introduction to financial statement fraud - acc...

Introduction to Financial StatementFraud

Deloitte Financial Advisory Services LLP

September 18, 2008

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

Financial Statement Reporting


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.


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


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


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


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

Fraud Basics


Fraud Basics: Types of Fraud

Financial Fraud

Misappropriationof Assets

Corrupt BusinessPractices

FraudulentFinancialReporting


Misappropriation of Assets

Source: AICPA Journal of Accountancy (12/01) and ACFE.


Corrupt Business Practices

! Improper or unauthorized expenditures

! Self-dealings

! Violations of laws and regulations


Corruption Perception Index

Source: http://www.transparency.org/policy_research/surveys_indices/cpi/2007


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


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


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


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


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

Common Fraud Schemes

Common Fraud SchemesRevenue Recognition


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


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


Common Fraud Schemes:Revenue Recognition – Issues

! Channel Stuffing

! Side Agreements

! Backdated Agreements

! Bill & Hold Transactions

! Contingent Sales


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

Common Fraud SchemesReserve Manipulation


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


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


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”

Common Fraud SchemesImproper Expense Capitalization


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.


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


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

Common Fraud SchemesQuality of Earnings & Level of Disclosure


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


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

Foreign Corrupt Practices Act(“FCPA”)


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


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.


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.


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


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

Questions & Answers


Speaker Contact Information

! Howard ScheckPartner

Deloitte Financial Advisory Services LLP202 378 [email protected]

! Paula TookeySenior ManagerDeloitte Financial Advisory Services LLP

202 378 [email protected]

About Deloitte

Deloitte refers to one or more of Deloitte Touche Tohmatsu, a Swiss Verein, and its network of member firms, each of which is a legally separateand independent entity. Please see www.deloitte.com/about for a detailed description of the legal structure of Deloitte Touche Tohmatsu and itsmember firms. Please see www.deloitte.com/us/about for a detailed description of the legal structure of Deloitte LLP and its subsidiaries.

Copyright © 2008 Deloitte Development LLC. All rights reserved.

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