Understanding Financial Statement Fraud

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Understanding Financial Statement Fraud

• Presented by
• Jeffrey T. Harfenist, MBA

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Program Focus

• Address financial statement fraud stemming from
  irregularities not misappropriation of assets
• Discuss restatements in the recent past as well
  as the conditions necessary for fraud to flourish
• Explore methods employed to distort reported
  results
• Discuss some fraud warning signs

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Who Is Responsible?
Financial Statement Fraud
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Responsible Parties Include
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Restatements Resulting From Errors
Irregularities
133 Increase
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Errors vs. Irregularities

• Errors Involve
• Mistakes in gathering and processing data
• Incorrect use of estimates
• Certain mistakes in applying accounting principles

• Irregularities Involve
• Manipulating, altering or falsifying records
• Intentional omission of events, transactions or
  significant events
• Misapplication of accounting principles with
  intent to deceive

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How Does Fraud Occur?
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The Origins of Fraud
Pressure
The Fraud Triangle
Opportunity
Rationalization
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The Trajectory of Fraud

• Fraud starts out small
• Increases in complexity and aggressiveness
• Grows in magnitude and number of participants
• No way out

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Feeding the FraudGrowth Machine
Reported After-Tax Net Income
Defer expenses from Q2 to Q3
Defer expenses from Q3 to Q4
Accelerate revenues from Q4 to Q3
Continued manipulation leads to targets being
achieved
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Anatomy of a Fraud
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The Slippery Slope
Utilize aggressive reserves
Delay/alter expense recognition
Accelerate revenue recognition
Make unsupportable entries
Exploit acquisition reserves
Fabricate additional revenues
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Utilize Aggressive Reserves

• Bad debt reserves
• Returns allowances
• Inventory obsolescence
• Change pension assumptions
• Special charges

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The Slippery Slope
Utilize aggressive reserves
Delay/alter expense recognition
Accelerate revenue recognition
Make unsupportable entries
Exploit acquisition reserves
Fabricate additional revenues
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Delay or Alter Expense Recognition

• Fail to write down impaired assets
• Shift expenses to earlier periods
• Investment income offsets expenses
• Capitalize operating expenses

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Capitalize Operating Expenses
Reduce GA by shifting 3mm in repairs expense to
the Balance Sheet
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Capitalize Operating Expenses
Bury the 3mm of GA expense in Prepaid Assets
and PPE
Increase operating income by 3mm less annual
depreciation
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The Slippery Slope
Utilize aggressive reserves
Delay/alter expense recognition
Accelerate revenue recognition
Make unsupportable entries
Exploit acquisition reserves
Fabricate additional revenues
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Accelerate Revenue Recognition

• Channel stuffing
• Bill and hold transactions utilized
• Quarters kept open
• LT contracts accelerated
• Side agreements
• Quid pro quo

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The Slippery Slope
Utilize aggressive reserves
Delay/alter expense recognition
Accelerate revenue recognition
Make unsupportable entries
Exploit acquisition reserves
Fabricate additional revenues
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Make Unsupportable Entries

• No relationship to underlying transaction
• Book nonexistent inventory
• Fail to eliminate inter-company sales

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Failure to Eliminate Inter-Company
Sales
Sells 50mm of wood products to related party _at_
40 profit margin
Receives the materials and increases inventory by
50 mm
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Failure to Eliminate Inter-Company
Sales
Without proper elimination, Parent overstates its
net income by 20mm
20mm in gross profit buried in inventory
_at_ 40 margin, 50mm sale increases net income by
20mm
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The Slippery Slope
Utilize aggressive reserves
Delay/alter expense recognition
Accelerate revenue recognition
Make unsupportable entries
Exploit acquisition reserves
Fabricate additional revenues
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Exploit Acquisition Reserves

• Release questionable reserves into income
• Establish sham reserves
• Undervalue acquired assets

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UndervalueAcquired Assets

• XYZ Corporation purchases a target for
  250,000,000 in consideration
• Allocates the purchase as follows
• 110,000,000 to hard assets
• 40,000,000 to inventory
• 20,000,000 to IP
• 80,000,000 to goodwill

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UndervalueAcquired Assets
Undervaluing inventory artificially lowers the
Materials component of Cost of Sales
Overstates Gross Profit and ultimately Net Income
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The Slippery Slope
Utilize aggressive reserves
Delay/alter expense recognition
Accelerate revenue recognition
Make unsupportable entries
Exploit acquisition reserves
Fabricate additional revenues
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Fabricates Additional Revenues

• Create phony invoices
• Merger hold backs
• Treat borrowings as operating revenue

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Treat Borrowing as Operating Revenues
Borrowings should be reflected as Notes Payable
Improper treatment understates future obligations
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Treat Borrowing as Operating Revenues
Operating revenue is overstated by 30mm
With no related cost, 100 drops to bottom line
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Borrowing as Revenues -Effect on Cash Flow
Favorably impacts Net Income as well as CFFO
Appears that the majority of cash is being
generated internally
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Borrowing as Revenues -Effect on Cash Flow
Cash flow related to financing is misstated
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Frauds Warning Signs
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Potential Warning Signs.

• Balance Sheet
• Accounts receivable grows substantially faster
  than sales
• Aggressive revenue recognition

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Potential Warning Signs.

• Balance Sheet
• Bad debt reserves decline relative to accounts
  receivable
• Understating reserves leads to inflated operating
  income

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Potential Warning Signs.

• Balance Sheet
• Prepaid expenses grow relative to total assets
• Improperly capitalizing expenses

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Potential Warning Signs.

• Balance Sheet
• Growth in A/P substantially exceeds revenue
  growth
• Failing to pay current expenses will require
  larger cash outlays in future periods (Bonus may
  be tied to CFFO)

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Potential Warning Signs.

• Balance Sheet
• Gross PPE increase sharply relative to total
  assets
• Improperly capitalizing repairs and maintenance
  expenses

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Potential Warning Signs.

• Income Statement
• Majority of net income comes from one-time gains
• Core business may be deteriorating

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Potential Warning Signs.

• Income Statement
• Operating expenses decline sharply relative to
  sales
• Improperly capitalizing expenses or offsetting
  investment gains

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Potential Warning Signs.

• Income Statement
• Seller provides financing and/or extended payment
  terms
• Quality of earnings may be suspect

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Potential Warning Signs.

• Statement of Cash Flows
• Cash flow from operations materially lags net
  income
• Quality of earnings may be suspect

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Potential Warning Signs.

• Statement of Cash Flows
• Company fails to disclose details of cash flows
  from operations
• Attempt to hide source of cash flow problems

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Potential Warning Signs.

• Statement of Cash Flows
• Company cash flows come primarily from assets
  sales, borrowings or equity offerings
• Sign of material weakness in core business

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Potential Warning Signs.

• Footnotes, MDA, Proxy Auditors letter
• Change in accounting principles, estimates and
  classification
• Attempt to hide operating problems

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Potential Warning Signs.

• Footnotes, MDA, Proxy Auditors letter
• Change in auditor, CFO or outside counsel
• Questionable application of accounting principles

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Potential Warning Signs.

• Footnotes, MDA, Proxy Auditors letter
• Very acquisitive in recent past
• Potential for masking past poor performance and
  manipulating net income

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Where Do We Go From Here?
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Consider the Following.

• 2002 profits were 50 below 2000 levels
• 273 companies have trimmed 1st Qtr estimates...
• Healthcare and energy costs are soaring
• Pension liabilities are staggering
• Past acquisitions are proving to be disastrous
• Companies lack pricing power
• Earnings pressure has not abated
• As A Result

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Restatements Resulting From Errors
Irregularities
Continue To Increase In the Near Term
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Stripes will still be in fashion in 2003 and
beyond!
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Thank You.
For additional information, please
contact Jeffrey T. Harfenist, MBA Direct (713)
407-3964 Email jeffha_at_mfslhou.com