Avant-OCTN-MA Q of E Diligence and Fraud Discussion Items 052615JD

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Quality of Earnings Diligence, Forensic Accounting & Fraud Issues

FOREWARNED IS FOREARMED

James F Davidson, CPA/CFF, CFE, CFS, CGMA, CM&AA, CBA, CIRA, CTP

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Lessons from True Stories

• Misleading Financials - Loss of Value – Millions!

• True Stories / Actual Experience

$40 million investment Gone – Consumer products (private; California)

$600 million Bankrupt – Plastics manufacturer (public; Pennsylvania)

$300 million Distressed – Consumer products (international private; Utah)

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• True Stories/Actual Experience

$60 million Distressed – Industrial products manufacturer (private; South Carolina)

$100 million Bankrupt – Restaurant chain (private; Oklahoma)

$100 million Defunct; Principals Imprisoned–Design / Office services; furniture distribution(private; New York)

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$50 million Distressed – Software/E-Commerce (private; Colorado)

$100 million Bankrupt – Electronics manufacturer (private/public; California/China)

$150 million Bankrupt – Construction (private; Florida)

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$150 million Bankrupt – Medical devices; consumer products (private; Toronto)

$150 million Distressed – food service; consumer products (private; Hawaii)

$300 million Uncertain– E-retailing; consumer products; (private; California; China)

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Lessons from True Stories• Misleading Financials –Related Topics – Takeaways

• What, How, and Why?

• Poor Financial Diligence and / or

• Weak Quality of Earnings Ignored

• External audits detected only 3% of frauds

• Ranked poorly in limiting fraud losses

• External audits have preventive effect

• Usefulness for uncovering fraud is limited

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Quality of Earnings• Confusing to many even sophisticated investors

• Many believe CPA audit sufficient, but different focus

• Focus on EBITDA alone leaves underestimated risks and limitations

• Not true cash flow • Ignores capital expenditures, working capital requirements,

current debt payments, and taxes• Surrogate for operating cash (not investing/financing)• No GAAP definition increases manipulation risk

• Pending investor requests:• 13 Week Rolling Cash Flow• TTM and listing of assets/liabilities

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Quality of Earnings

• Objectives

• Determine Normalized / Recurring EBITDA• Assess and validate EBITDA adjustments• Determining true “one-off” requires judgment

• Firstly, ensure EBITDA based on GAAP• Quality of Assets focus, e.g., valuations and reserves

• Inventory and receivables are most problematic• Affects both sales and gross profit• Changes in reserves/assumptions?

• All liabilities included? (affect working capital and expenses)• Foreign exchange effects included• Stock/option/compensation included• Management fees included

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Quality of Earnings• Objectives

• Secondly, evaluate seller proposed adjustments• Scrutiny of underlying documentation mandatory• Objectively determine in context of the business• Ensure truly nonrecurring/extraordinary?• Don’t confuse GAAP with other add-backs

• Next, apply diligence adjustments, e.g., items not identified by seller/management, e.g., corporate allocations/carve-out issues, etc.• Deferral of discretionary expenses, e.g., R&M, R&D, marketing• Standalone before pro forma synergies• Operating lease versus capital or rent versus owned

• Finally, assess nonfinancial items• Quality of Management • “Stickiness” of customers• Commodity and supplier risk

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Key Topics

Focus – Poor Diligence and/or Portfolio Monitoring

Fraud Schemes

• Asset Misappropriation

• Corruption

• Financial Statement Manipulation

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• Taking something through deception or concealment (intentional)

• Fraud often indistinguishable from incompetence or mismanagement but same result

• Occupational frauds are in connection with fraudster’s occupation (i.e., employment)

• http://www.acfe.com/fhc.aspx?Site=ACFEWEB – Costs of Fraud

Fraud Overview

http://www.acfe.com/fhc.aspx?Site=ACFEWEB

OCCUPATIONAL FRAUD SCHEMES

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“Fraud Tree” Classification System

What Conditions Create Opportunity?

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Opportunity

• Tone at the Top (Senior Management, Board, culture, ethics, etc.) http://view.vzaar.com/929183/player (ACFE / AICPA)

http://www.acfe.com/content.aspx?id=4294975036&terms=(video)+

• Weak internal controls (segregation of duties, supervision)

• Poor record keeping

• Extreme trust

• Lack of action for previous frauds

http://view.vzaar.com/929183/player

http://www.acfe.com/content.aspx?id=4294975036&terms=(video)+

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FINANCIAL STATEMENT MANIPULATION

• Revenue Overstatement

Most common misstatement

Fictitious

Timing

Improper cutoff

Bill and hold

Intercompany & related party

Channel stuffing

Unissued credits

Conditional and consignment

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• Inventory Overstatement

Second most common misstatement

Capitalized SG&A Expenses

Capitalized variances in WIP, top-side

Applied overhead is larger than actual

Capitalized “idle capacity” i.e., excess overhead

Obsolescence not recognized / understated

Inventory turnover by SKU not provided

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• Asset (EBITDA) Overstatements

Capitalized repair & maintenance expenses

Non-removal of replacements

Judgments warrant special scrutiny

Concerns with EBITDA

Supplement or replace with ROA, RONA, ROTA, etc.

Impairments deferred

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• Liability / Expense Understatements and EBITDA Overstatements

Under-valued liabilities

Invoices (liabilities/expenses) not recorded

General accruals overlooked

Sales returns /credits (contra) understated

Trade debt renegotiated as long term debt

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Red Flags & Warning Signs(Don’t ignore them!)

• Incomplete Reporting

Erratic, incomplete, late, financial information (classic)

Unreconciled accounts, especially cash/bank

Topside entries not pushed down to individual companies

Acquisitions preventing comparable period analysis

Numerous / excessive adjustments

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• Incomplete Reporting (continued)

• Historic financial information not reproduced from information systems

• Excessive number of manual checks

• Continuous adjustments to inventory

• Weak, tenuous, inconsistent explanations

• No audit or downgraded CPA involvement

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• Questionable Accounting Involvement

Management, particularly CEO, override of controls

Tight management control or involvement by principals

Heavy accounting staff turnover

Different audit firms for related companies

CFO not involved or distances from reported numbers

Accounting personnel work in “silos” and absolveresponsibility beyond narrow sphere

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• Ineffective Corporate Governance

Minimal board oversight; or

Excessive board involvement or micromanagement

No outside /independent directors (separation of duties)

Undocumented or poorly drafted policies and procedures

Frequent / unusual related party transactions and/or complex legal structure

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• Performance Too Good to Be True

• Rapid growth beyond reasonable expectations

• Company not materially impacted by external forces • Recession• Supply limitations• Infrastructure constraints

• Company outperforms competitors, industry, etc. without clearly delineated reason

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• Unavailable or Missing Records

Lack of timely documentation

Documentation subject to frequent “revisions”

“Those documents were destroyed / lost” e.g., system conversion lost traces of data

Failure to maintain original documents, e.g., shippers / receivers, etc.

Customers, vendors, lenders express concerns about information (e.g., excessive credits/adjustments)

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• Principal Domination or Excessive Management Control

Restrictive control of information by key management

Information filtered or “reviewed” before release

Individuals “walled-off” or unwilling to speak freely in presence of key individuals

Employees provided titles without actual responsibility

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• Audit Delays

Company delays or skips collateral or financial audits

Repeated excuses or confusing explanations

Fails to provide requested information

Hinders audit process

Limits time frame for audit or diligence

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Red Flags & Warning Signs

(Don’t ignore them!)

• Site Inspection Inconsistent with Performance

Minimal Level of activity

Key personnel are not present

Amounts, volume, types of inventory

Information not readily available

Operational indicators inconsistent with reported sales or financial information

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• “Twitchy” Non Executives and Gossip

Comments that don’t add up or make sense

Worries and concerns

Staff whispers and rumors that “not is all right”

Information not readily available

Confidentially shared information among lower level or operationally oriented employees

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• Overdrafts and Other Signs of Liquidity Issues

Particular concern when “apparent” good performance

Borrower has repeated overdrafts

Borrowing base over-advances

Repeated late payments

Trade creditor “overstretching” and complaints

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Red Flags & Warning Signs

• Be Wary of Emotion, Time, and Costs Invested

• More Costly Later?

• Case Study - XT?

“Death by a Thousand Cuts”

Lack of transparency and cash Flows

Inability to reconcile reported revenues to cash

No clarity of cash flows by company

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XT Red Flags and Risk Factors

Incomplete Reporting

Topside journal entries (not pushed down to individual company ledgers)

Historic financial information could not be accurately reproduced from the information systems

Disparate information systems

Acquisitions prevent comparable period analysis

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Incomplete Reporting (continued)

Erratic, incomplete, and late reporting of financial information

Accruals not timely recorded

Change in fiscal year ends

Unreconciled subsidiary to general ledger accounts, particularly bank accounts

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Questionable Accounting Involvement

Management, particularly CEO, overrides controls

Tight control (involvement) by CEO in financial information

Heavy turnover of accounting staff

CFO distancing himself from historic reporting process and reported numbers

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Questionable Accounting Involvement (continued)

Accounting personnel work in “silos” and absolve responsibility beyond small sphere of influence

CEO heavily involved with prior year audit and only person with knowledge and explanations of journal entries

CEO computing EBITDA adjustments over and above CFO computations

CEO computing obsolescence reserve calculations

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Unavailable or Missing Records

Lack of timely documentation

Documentation subject to frequent “revision”

Original records, e.g., receiving / shipping records not available at the Company

IT system conversion potentially “masking” or “erasing evidence of accounting malfeasance

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Excessive Domination and Control By Principals or Key Management

Unreasonably restrictive control on financial or business information by CEO

Financial data “filtered” through CEO prior to release

Senior executives “walled off” or unwilling / afraid to speak freely in presence of CEO

CEO “share” of EBITDA adjustments with CFO to get CFO on “same page”

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Site Inspection Inconsistent with Performance

Level of activity, inventory, and other objective indicators of performance not coinciding with sales or scale of purported operations

Key employees not present and critical information not readily accessible

“Twitchy” non-executives and office gossip

Employee concerns about something not adding up or information not making sense

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Audit Delays

Company delayed financial review

Downgraded from audit to financial review

No physical inventory performed in years

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Overdrafts and Other Signs of Liquidity Issues

Company repeatedly over-advanced on borrowing base

Company resorting to credit cards because no more credit available

All disbursements must be cleared by bank before release

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Describe relationship with auditors.

What types of audit adjustments were identified?

What type of internal audit function exists?

What’s degree and nature of audit committee involvement?

Do you formally respond to deficiencies?

Fraud Detection Inquiries - CFO

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• What is nature of recommendations issued by CPA’s?

• Communicated to the board or audit committee?

• Material control weaknesses?

• Significant deficiencies?

• Nature and amount of audit adjustments?

• Waived audit adjustments?


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• Why key management and accounting personnel turnover?

• Why the delays in financial reporting?

• Has there been turnover in major providers (i.e., legal counsel, lenders, auditors, vendors, etc.)?

• What is nature of recommendations by outside CPA’s?

• Material control weaknesses? Significant deficiencies?


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• Can you explain performance of the company in light of current events (e.g., why are sales increasing in a declining market?)

• Has the company changed accounting policies and / or procedures? Why?

• Are there any unusual transactions?


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Telling Financial & Ratio Analyses

• Banish M Score Powerful predictor of financial manipulation Better predictor of manipulation than misappropriation Five and eight factor formulas

• Altman Z Score 80%-90% accurate predictor of bankruptcy Two of five ratios standalone indicator of fraud Distress and fraud oftentimes related

• F-Score Predicts material misstatements 28 ratios; 2/3 relate to revenues and soft assets Higher percentage off balance sheet financing (e.g., leases)

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BENIESH “M” SCORE Example(PARAMETERS)

Year 2012 2013

Net Sales 93,823 93,685

Cost of Goods 52,155 49,193

Net Receivables 1,174 1,373

Current Assets 73,717 67,991

Property, Plant and Equipment 2,532 2,058

Depreciation 1,696 1,716

Total Assets 86,291 84,832

SGA Expense 32,426 33,013

Net Income 5,741 9,888

Cash Flow from Operations 8,416 2,877

Current Liabilities 26,297 26,275

Long-term Debt 1,232 1,470

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BENIESH “M” SCORE (Example)

Derived Variables

Other L/T Assets [TA-(CA+PPE)] 10,042 14,783

Days Sales in Receivables Index 0.85

Gross Margin Index 1.07

Asset Quality Index 0.67

Sales Growth Index 1.00

Depreciation Index 1.13

Sales, General and Administrative Expenses Index 0.98

Total Accruals to Total Assets (0.03)

Leverage Index 0.98

M-score5 variable model -3.168 variable model -2.83if M > -2.22, firm is likely to be a manipulator

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BENIESH “M” SCORE Formula

(Equation)

5 variable equation

M = -6.065+ .823 DSRI + .906 GMI + .593 AQI + .717

SGI + .107 DEPI

8 variable equation

M = -4.84 + .920 DSRI + .528 GMI + .404 AQI + .892

SGI + .115 DEPI -.172 SGAI + 4.679 Accrual to TA -

.327 Leverage

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ALTMAN “Z” SCORE

• Predicts likelihood of bankruptcy within two years

• Test highly accurate

• May be monitored each year for corrective action

• Across industries and company sizes and types• Public• Private• Manufacturing • Service

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Z Z1 Z2

LEGEND Public Private General

Mfg. Mfg. Use

Financially sound if greater than 2.99 2.9 2.6

Caution required if between 2.77 - 2.99

Likely bankrupt within 2 years if between 1.8 - 2.7

Likelihood of bankruptcy is high if below 1.88 1.23 1.1

Average for non-bankrupt companies 5.02 4.14 7.7

Average for bankrupt companies -0.29 0.15 4.06

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ALTMAN “Z” SCORE (PARAMETERS)

Income statementNet sales 200Operating income 10

Balance sheetCurrent assets 95

Total assets 150

Current liabilities 80

Total liabilities 125

Retained earnings 25

Public companiesMarket value of equity 300

Private companies (book value of equity) 200

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(CALCULATIONS)

Z-Score 3.3 2.4 3.3

Z Z1 Z2

Factor Public Private General

Mfg. Mfg. Use

Working capital/Total assets X1 0.1 1.2 0.717 6.56

Retained earning /Total assets X2 0.17 1.4 0.847 3.26

EBIT/Total assets X3 0.07 3.3 3.107 6.72

Market value of equity/Total liabilities X4 2.4 0.6

Book value of equity/Total liabilities X4A 1.6 0.42 1.05

Net sales/Total assets X5 1.3 1 0.998

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ALTMAN “Z” SCORE - XT

(PARAMETERS)Income statement

Net sales 103,952 Operating income 603

Balance sheetCurrent assets 46,219

Total assets 56,794

Current liabilities 60,199

Total liabilities 61,759

Retained earnings (4,967)

Private companies (book value of equity) (4,965)

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ALTMAN “Z” SCORE XT

(CALCULATIONS)

Z-Score 4.4 1.6 -1.9

Z Z1 Z2

Factor Public Private General

Mfg. Mfg. Use

Working capital/Total assets X1 (0.2) 1.2 0.7 6.6

Retained earning /Total assets X2 (0.1) 1.4 0.8 3.3

EBIT/Total assets X3 0.0 3.3 3.1 6.7

Market value of equity/Total liabilities X4 4.9 0.6

Book value of equity/Total liabilities X4A (0.1) 0.4 1.1

Net sales/Total assets X5 1.8 1.0 1.0

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• Trust your “gut,” because downside too great

• Don’t ignore Red Flags

• Revenue / receivables should be first concern

• Inventory overstatements should be second concern

• Use proven financial ratios, e.g., M Score, Z Score, F-Score and CCC, among others

Just a Few Takeaways?

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• Scrutinize related party transactions carefully

• Non-consolidated affiliates are particularly suspect

• Evaluate related party transaction trends in relation to total sales and total assets

• Overly complicated corporate structure

• Granularity and disaggregation of data are key


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• Remember, the “devil is in the details”

• Don’t trust and rely upon financial audits

• Staff oftentimes inexperienced and not focused on fraud

• Not generally fraud or forensic oriented

• Review or worse, no external CPA involvement


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Action Steps at First Signs of Fraud

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Action Steps(Early and Decisive to Mitigate Loss)

• Identify/Articulate Specific Concerns

• Discuss issues and suspicions with independent observers

• Vocalize any indications of fraud

• Use analysis to:• Confirm “gut” feelings• Evaluate various options, including exiting the

relationship or investment• Bring in specialized resources • Consider legal options and requirements, e.g., reporting

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• Bring in Others at First Sign of Fraud

• Internal / external for fresh perspective

• Existing portfolio manager or lending officer may:

• Be emotionally invested• No longer objective

• Consider involvement of Special Assets personnel

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• Preserve All Records

• Emails and other electronic files

• Paper files

• Financial statements

• Loan applications

• Underwriting

• Credit Files

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• Meticulously Document Borrower Communications

• Wary of lender liability claims

• Expand supervisory involvement

• Closer scrutiny

• Ongoing monitoring

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• Identify All Relevant Credit and Lending Relationships

• Inter-creditor relationships

• Business and personal bank accounts

• Loans to related entities or guarantors

• Evaluate Cross-Defaults

• Asses flow of funds among entities

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Action Steps(Early and Decisively to Mitigate Loss)

• Notice of Default

• Proactively and quickly issue notice

• Misrepresentations of financial condition

• Misappropriation of funds

• Other misconduct by principals

• Other fraudulent conduct in events of default under agreement

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• Regulatory Reporting

• Report fraud and other suspicious activity by filing Suspicious Activity Report (“SAR”)

• Other legal and compliance requirements

• For example, properly treat as non-performing asset under regulatory guidelines

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• Outside Professionals

• Determine if needed for conducting forensic investigation to determine scope of fraud and/or sources of recovery, etc.

• Determine if CRO or receiver is appropriate

• Evaluate risk of litigation by borrower, guarantor, or

third parties

• Assess potential for bankruptcy

Representative Financial Firm Clients

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http://www.caymuscapital.us/home.php

http://www.caymuscapital.us/home.php

Representative Clients

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Avant-OCTN-MA Q of E Diligence and Fraud Discussion Items 052615JD

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