ACCOUNTING SCANDALS AND

DETECTING FINANCIAL

IRREGULARITIES

Tom Robinson, CFA

Managing Director, Americas

Tom.robinson@cfainstitutel.org

+1-434-242-7606

www.linkedin.com/in/trrphd

AGENDA

• A Short History of Accounting Scandals

• Framework for Detecting Irregularities

• Red Flags and Other Warning Signs

• Q & A

2

FINANCIAL FRAUD

Pressure or Incentive

Opportunity Rationalization

GEORGE SANTAYANA

“Those who ignore history are doomed to repeat it”

SOME HISTORIC SCANDALS

These are just a few of many

SCANDALS OVER TIME – 1920S

• Kreuger & Toll 1920s/1930s

- Swedish match conglomerate

- Fictitious assets – largely intangibles

SCANDALS OVER TIME – 1930S

• McKesson & Robins – Late 1930s

- Musica Brothers/Foreign Crude Drug Business

- Fictitious Sales, Receivables and Inventory

- déjà vu – McKesson HBOC late 1990s

SCANDALS OVER TIME - 1960S

• National Student Marketing 1960s

- Campus marketing program with a P/E of 100

- Overstated sales and receivables

SCANDALS OVER TIME - 1970S

• Equity Funding 1970s

- Mutual Funds/Insurance

- Fictitious life insurance of $2 billion out of $3 billion sold

- Department 99

SCANDALS OVER TIME – 1970 &1980S

• ESM securities. Founded 1975 with $75,000 in South Florida

• U.S. Government Securities Dealer - Repurchase Agreements

- Sale To customer with simultaneous agreement to repurchase as a specified price

- Reverse Repurchase Agreements

- Purchased from customer

• Unfortunately was also speculating on margin.

• Engaged in elaborate scheme to hide losses in related companies by entering into offsetting transactions with related company.

• Eventually fell apart causing the failure of Ohio S&Ls and losses in the hundreds of millions for many other S&Ls and municipalities.

SCANDALS OVER TIME – 1980S

• Crazy Eddie, Inc. 1980s

- Electronics retailer

- Overstated sales, receivables and inventory

- What is wrong with this picture:

- Year Days Inventory

- 1984 79.68

- 1985 93.68

- 1986 112.42

- 1987 146.23

SCANDALS OVER TIME – 1980S

• Miniscribe 1985 to1986

• “Q.T. Wiles”

- Sales + 62.23%

- Receivables + 147.94%

- Inventory + 100.49%

- Gross Margin

- 1985: 6.46%

- 1986: 28.87%

SCANDALS OVER TIME – 1990S

Sunbeam

“Chainsaw Al Dunlap”

1996 1997

Sales -3.21% +18.69%

Inventory -22.41% +57.89%

Receivables -1.28% +38.47%

SCANDALS OVER TIME – 1990S

• Sunbeam

- The Company recognizes revenues from product sales principally at the time of shipment to customers. In limited circumstances, at the customers request the Company may sell seasonal product on a bill and hold basis provided that the goods are completed, packaged and ready for shipment, such goods are segregated and the risks of ownership and legal title have passed to the customer.

- …During 1997, the Company initiated early buy programs for highly seasonal products such as grills and warming blankets in order to more levelize production and distribution activities.

SUNBEAM

(250,000)

(200,000)

(150,000)

(100,000)

(50,000)

0

50,000

100,000

150,000

1996 1997

Net Income(thousands)

Operating CashFlow (thousands)

SCANDALS OVER TIME – 2000S

• Allou Health and Beauty

• Enron

- Special Purpose Entities

- Mark to Market Accounting

• Adelphia

- “Looting”

• Parmalat

- Off-balance sheet debt/Overstated cash

• Tyco

- Improper loans/forgiveness/spending

ALLOU HEALTH AND BEAUTY

(35,000,000)

(30,000,000)

(25,000,000)

(20,000,000)

(15,000,000)

(10,000,000)

(5,000,000)

0

5,000,000

10,000,000

2000 2001 2002

Net Income

Operating CashFlow

ENRON’S 2000 FORM 10K

• In 2000 and 1999, Enron entered into transactions with limited partnerships (the Related Party) whose general partner's managing member is a senior officer of Enron.

• In 2000, Enron entered into transactions with the Related Party to hedge certain merchant investments and other assets. …Enron contributed to newly-formed entities (the Entities) assets valued at approximately $1.2 billion…

• In 2000, Enron entered into derivative transactions with the Entities with a combined notional amount of approximately $2.1 billion to hedge certain merchant investments and other assets…

ENRON

- ENRON VICE CHAIRMAN CLIFF BAXTER RESIGNS

- FOR IMMEDIATE RELEASE: Wednesday, May 2, 2001 HOUSTON -- Enron Corp. announced today that Vice Chairman J. Clifford Baxter is resigning from the company

- ENRON ANNOUNCES SKILLING RESIGNATION; LAY ASSUMES PRESIDENT AND CEO DUTIES

- FOR IMMEDIATE RELEASE: Tuesday, August 14, 2001 HOUSTON -- Enron announced today that its Board of Directors has accepted the resignation of Jeffrey K. Skilling as Enron’s President and CEO. Skilling will continue to serve as a consultant to Enron and its Board of Directors. Kenneth L. Lay, currently Enron’s chairman of the board, will assume the additional responsibilities of president and CEO and has agreed to extend his employment agreement with the company through the end of 2005.

FINANCIAL STATEMENTS

Balance Sheet

Income Statement

Statement of Cash Flows

Statement of Owners’ Equity

Footnotes/Management Discussion

FRAMEWORK: THE ACCOUNTING EQUATION

21

FRAMEWORK: THE ARTICULATION

OF FINANCIAL STATEMENTS Beginning Balance Sheet

Assets = Liabilities + Owners' Equity

Cash Accounts

Receivable Inventory

Investment

Seccurities

Property

(Net) Other

Short

Term

Long

Term

Contributed

Capital

Retained

Earnings

Other

Comprehensive

Income

+/- Net

Cash

Flow

+/- Net

Contributions +Earnings +/-Other

-Dividends

Ending Balance Sheet

Assets = Liabilities + Owners' Equity

Income Statement

Revenues - Expenses + Gains - Losses = Earnings

Cash Flow Statement

+/-

Cash Flows From

Operating Activities

+/-

Cash Flows From

Investing Activities

+/-

Cash Flows From

Financing Activities

= Net Cash Flow

FRAMEWORK: ARTICULATION EXAMPLE

• Provisions of services in exchange for cash

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FRAMEWORK: CHECKS AND BALANCES

Spending $10,000 of Cash for an expense

impacts net income and hence the balance

sheet through owner’s equity

FRAMEWORK: CHECKS AND BALANCES

Spending $10,000 of Cash for an asset does not impact net

income, but does impact the balance sheet

WORLDCOM

• June 2002

• Audit committee reports improper booking of $3.85 billion of expenses

• “Line costs” were capitalized as Property, Plant and Equipment rather than expensed. Also classified as an investing cash outflow rather than operating.

• “The principal components of line costs are access charges and transport charges.“

WORLDCOM

(2,000)

(1,000)

0

1,000

2,000

3,000

4,000

5,000

6,000

7,000

8,000

9,000

1995 1997 1999 2001

OperatingIncome (millions)

WORLDCOM

0.00%

10.00%

20.00%

30.00%

40.00%

50.00%

60.00%

1995 1997 1999 2001

Line Costs as aPercent of Sales

WORLDCOM

0.00%

5.00%

10.00%

15.00%

20.00%

25.00%

30.00%

35.00%

40.00%

45.00%

50.00%

1995 1997 1999 2001

PP&E as a Percent

of Assets

WORLDCOM

(4,000)

(2,000)

0

2,000

4,000

6,000

8,000

10,000

1995 1997 1999 2001

OperatingIncome (millions)

Free Cash Flow(Millions)

WORLDCOM 10K RESTATEMENTS

• Cumulative reduction in equity of $70.8 billion

• 2001 NI reduced $17.1 billion

• 2000 NI reduced $53.1 billion

• Line costs adjustment about $2 billion in 2000 and $3 billion in 2001

TYPICAL IRREGULARITIES

Overstating Earnings Overstating Financial

Position

Overstating Operating Cash Flows

Corporate Governance/Related Party/Auditor Issues

Use of Reserves/Provisions Impacting Multiple Financial

Statements and Years

OVERSTATING EARNINGS

Aggressive revenue recognition (too soon)

Deferral of expenses

Classification of non-operating income or non-

recurring income as revenue

Classification of operating expenses as non-

operating or “special”

AGGRESSIVE REVENUE

RECOGNITION/DEFERRAL OF EXPENSES

35

IN BOTH CASES

36

REVENUE/GAIN CLASSIFICATION

37

SATYAM COMPUTER SERVICES LIMITED

Millions of USD FYE March 2008 FYE March 2007 Change

Revenue 2,138.1 1461.4 +46%

Trade Receivables –

Short Term (Asset) 598.8 396.1 +51%

Trade Receivables –

Long Term (Asset) 38.2 21.2 +80%

Unbilled Revenue (Asset) 81.5 38.6 +111%

Investments in Bank

Deposits (Asset) 894.8 782.7 +14%

Total of these assets 1,613.3 1,238.6 +374.70 USD

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SINO-FOREST

• Creative way to deal with the increase in accounts receivable resulting from

fraudulent timber sales (among other fraudulent activities).

• Sino-Forest created other companies that it effectively controlled and engaged

in fraudulent purchase and sales of timber.

• In this manner, both accounts receivable and accounts payable (a liability for

amounts due to alleged suppliers for timber purchases) would have been

overstated.

• Sino-Forest engaged in an additional scheme to offset the receivables and

payables between the controlled “customers” and “suppliers.”

• Of course, the offset was not perfect since the sales prices exceeded the

purchase prices and more and more purchases and sales had to be recorded

to keep the scheme going.

• Overall Impact

- ↑A/R, ↑Equity + ↑Inventory,↑ A/P + ↓A/R,↓A/P = ↑Inventory, ↑Equity

39

SINO-FOREST

40

US$ m 2010 2009 2008 2007

Revenues 1,924 1,238 901 714

Net Income 395 286 229 152

Cashflow From Operations Before Δ in Working Capital 1,174 826 542 456

Δ in Accounts Receivable (346) (59) (111) 24

Δ in Other Working Capital 12 17 53 7

Net Cashflow From Operations 840 784 483 486

Additions to Timber Holdings (1,359) (1,032) (657) (640)

Other Investing Expenditure (43) (36) (47) (52)

Cashflow Before Financing (562) (285) (221) (206)

RED FLAGS/WARNING SIGNS –

OVERSTATING EARNINGS • Examine revenue recognition policy in footnotes relative to peers

• Are customer receivables growing faster then revenues?

• Is operating cash flow significantly lower than accounting earnings?

• Did significant revenues occur late in the year?

Aggressive revenue recognition (too soon)

• Were “gains” included in revenue?

• Is the company’s operating description appropriate?

• Were one-time or non-recurring items included in revenue?

• Were any gains or revenue based on re-valuation of assets?

Classification of non-operating income or non-

recurring income as revenue

• Are depreciation/amortization periods longer then peer companies?

• Are there any deferred expenses listed as an asset on the balance sheet (other than deferred taxes)?

• Are there any unusual assets or unexplained large increases in assets such as inventory, particularly relative to revenues?

Deferral of expenses

• Were any expenses or losses listed as “special,” extraordinary, or non-recurring at the bottom of the income statement?

• Are there unusually high margins relative to peers (also applies to deferral of expenses)?

Classification of operating expenses as non-

operating or “special”

OVERSTATING FINANCIAL POSITION

Exclusion of Assets and Liabilities

(Unconsolidated Entities/Joint Ventures)

Off Balance Sheet Liabilities/Financing

Overstating Assets

OVERSTATING FINANCIAL POSITION

43

OVERSTATING FINANCIAL POSITION

Assets HKD 10,000,000

Liabilities HKD 8,000,000

Owners’ Equity HKD 2,000,000

Net Earnings HKD 500,000

• Common ratios used by analysts are liabilities to assets and return on assets

(net earnings/total assets). For this company, liabilities to assets are 0.80 or

80%, and return on assets is 0.05 or 5%. If this company were able to remove

HKD 5,000,000 of assets and liabilities from its balance sheet by accounting

magic, they would achieve liabilities to assets of 0.60 or 60% and return on

assets of 0.10 or 10%. They now look less risky (lower level of debt) and more

profitable (higher return on assets).

44

OLYMPUS CORPORATION

• Olympus Corporation: Japan-based manufacturer of precision machinery and instruments founded in 1919

• Loss of slightly less than JY 100 billion in 1990

• Olympus kept the loss off of its own books by transferring financial assets that had declined in value to a series of companies that were not consolidated into Olympus’ balance sheet

- Assets transferred at accounting book cost rather than their fair market value

- The funds used by these other entities came from bank borrowing arranged by Olympus

- Olympus therefore did not report any gain or loss on the sale

• Accounting rules changed to require consolidation

• Olympus engineered a plan to purchase these entities at a price much greater than their value (due to the embedded loss in those entities)

• Olympus recorded the excess of the purchase price over the fair value as goodwill

• As with most such games, it came to an end when Olympus had to finally recognize a loss, but they initially did so by calling it an impairment loss related to the numerous acquisitions

45

BRE-X

• Canadian company with gold mine in Busang, Indonesia

• A “penny” stock whose price soared to C$286 per share after announcing significant reserves of gold (70,000,000 troy ounces)

• Collapsed after it was discovered that the gold did not exist

• While Bre-X was an outright fraud, other examples are companies that are aggressive in their reserve estimates. An example is Shell oil who ended up slashing their proven oil reserve estimates by 20% after they were questioned by regulators about reserves they were claiming that were not claimed by other oil companies who partnered in the same projects

- For example (one small part of the 20%): Barrow Island off the west coast of Australia where reserves might not have been accessible due to the nature of a protected area. Exxon and Chevron were also partners in this project but were conservative in not counting these reserves at the time (early 2000s). [More recently the companies have received approval to develop these reserves.]

46

RED FLAGS/WARNING SIGNS –

OVERSTATING FINANCIAL POSITION

• Scrutinize the footnotes for off balance sheet borrowing or guarantees

• Does the company utilize operating leases more than peers?

Off Balance Sheet Financing

• Scrutinize the footnotes for use of the equity method of accounting (versus consolidation)

Unconsolidated Special Purpose

Entities/Joint Ventures

• Does the company have unusual increases in intangible assets?

• Does the company have assets which are subject to significant estimates and assumptions? (e.g., reserves, securities without market values)

Intangible Assets/Valuation of

Assets

USE OF RESERVES, PROVISIONS,

ACCRUALS, AND DEFERRALS

Revenue Expense

Cash flows occur

later than

reflected in

earnings

Asset

Accounts Receivable

Liability

Accrued Expenses

Deferred Tax Liability

Contingencies

Contra Asset

Allowance for Doubtful

Accounts

Cash flows occur

before reflected in

earnings

Liability

Unearned Revenue

Deferred Revenue

Asset

Property and Equipment

Prepaid Expense

Deferred Tax Asset

Deferred Expenses

USE OF RESERVES, PROVISIONS, ACCRUALS,

AND DEFERRALS

• “Dell’s SEC settlement: Taking Away Dell’s Cookie Jar”, the Economist online,

July 23, 2010: Exclusivity payments from Intel that were drawn upon to boost

income when needed

• “The EU Smiled While Spain’s Banks Cooked the Books,” Bloomberg, June 14,

2012: ‘Dynamic provisioning’ rainy day reserves set up in prior years masked

onset of crisis

• “A Dip into JP Morgan’s Cookie-Jar Quarter,” the Wall Street Journal, July 16,

2012: Releasing $2.1 billion in loan loss reserves

49

USE OF RESERVES, PROVISIONS, ACCRUALS,

AND DEFERRALS: WARNING SIGNS

50

Unusual fluctuations in typical “reserve” accounts

• Allowance for doubtful accounts, credit losses, etc.

• Prepaid expenses

• Unearned revenues

• Deferred assets or liabilities

• Contingencies

OVERSTATING OPERATING CASH FLOWS

Expenditures improperly classified

as capital expenditures

Borrowing transactions treated as operating cash

inflow

Acceleration of cash received for revenues

or deferral of cash paid for expenses

SINO-FOREST

52

US$ m 2010 2009 2008 2007

Revenues 1,924 1,238 901 714

Net Income 395 286 229 152

Cashflow From Operations Before Δ in Working Capital 1,174 826 542 456

Δ in Accounts Receivable (346) (59) (111) 24

Δ in Other Working Capital 12 17 53 7

Net Cashflow From Operations 840 784 483 486

Additions to Timber Holdings (1,359) (1,032) (657) (640)

Other Investing Expenditure (43) (36) (47) (52)

Cashflow Before Financing (562) (285) (221) (206)

OVERSTATING OPERATING CASH

FLOWS: WARNING SIGNS

• Are there abnormal increases in long-term assets?

• Are there unusual assets?

• Any abnormal changes in capital expenditures?

Expenditures improperly classified

as capital expenditures

• Are there contingent or other off balance sheet liabilities disclosed (or not disclosed)?

• Look for reciprocal or repurchase agreements/insurance type contracts

• Is there any revenue from an unusual type customer (financial services firm)?

Borrowing transactions treated as operating cash

inflow

• Look for factoring, sales of receivables, or other transactions to bring cash flow in early

• See if the company is delaying payments to suppliers and others, such as an increase in accounts payable

Acceleration of cash received for revenues

or deferral of cash paid for expenses

CORPORATE GOVERNANCE/RELATED

PARTY/AUDITOR ISSUES

Related party transactions

Insufficient external representation on board

Management use of excessive compensation, perks, or disproportionate

expenditures

Auditors

CORPORATE GOVERNANCE/RELATED

PARTY/AUDITOR ISSUES: WARNING SIGNS •Business transactions between company and management (sales/leasing)

•Family members involved in company or other companies that the subject company does business with

•Are there significant loans to management or affiliated companies either from the company or related entities?

Related party transactions

• Examine board membership for external members

• Examine possible interlocking directors

Insufficient external representation on board

• Disclosures of compensation or perks in excess of those in similar companies

• Excessive use of stock-based compensation/options

Management use of excessive compensation, perks, or disproportionate

expenditures

• Resignation of

• Frequent changes in

• Disagreements with Auditors

SINAR MAS GROUP/BANK INTERNASIONAL

INDONESIA

• Sinar Mas Group – a conglomerate of businesses owned primarily be a single

family but with publicly traded affiliates such as Asia Pulp & Paper.

• Bank Internasional Indonesia – bank owned 89% by the same family.

• When bank failed in 1999 and was taken over by Indonesian government it

was found that 52% of the bank’s loans were to subsidiaries of Sinar Mas

Group.

56