What Fraudsters Know That We Don't - Financial Statements Fraud

FRAUD

WHAT FRAUDSTERS KNOW THAT WE DON’T: FINANCIAL STATEMENTS FRAUD ROBIN SINGH, CFE, CFAP, MBA, MIT - A CERTIFIED FORENSIC EXAMINER & EXPERIENCED IN ADDRESSING ANTI-FRAUD/ ANTI-CORRUPTION/COMPLIANCE LAW RELATED ACTIVITIES, WORKING WITH ABU DHABI GOVERNMENT IN HEALTHCARE DOMAIN, EXPLAINS SOME OF THE METHODS FRAUDSTERS USE TO MANIPULATE FINANCIAL STATEMENTS.

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w Maintain their market status: most fraudsters suffer from NPD (Narcissistic Personality Disorder), which means they have an inflated sense of their own importance and believe that they are ‘special’; this also helps them receive good performance bonuses. w False impression: inflated numbers allows the customers to hold their company in high esteem, thus creating a market sentiment for an upward push in the stock market. This further invites analysts to declare a healthy forecast and leads to buying recommendation for the company.

of the most important elements for a company to be successful, in today’s environtment, is to protect their shareholder’s investment(s). A large part of how this performance is communicated to shareholders is in the company’s financial statements and it is vital this information is presented clearly. The information given to the investor in these statements directly impacts continued investment and shareholder confidence. Therefore it comes as no surprise that, on occasion, information in these statements can be altered to present a different reality. What I will shed light on is the language and mechanisms behind the most common type of occupational fraud: financial statement fraud. In line with Association of Certified Fraud Examiner (ACFE), occupational frauds can be classified into three primary categories: asset misappropriations, corruption and financial statement fraud. Of these, asset misappropriations are the most common (85 per cent of cases) but least costly, causing a median loss of $130,000. In contrast, financial statement fraud occurred only in nine per cent of ACFE’s selected population, but had the greatest financial impact, with a median loss of $1 million. Corruption schemes fell in the middle in terms of both frequency (37 per cent of cases) and median loss ($200,000) - see figure 1.

ONE MUST RECOGNISE THAT WITH THE COMPLEXITY OF ACCOUNTING RULES (IAS, GAAP, ETC.), UNINTENTIONAL MISTAKES MIGHT HAPPEN

WHAT IS THE INTENT BEHIND A FINANCIAL FRAUD STATEMENT?

TOOLS OF THE TRADE

There are a number of reasons that a management level executive commits financial statement fraud. The most common are: w To demonstrate a strong bottom line: this helps them to obtain financing, negotiate purchase of an acquisition when needed and keeps their EPS (Earning Price per Stock) healthy and growing.

Some of the recognised common mechanisms that a fraudster uses whilst committing a financial statement of fraud are: w Capitalising of expenses (e.g. WorldCom approach); w Improper revenue recognition (e.g. ENRON’s, Satyam Computers approach); w Improper asset evaluation (e.g. ENRON again); cont. overleaf

Figure 1: Median Loss $130,000 Asset Misappropriation

$120,000 $135,000 $130,000

Corruption

$120,000 $135,000 $1,000,000

Financial Statement Fraud

2014

$1,000,000

2012

$4,100,000

2010 $0

$2,000,000

$4,000,000

$6,000,000

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FRAUD cont. from page 37

w Improper deferral of expenses into another period (e.g. American Pasta Company’s approach); w Manipulation of accruals and reserves (e.g. Allied Crude Vegetable Oil Refining, Satyam Computers approach); w Asset overstatement/liability understatement schemes (e.g. Crazy Eddie’s approach); w Related parties transactions and investment issues (e.g. Tyco, Refco’s approach). One must recognise that due to the complexity of accounting rules (IAS, GAAP, etc.), mistakes are bound to happen and thus it becomes imperative to differentiate between intentional and unintentional acts. That said I would like to talk of some ways that a fraudster may utilise his skills to manipulate financial statements using the mechanisms mentioned.

ANALYSIS OF FINANCIAL STATEMENTS, ON ITS OWN IS NOT SUFFICIENT TO IDENTIFY RED FLAGSH

Scenario 1: Capitalising of Expenses A dubious management aiming to achieve their debtors and shareholder’s satisfaction will try to manipulate their expenses and show higher revenue/sales which would lead to a high net income. Capitalising expenses (e.g. water and electricity or marketing cost, etc.) helps transactions to be treated as an asset, with the hope that the expenses would be depreciated to zero. Out of sight is out of mind. This creates a false impression as a high assets base will attract more investors and easy funding. Bottom line: Fraudsters try to deceive stakeholders through manipulation and false perception.

selling an unused asset to another company; or acquiring a target company for a higher price, while having a side agreement to buy back the asset or repatriate the excess cash. A management trying to recognise revenue incorrectly will always try to denote extra cash coming from a target entity as revenue (possibly against a sale which took place in a previous accounting period) - see figure 2. Other methods used by management to recognise fictitious revenue are: w Channel stuffing: This practice of offering deep discounts, extended payment terms to customers to increase their company’s sales in the current period which the company would not have sold until the next period. w Bill and hold transactions: refers to revenue internationally recognised in an earlier period, even though the management is aware that the shipment, which has set sail (or in transit), will not be accepted by their client until a later date.

Scenario 2: Improper revenue recognition Though there are many ways used in past frauds to recognise revenue incorrectly, one of the ways that has been complicated by the fraudsters is the round tripping mechanism. A round-tripping is a form of barter that involves a company

Scenario 3: Improper asset evaluation/write offs All assets are purchased at a price and their usefulness has a shelf life. Depreciation systematically allocates or moves the asset’s cost from the balance sheet to expense on the income statement over the asset’s useful life. All

Figure 2: Round tripping in an M&A transaction – An illustration Estimated & paid an overvalued price to the target with a side agreement to pay the excess amount back

Target: XYZ

Acquirer: ABC The target pays back the excess amount, which the acquirer’s management treats as Revenue. Generally happens within 24 hours to 48 hours’ time window.

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governments require companies to follow a policy and not change the policy as per their whims and fancies. A fast, slow or no depreciation has an effect on the bottom line, where misstating expenses inflates the bottom line and increases the asset value. Furthermore, inappropriate revaluation of an asset has the same impact. Not writing off a non-performing asset has the same effect as above. While there is another category of write offs which is the money (or receivables) which will never be received. A dubious management would demonstrate a sale with a ship that has set sail. Since these will not be delivered to any customers they wouldn’t receive any money, resulting in a write off. This would inflate a company’s receivables (money to be received from their customers) in the end only to be written off. Scenario 5: Manipulation of accruals and reserves Some companies hate paying taxes and might not be interested in payouts especially when it reduces their share of bonuses. In order to reduce the tax effect, a company does not publish all their positive earnings in that period, rather publishes them as liabilities. The most common way to do this is to misstate their expenses by increasing their payables/ inflating their liabilities and reducing their net income, helping them pay fewer taxes. While in troubled economic times these liabilities are moved to the positive side demonstrating profit. Scenario 6: Understatement of liabilities The overall objective always has been to inflate their net income during their distress times by not recording entries in their period of occurrence. As an example, companies might incur water and electricity charges for a particular month but since they haven’t received the bill in that month they may ignore recording it. This would understate their liabilities and expenses and help their bottom line. Scenario 7: Related parties transactions In simple words related party transactions are defined as a parent company and its subsidiaries or subsidiaries of a common parent: companies create a Special Purpose Vehicles (SPV) to do their dirty laundry. Enron created multiple SPVs which would take loans on Enron’s behalf, while Enron used the money without having any payables. This leads to non-disclosure of liabilities or collectables categorised as revenue, etc. in their financial statement, representing it to be a cash rich company. Lastly companies might sell assets below or above market price to their parties which might not actually exchange hands. Scenario 8: Investment issues Investment issues relate to not recognising losses. These include fictitious/overvalued investments, improper

categorisation of losses, etc. (impacting cash flow statements) and can have the same effect as understanding one’s liabilities.

PREVENTING FRAUD USING FINANCIAL AND STATISTICAL METHODS There are a variety of tools available to help combat the above mechanisms; one of those is ratio and Analysis (R&A). R&A helps define trends relating to assets and liabilities, profit trends, etc. which can be a good indicator of what’s in and out. The following tests do not necessarily indicate fraud but help identify red-flags: w Accounts receivable (AR) growth versus sales growth. If AR grows faster than sales then it indicates that either the revenue collection cycle is too long or customers are not paying. Either situation reduces liquidity. When calculating year on year trends this can be a good indicator of what is happening in conjunction with others.

DIGITAL DATA AND EXAMINING PATTERNS ARE AN APPROACH BEING PROACTIVELY USED BY INVESTIGATORS TO PREVENT OR DETECT FRAUD. w Property, plant, and equipment (PPE) as a percentage of total assets. PPE are long term assets. For a manufacturing company a PPE would be a factory, while for a financial institution it might be an office building. This does not rapidly rise or fall. A negative/declining case may indicate the money is not flowing to their core business. If not then where? Shell companies? w Cost of goods sold (COGS) as a percentage of sales. COGS is the amount denoted for inventory which is then sold to its customers. A large variance in this could be represented because of some accounting irregularities some people apply the wrong accounting standard. w Accounts payable versus sales growth. In the long run if payables are growing faster than sales, it means that there is some cash sitting to be paid. Some questions to ask are, is it never used? Is it actually present? Who has the authority to use that (Look at delegation of authority)? Other key ratios to see would be return on assets/equity, sales trends, revenue growth versus net income growth, debt ratios, etc. cont. overleaf

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Figure 3: Benford Analysis – An illustration 35

30.000 Needs further investigation

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Other Statistical Methods: Digital data and examining patterns are an approach being proactively used by investigators to prevent or detect fraud. Benford Law is one such approach, developed by Frank Benford (1920s). It guides on the occurrence of digits in the data. Benford’s Law concludes that the likelihood of the first digit taking on a value decreases as the value of the digit increases. Benford calculates that the first digit will be a ‘1’ about 30 per cent, whereas ‘9’ only has an expected frequency of about five per cent as the first digit. This comes in handy when trying to analyze abnormal patters such as legitimate reimbursements made to the executives for entertainment, abnormities to invoices paid to vendors, etc. One should start asking questions when these numbers / pattern fall outside a proven pattern - see figure 3. The Fraud Z-Score Model is a statistical model developed by Beneish and used to detect a soundness of a financial statement. The z-score utilizes variety of KPIs such as working capital, total assets, retained earnings, earnings before interest and tax, etc. to identify if a company is financially sound. Excel sheets are available online if any one wishes to try.

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Ted Hill, ‘American Scientist’, July-August 1998, pp.358-363

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Actual Percent Predicted Benfords

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The Fraud F-Score Model is a statistical method that helps determine the likelihood of financial reporting manipulation. It is always good to ask, which is the auditing firm employed? Fraudsters have big egos and believe in the best and want to be associated with top tier firms and not tier two or three firms. Analysis of financial statements, on its own is not sufficient to identify red flags. One must have a clear understanding of the accounting principles and industry averages to go along with it!

A DUBIOUS MANAGEMENT WOULD DEMONSTRATE A SALE WITH A SHIP THAT HAS SET SAIL.