The greatest number of actions brought in the area of revenue recognition Improper timing of revenue recognition Improper valuation of revenue 101 enforcement matters involved improper expense recognition Improper capitalization or deferral of expenses, improper use of reserves, or understatement of expenses 23 enforcement matters involved improper accounting for business combinations Other matters involved disclosure issues, such as inadequate MDA and improper use of off balance sheet arrangements Copyright AICPA Unauthorized copying prohibited

Specific types of Financial Statement Fraud Type of FraudSpecific schemeNumber of Cases Improper revenue recognition Improperly timed revenue recognition 81 Fictitious revenue80 Improper valuation21 Failure to record expenses or losses via improper capitalization/deferra l or lack of accrual 49 Copyright AICPA Unauthorized copying prohibited

Specific types of Financial Statement Fraud Type of Fraud Improper expense recognition Specific Scheme No. of Cases Overstating ending inventory values to reduce cost of goods sold25 Understating bad debts or loan losses19 Improper use of restructuring and other reserves 17 Failure to record asset impairments 5 Copyright AICPA Unauthorized copying prohibited

Specific types of Financial Statement Fraud Type of Fraud Improper accounting in connection with business combinations Specific Scheme No. of Cases Improper asset valuation8 Improper use of merger reserves8 Inappropriate application of purchase/pooling methods4 Copyright AICPA Unauthorized copying prohibited

Specific types of Financial Statement Fraud Type of Fraud Other areas of improper accounting Specific Scheme No. of Cases Inadequate disclosure in MD&A and elsewhere 43 Failure to disclose related-party transactions 23 Improper accounting for non-monetary and roundtrip transactions 19 Improper accounting for foreign payments in violation of FCPA 6 Improper use of off-balance-sheet arrangements 3 Improper use of non-GAAP financial measures 2 Copyright AICPA Unauthorized copying prohibited

Participation of Management Majority of persons held responsible for accounting violations were senior management In these enforcement matters, charges were brought against 75 Chairmen of the Board, 111 Chief Executive Officers, 111 Presidents, 105 Chief Financial Officers, 21 Chief Operating Officers, 16 Chief Accounting Officers, and 27 Vice Presidents of Finance. Copyright AICPA Unauthorized copying prohibited

Some of the cases that occurred between 1997 and 2002 included Enron, WorldCom, Adelphia, Home Store, Cendant, Qwest, Xerox, Sunbeam, and Waste Management. Many of these frauds have led to huge bankruptcies, the loss of investor confidence, and the loss of trillions of dollars in market value Copyright AICPA Unauthorized copying prohibited

Unfortunately, when a company perpetrates financial statement fraud, the market value of that company's stock usually declines much more than the amount of the fraud. Copyright AICPA Unauthorized copying prohibited

Phar-Mor: An Example of Financial Statement Fraud Background of the Phar-Mor Case: Phar-Mor’s prices were so low that competitors wondered how Phar-Mor could make a profit Phar-Mor began losing money after 5 to 6 years Mickey Monus and his team manipulated income statements to avoid reporting losses on the financial statements and to meet Wall Street expectations In order to hide cash flow problems, attract investors, and make the company look profitable, Mickey Monus and his employees altered inventory accounts to understate cost of goods sold and overstate income In addition to financial statement fraud internal investigations of the company revealed estimated embezzlement of excess of $10 million Copyright AICPA Unauthorized copying prohibited

Understated certain expenses that came in over budget and overstate those expenses that came in under budget to make operating results appear in line with budgeted results To inflate inventory accountants would credit inventory on sales, but debit—not cost of goods sold—but a “bucket” account At year end bucket accounts were emptied by allocating the balance to inventory—thereby understating cost of goods sold—and overstating income Also took exclusivity payments from vendors—recognizing all as income immediately The fraud led to the bankruptcy of the 28th largest private company in the US, causing $1 billion in losses Mickey Monus received a seven-month prison sentence for his involvement in the fraud Copyright AICPA Unauthorized copying prohibited

The fraud was discovered when a travel agent noted that Phar-Mor's checks were being used to cover World Basketball League expenses, the travel agent then showed the check to her landlord, a Phar-Mor investor. Copyright AICPA Unauthorized copying prohibited

Motivations for Financial Statement Fraud Attempt to improve the reported financial information to support a high stock price, to support a bond or stock offering, or to increase the company's stock price When top executives own considerable amounts of company stock, or stock options, a decrease in stock price would significantly decrease their own personal net worth or make the stock options worthless. As a result, top executives need to keep the stock price high and, therefore, need high income to support a high stock price. Investors place value on stocks that report increased earnings each year. Indeed, a dip in income can significantly reduce a company's stock price. Copyright AICPA Unauthorized copying prohibited

Sometimes, fraudulent financial statements result because division managers overstate their results to meet company or other expectations. Two different motivations for committing financial statement fraud. In the first case, managers were motivated to commit fraud in order to meet Wall Street's earnings forecasts, and in doing so, boost the company's stock price and subsequently the value of management's personal stock. In Phar-Mor's case, it was the fear of failure that motivated the fraud. In the end, these two reasons, greed and fear, motivate not just financial statement fraud but nearly all types of fraud. Copyright AICPA Unauthorized copying prohibited

Backdating stock options As many as 20% of all public corporations may have allowed officers and directors to illegally "backdate" personal stock options. Until 2006, if the option granting price ($15 in this case) were the same as the market price on the date the option was granted, the company was not required to report compensation expense on its income statement. However, if the options were granted at a price lower than the market share price (referred to as "in-the-money" options) on the day the options were granted, say $10 in this example, then the $5 difference between the option granting price and the market price had to be reported as compensation expense by the company and represented taxable income to the recipient. Copyright AICPA Unauthorized copying prohibited

The fraudulent stock option backdating practices involved corporations, by authority of their executives and/or boards of directors, awarding stock options to their officers and directors and dating those options to a past date in which the share price of the company's stock was unusually low. Dating the options in this manner ensured that the exercise price was set well below market, thereby nearly guaranteeing that these options would always be "in the money" when they vested and thus provided the recipients with windfall profits. Copyright AICPA Unauthorized copying prohibited