Fraudulent Financial Reporting – Identifying Red Flags.

Fraudulent Financial Reporting – Identifying Red Flags

2F O R E N S I C

Basic Understanding of Financial Disclosures Is Important

Financial reporting encompasses more than balance sheet and income statement

- Statement of cash flows can be enlightening as to potential problem areas

- Footnotes provide details behind the numbers

• Debt compliance

• Contingent liabilities

• Commitments

• Accounting policies

- Public companies are required to disclose impact of new accounting rules that have not yet been implemented

3F O R E N S I C

Basic Understanding of Financial Disclosures Is Important (Continued)

Management’s discussion and analysis of financial condition and results of operations supplements the financial statements

- Liquidity

- Critical accounting policies

- Off – balance sheet arrangements

- Quantitative and qualitative disclosures about market risk

Non – GAAP financial disclosures

- Excludes amounts, or is subject to adjustments that have the effect of excluding amounts, that are included in the most directly comparable measure calculated and presented i/a/w GAAP

- Includes amounts, or is subject to adjustments that have the effect of including amounts, that are excluded from the most directly comparable measure calculated and presented i/a/w GAAP

4F O R E N S I C

Basic Understanding of Accounting Is Important

Certain elements of the financial statements result from accounting estimates, which are not as precise as other reported amounts

- Valuation allowances and reserves against recorded assets

- Reserves for future obligations

Underlying certain elements of the financial statements are valuations that must consider whether assets are impaired

- Goodwill

- Other intangible assets

- Investments

- Other long – term assets

Assessment of contractual terms is required for many transactions to determine timing of revenue recognition, e.g. contracts that include multiple deliverables over some period of time

Correlation between accounts

5F O R E N S I C

Financial Reporting Is Difficult Even When Fraud Does Not Occur

As evidenced by previous examples, accounting is not an exact science. These areas provide greater opportunity for fraud

Critical accounting policies should be considered and used as a roadmap to when potential issues may arise

Less robust and transparent financial disclosures may signal weaknesses and/or “bad news”

Auditors are taught to use professional skepticism

- All users of financial statements should be professionally skeptical as they study financial statements and disclosures

- Don’t make assumptions of honesty or lack thereof

6F O R E N S I C

Fraudulent Financial Reporting

Definition

Intentional misrepresentation of financial information required for management and/or external reporting.

- May or may not involve actual theft of cash or other assets

- Can materially affect the financial statements

- Could include omission of required or pertinent disclosures (amounts and commentary)

- Not necessarily the result of a grand plan or conspiracy. Management may rationalize the appropriateness of a material misstatement as an

aggressive rather than indefensible interpretation of complex accounting rules, or as a temporary misstatement of financial statements, including interim statements, expected to be corrected later when operational results improve

7F O R E N S I C

Fraudulent Financial Reporting (continued)

Fraudulent financial reporting may include:

Manipulation, falsification, or alteration of accounting records or supporting documentation from which financial reports are prepared

– Revenue recognition

– Inventory

Misrepresentation in or intentional omission from financial reports of events, transactions or other significant information

Intentional misapplication of accounting principles relating to amounts, classification, manner of presentation or disclosure

– Reserve manipulation (“cookie jar”)

– Expense/capitalization and deferral

– Acquisition and restructuring charges

8F O R E N S I C


Techniques that are used to mislead investors and other stakeholders

- Recording revenue too soon or of questionable quality

- Recording bogus revenue

- Boosting income with one-time gains

- Recording fictitious inventory or manipulating inventory counts

- Improperly capitalizing expense to inventory

- Shifting current expenses to a later period

- Failing to record or improperly reducing liabilities

- Shifting current revenue to a later period

- Shifting future expenses to the current period as a special charge

- Omitting required disclosures

• Debt covenants

• Commitments and contingent liabilities

• Related party transactions

• Accounting changes

• Significant events

Recent studies have indicated that of recent restatements, over one-third are the result of revenue misstatements

9F O R E N S I C

Understanding fraudulent financial reporting

The key to understanding financial fraud perpetuated as a result of accounting irregularities, and ultimately, the key to preventing it, is to understand the

corporate environment in which the fraud grows and the way that this environment influences individual conduct.

Also areas of financial reporting that are most susceptible to fraud, inappropriate manipulation, or inappropriate earnings management must be identified.


10F O R E N S I C

Conditions generally present when fraud occurs

Incentives or excessive pressure to achieve targets,

Absent, ineffective, or weak internal controls that provide an opportunity for fraud to be perpetrated, or

Attitudes or rationalizations that allow individuals to knowingly and intentionally commit a dishonest act.


11F O R E N S I C

Factors that can contribute to the risk of fraudulent financial reporting

Understaffed accounting and internal audit departments

Fear of losing one’s job or missing out on a promotion path

Low morale, lack of openness in the culture, or a culture of blame

Highly leveraged reward structures

Personal interest of management in the company’s share price

History of preparing over-optimistic forecasts

Cash flow problems, possibly breach of debt covenants

Aspects of the profit and loss account based on a significant degree of judgment

Significant, unusual, or highly complex transactions

History of sloppy balance sheet management


12F O R E N S I C

Factors that can contribute to the risk of fraudulent financial reporting (continued)

High degree of competition or market saturation, accompanied by declining margins and customer demand

High vulnerability to rapid changes, such as technology, product obsolescence, or interest rates

Recurring operating losses

Rapid growth and unusual profitability, especially compared to that of other companies in the same industry

Profitability or trend level expectations of analysts and others

Significant related party transactions

High turnover of senior management, counsel, or board members


13F O R E N S I C

Case study – Overview

Hypothesize a company that goes public at a time of extraordinary economic expansion and wonderful market performance…

Unfortunately, the company’s industry is beginning to slow down…


14F O R E N S I C

Case study – What happens?



Senior management panics…


15F O R E N S I C





A division head feels the pressure of the unrealistically aggressive earnings target and the potential consequence of failure…


16F O R E N S I C






New quarter, new problem….


17F O R E N S I C







Another quarter, bigger problem….


18F O R E N S I C







Another quarter, bigger problem….

The situation deteriorates…


19F O R E N S I C

Case study – The Pattern

Even though the hypothetical is fairly simple and straightforward, there is a distinct, observable and recognizable pattern that is fairly typical.

Greed or drive to achieve

Pressure

Fear of failure

Gray areas of accounting that can be rationalized/opportunity to manipulate

Full-blown fraud


20F O R E N S I C

Red Flags

Sales and income are decreasing while accounts payable and receivable increase

Large number of account write-offs

Increased inventory not accompanied by increased revenues

Operating income significantly exceeding cash flows

Acquisitions or “restructurings” with no apparent business purpose/ frequent restructurings

Line of credit “maxed” out for long periods of time

Debt covenant issues/waivers


21F O R E N S I C

Red Flags (continued)

Limited or seemingly incomplete disclosures

Lack of disclosure of impact of new accounting rules

Management compensation predominantly linked to short-term performance

Significant related party transactions with minimal disclosure

Increasing intangible assets not supported by increased operating income

Allowances that are not correlated with receivables

Revenue or profit growth out of line with the industry or inconsistent with the degree of risk, i.e. significant profits in products which are inherently low risk


22F O R E N S I C

Red Flags (continued)

Revenues that are not correlated with balance sheet items

Expenses that are not correlated with revenues and reasonably explained

Less than robust disclosure of critical accounting policies

Critical accounting policy disclosure that implies aggressive accounting

Earnings that consistently and precisely meet analyst expectations


23F O R E N S I C

The aforementioned red flags are general in nature and could relate to or be discovered in a routine review of financial statements, footnotes, and management’s discussion

A few examples of specific purchasing and inventory fraud follow, along with the red flags that might be observable with a more detailed analysis

These represent examples of the types of items that auditors might encounter during audits


24F O R E N S I C

Manipulation of rebates and discounts — Examples

Rebates taken conditional on levels of purchases from the supplier. The conditions may not be included in the written purchase contract. They may form part of some hidden contract terms or a side letter.

Misrepresentation or forging of confirmations and contract details regarding rebates

Fraudulent Financial Reporting in Purchasing

25F O R E N S I C

Manipulation of rebates and discounts — Red flags

Abnormal numbers and/or value of credit memos around period ends

Volume discounts/rebates not monitored independently against quantities bought

Stock surpluses (indicating possible over-purchasing) to trigger volume discounts

Fraudulent Financial Reporting in Purchasing (continued)

26F O R E N S I C


Hidden contract terms — Examples

Side letters with suppliers to manipulate invoicing to enable favorable expensing or capitalization of services rendered or products delivered

Hidden contract terms — Red Flags

Unusual trends just before and after period end.

Supplier billing descriptions are unusual/different

Unusual business relationships and transactions

27F O R E N S I C

Delaying/advancing payments — Examples

Non-standard payment agreements with suppliers to reduce or inflate apparent prices to shift profits/losses from one period to the next


28F O R E N S I C

Delaying/advancing payments — Red flags

Vague terms in contracts and no detailed review of charges such as travel, advertising, consultancy fees, recruitment, maintenance and leasing

No competitive bidding


29F O R E N S I C

Fraudulent Financial Reporting in Inventory

Improper Valuation – Examples

Inflated valuation of raw materials

Inflated valuation of work in progress

Improperly capitalized costs

Losses on unprofitable contracts recorded against work in progress of profitable contracts

30F O R E N S I C

Fraudulent Financial Reporting in Inventory (continued)

Misvaluation – Red flags

Profit or bonus targets reached in latter part of the year with increased inventory and flat performance otherwise

New explanations about salability of inventory and market conditions

Unusual trends in the valuation of particular product lines or work-in-progress and/or margins

31F O R E N S I C


False status of inventory – Example

Forged or altered information regarding the prospects of disposal or realizable values of inventory

Misrepresentations regarding ownership

Inflated or fictitious consignment inventory

Inventory sold or leased at the time of an inventory count counted as unsold inventory

32F O R E N S I C


False status of inventory – Red flags

New or unexpected explanations for valuation

Obsolescent or slow-moving stock lines which miraculously find a new market – for example a distributor in an emerging market where the status of the counter-party and the distribution channel is clouded in secrecy

Increased level of inventory in relation to recent history or sales

Change in correlation between recently received inventory and related accruals

33F O R E N S I C


False quantity of inventory – Example

Inclusion in inventory of items already sold to third parties

Maintaining empty storage crates

Manipulation of cut-off

Falsification of records regarding inventory in transit

Falsification of inventory count sheets or receiving reports

34F O R E N S I C


False quantity of inventory – Red flags

Close monitoring by management of products/items being checked by auditors

Different handwriting on certain count sheets which are part of a sequence counted by one person

Unusual trends in stock levels

35F O R E N S I C

Internal Audit GroupIntegrity Compliance

Three Components to Managing Fraud and Misconduct

Prevention Detection

Fraud Investigative UnitInclusion of these groups within an organization leads to enhanced control environment

Investigation

36F O R E N S I C

Managing Fraud and Misconduct Risk (continued)

Detecting Fraud

Not simple or easy – since by its definition/nature, fraud involves:

Concealment

• Withholding Information

• Misrepresenting Information

• Falsification of Documents

• Collusion

– Management

– Employees

– Third Parties

Willful

37F O R E N S I C


Detecting Fraud (continued)

Not simple or easy – but not impossible

Effective detection requires:

• Strong corporate fraud risk management policies and procedures aligned with business strategy

• Understanding of fraud red flags

• Understanding of proper business processes

• Understanding of business environment and the people in the business

• Appropriate techniques

• Appropriate tools

• Experienced, and sufficient professionals to detect

• Feedback loop for lessons learned from internal/external audits and investigations

38F O R E N S I C


Detection

Analytical Analysis

– The application of comparisons, computations, inquiries, inspections and observations to analyze and develop expectations about relationships among financial and operating data for comparison to recorded account balances or classes of transactions.

Types of analytical and expectation procedures

– Reasonableness analysis

– Trend analysis

– Ratio analysis

– Vertical Analysis

– Horizontal Analysis

39F O R E N S I C


Vertical and Horizontal Analysis

40F O R E N S I C


Vertical and Horizontal Analysis

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