Business Financial Crime: Financial Statement Fraud

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Business Financial Crime Financial Statement
Fraud
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Learning Outcomes

• Appreciate financial statement fraud stemming
  from irregularities not misappropriation of
  assets
• Understand main rationale for such fraud activity
  in the recent past, as well as the conditions
  necessary for such fraud to flourish
• Describe some of the main methods employed to
  distort reported results
• Appreciate some fraud warning signs

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Enron (2002)

• Admits that for over 3 years its net income was
  inflated by almost 600,000,000.
• May have overstated assets by 24,000,000,000
  according to company executives
• Engaged in energy swaps to overstate revenues

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Reliant Resources Inc. 2002

• Conducted fake transactions with four power
  companies, inflated revenue by 10 over 3-year
  period.
• Dynegy also indicated that it conducted similar
  transactions.

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WorldCom Inc., 2002

• Reports corrected income to reflect Unspecified
  Net Loss
• Original expenses of 41.8 billion were corrected
  to be above 43.3 billion.
• By August of 2002, found 7.1 billion in expenses
  and irregularities.

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Xerox Corporation, 2002

• 6.5 billion recorded as equipment sales revenue
  in 1997 through 2000 should have been 5.1
  billion in service, rental, and financing from
  1997-2001.

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IBM 2002

• Used a 290 million gain from sale of business 3
  days prior to end of 4th Qtr of 2001 to help beat
  Wall Streets profit forecast (Business Week, May
  6, 2002)
• This one-time, undisclosed gain was used to lower
  operating costs.

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Gillette (2003), James Kilts, CEO

• I asked why we made these big deals at the end
  of the quarter.
• Its you guys in Boston. You guys made us do
  it.
• The circle of doom
• Over-optimistic forecasts high goals
• Build inventory, overhead, new capital
• Miss targets, cut prices, cut advertising, give
  incentives to distributors/retailers

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The Issue Perpetrated by Management

• Different companies, different industries,
  different issues, different casts of characters
• The major cases all have two things in common
• ALL INVOLVE MANAGEMENT OVERRIDE OF AN OTHERWISE
  EFFECTIVE SYSTEM OF INTERNAL CONTROL
• THE BOARD OF DIRECTORS AND AUDIT COMMITTEES DID
  NOT DETECT THE OVERRIDE

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What is Earnings Management?

• Healy and Whalen (1999)
• Earnings management occurs when managers use
  judgment in financial reporting and in
  structuring transactions to alter financial
  reports to either mislead some stakeholders about
  the underlying economic performance of the
  company or to influence contractual outcomes that
  depend on reported accounting numbers.

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Incentives for Earnings Management

• Increase the firm's share price, particularly
  when the stock is about to be issued or used in a
  transaction.
• Decrease the firm's share price prior to a
  management buyout.
• Meet analyst or management earnings forecast.
• Increase managers' compensation that is tied to
  earnings performance.
• Avoid violating debt covenants.
• Reduce taxes by shifting income to lower tax rate
  years.

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Matching Earnings Estimates

• compute sales and subtract expenses to calculate
  the profit OR
• start with the profit that investors are
  expecting and manipulate sales and expenses to
  make sure the numbers come out right.

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Restatements in the USA in 2004Post Sarbanes
Oxley

• 253 of the restatements were associated with the
  audited financial statements
• 23 increase over 2003
• Revenue recognition reserves and contingencies
  were the leading cause of restatements

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Errors v 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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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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The Slippery Slope

• Utilize aggressive reserves
• Delay/alter expense recognition
• Manipulate revenue recognition
• Make unsupportable entries
• Exploit acquisition reserves
• Fabricate additional revenues

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Utilise Aggressive Reserves

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

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The Slippery Slope

• Utilize aggressive reserves
• Delay/alter expense recognition
• Manipulate 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
• Investment income offsets expenses
• Shift expenses to earlier periods
• Research and Development in related companies
• Capitalize operating expenses

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The Slippery Slope

• Utilize aggressive reserves
• Delay/alter expense recognition
• Manipulate revenue recognition
• Make unsupportable entries
• Exploit acquisition reserves
• Fabricate additional revenues

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Manipulate Revenue Recognition

• Channel stuffing
• A deceptive business practice used by a company
  to inflate its sales and earnings figures by
  deliberately sending retailers along its
  distribution channel more products than they are
  able to sell to the public.
• Side Agreements
• Quid pro quo
• Long term contracts accelerated

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The Slippery Slope

• Utilize aggressive reserves
• Delay/alter expense recognition
• Manipulate revenue recognition
• Make unsupportable entries
• Exploit acquisition reserves
• Fabricate additional revenues

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Creative Accounting

• No relationship to underlying transaction
• Book nonexistent inventory
• Fail to eliminate inter-company sales
• Abusing structured finance transactions

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Abusing Structured Finance Transactions

• THE PROBLEM
• The gap between reported operating income and
  operating cash flows is substantial.
• The Company needs to raise substantial amounts of
  cash, but is reluctant to issue additional
  equity.
• Issuing additional debt will likely negatively
  impact the opinions of rating agencies.
• A substantial portion of The Companys business
  is dependent upon the strength of its credit
  rating.

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Solution? A prepaid transaction
300M paid to SPE by Bank for forward contract
300M paid to Enron by SPE for forward contract
SPE
Forward contract to deliver 390,000 barrels of
oil over 46 months March 99 to Dec 02
Forward contract to deliver 390,000 barrels of
oil over 46 months March 99 to Dec 02
Bank
Enron
Bank pays Enron a floating price on the oil
Enron makes 46 monthly payments of 7.5m to bank
totalling 345m
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Accounting and Reporting Issues

• The substance of the transaction (a loan) was
  ignored it was accounted for based upon its
  form.
• Because of its characterization as trading"
  activity
• The balance sheet reported this obligation as a
  type of liability as opposed to debt.
• Additionally, reported as cash flow from
  operations as opposed to financing cash flows.

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Specifics of Transaction

• As a result of the Financial Engineering
• Total debt is materially understated.
• Several key measures are favorably impacted,
  including (1) funds flow interest coverage, (2)
  funds flow to total debt, and (3) debt to equity.
• Cash flow from operations is materially
  overstated, lessening the overall gap with
  operating income.
• Financing cash flows are materially understated.
• Enrons credit rating remains unchanged.

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The Slippery Slope

• Utilize aggressive reserves
• Delay/alter expense recognition
• Manipulate revenue recognition
• Make unsupportable entries
• Exploit acquisition reserves
• Fabricate additional revenues

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Exploit Acquisitions Reserves

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

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Establish Sham Reserves

• Purchaser acquires in-progress contracts with
  estimated profit margin of 18
• Further analysis reveals
• Future Contract Revenues 25,350,000
• Future Contract Expenses 23,875,000
• Contract Profit 1,475,000
• Estimated Return 5.82

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Establish Sham Reserves The Big Bath Effect

• ?Establish 30,000,000 reserve associated with
  future terminations
• ?Establish 16,000,000 reserve associated with
  future plant closings
• ? Establish 4,000,000 reserve associated with
  environmental remediation

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Establish Sham Reserves

• As 4,000,000 in future contract expenses get
  paid
• Cost of Goods Sold 4,000,000 CR PL
• Acquisition Reserve 4,000,000 DR B/S

Overstates Gross Profit, Operating Income
and Cash Flow From Operations
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Undervalue Acquired Assets

• XYZ PLC 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 Undervalued by 20m
• 20,000,000 to IP
• 80,000,000 to goodwill Overvalued by 20m

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Undervalue Acquired Assets
Undervaluing inventory artificially lowers the
Materials component of Cost of
Sales Overstates Gross Profit, Operating
Income and Cash Flow From Operations
XYZ PLC P L 31/12/06 Gross Operating Revenues 131,572,030 100.0
Cost of Sales
Materials 32,894,570 25.0
Outside Services 12,118,926 9.2
Supplies 4,020,900 3.1
Wages 21,334,230 16.2
Total Cost of Sales 70,368,626 53.5
Gross Profit 61,203,404 46.5

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The Slippery Slope

• Utilize aggressive reserves
• Delay/alter expense recognition
• Manipulate revenue recognition
• Make unsupportable entries
• Exploit acquisition reserves
• Fabricate additional revenues

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Fabricate Additional Revenues

• Create phony sales invoices
• Merger hold backs
• Treat borrowings as operating revenue
• Operating income overstated
• Falls through to profit
• Liabilities understated
• Favourable impact on operating cash flow and
  financing cash flows

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Potential Warning Signs

• Balance Sheet
• Trade debtors/Accounts receivable grows
  substantially faster than sales
• ? Aggressive revenue recognition

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Potential Warning Signs

• Balance Sheet
• Growth in Trade Creditors/Accounts Payable
  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

• Income Statement
• Majority of net income comes from onetime 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 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

• Notes, Directors report, Auditors letter
• Change in accounting principles, estimates and
  classification
• ? Attempt to hide operating problems

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Potential Warning Signs

• Notes, Directors report, Auditors letter
• Very acquisitive in recent past
• ? Potential for masking past poor performance and
  manipulating net income

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Other Warning Signs

• Reported NI grows faster than CFFO.
• Sales slow while inventories pile up.
• Bad debt reserves cut.
• Methods for calculating revenue costs
  change.
• Sales are booked before payments received.
• Dramatic change in gross margin.
• Turnover of auditor, key execs or lawyers.

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EXECUTIVE COMPENSATION AND CORPORATE FRAUD

• Executives at fraud firms face greater financial
  incentives to commit fraud than do executives at
  industry- and size-matched control firms.
• The likelihood of fraud is positively related to
  incentives from unrestricted stock holdings
• Executives at fraud firms exercise larger
  fractions of their vested options, sell more
  stock, and receive greater total compensation
  during the fraud years than the control
  executives.

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EXECUTIVE COMPENSATION AND CORPORATE FRAUD

• Operating performance measures suggest executives
  commit corporate fraud following declines in
  performance.
• Stock prices fall approximately twenty percent on
  average upon the disclosure of potential fraud,
  which suggests that frauds inflated stock prices
  during the fraud period.
• The results imply that optimal governance
  measures depend on the strength of executives
  financial incentives, especially following
  periods of poor performance, and that
  restrictions on an executives ability to sell
  shares could deter fraud.

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Will it happen again?

• Major costs such as oil costs are rising
• Companies lack substantial pricing power
• Pension liabilities are a big unknown
• Overpayment for past acquisitions
• Expensing of share options
• Earnings pressure has not abated
• As A Result

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Stripes will still be in fashion in 2007 and
beyond!
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References

• AICPA (2006) Fraud Can Audit Committees Make a
  Difference?, www.aicpa.org/audcommctr/spotlight/ac
  hilles_heel.htm, retrieved 12 Nov 2007.
• Erickson, M., Hanlon, M. and Maydew, E. (2004) Is
  There a Link Between Executive Compensation and
  Accounting Fraud?, working paper, www.ssrn.com,
  retrieved 14 Nov 2007
• Harfenist, J.T. (2002) Understanding Financial
  Statement Fraud, www.theiia.org/chapters/index.cfm
  /view.public_file/cid/112/fileid/7357, retrieved
  12 Nov 2007.
• Johnson, S.A., Ryan, H.E. and Tian, Y.S. (2005)
  Executive Compensation and Corporate Fraud,
  working paper, www.ssrn.com, retrieved 13 Nov
  2007.
• Shane, P. (2000) Earnings Management and Market
  Anomalies, Burridge Conference,
  leeds.colorado.edu/.../Burridge_Center_for_Securit
  ies_Analysis_and_Valuation/Forums/burridge-shane.p
  df, retrieved 12 Nov 2007