uncovering financial statement fraud: a case study

1. 1 Uncovering Financial Statement Fraud: A Case Study An Acquisition in Wonderland? Presented by Beth Junell, FTI Consulting, Inc. Objectives: 1) Background on the case 2) How fraud was perpetrated 3) How fraud was discovered 4) Lessons learnedObjectives: 1) Background on the case 2) How fraud was perpetrated 3) How fraud was discovered 4) Lessons learned

2. 2 Companies introduced December 1999 Acquisition occurred May 2000 Fraud discovered October 2001 (18 months later) Companies introduced December 1999 Acquisition occurred May 2000 Fraud discovered October 2001 (18 months later)

3. 3 Cast of Characters Purchaser Seller�s CFO Seller�s Controller Investors in Seller Plaintiff�s Expert Arbitrator Seller�s Attorney Alice Mad Hatter March Hare Cheshire Cat White Rabbit King of Hearts Queen of Hearts National Accounting Firm = 1 of Big 4 National Banks = well known, large institutions Plaintiff�s Expert (and forensic accountant) � partner at former firm; My role: 2nd chair, so-to-speakNational Accounting Firm = 1 of Big 4 National Banks = well known, large institutions Plaintiff�s Expert (and forensic accountant) � partner at former firm; My role: 2nd chair, so-to-speak

4. 4 Games at the Tea Party:Fraud Schemes to Overstate Revenue Use of unsupported topside entries to manipulate the general ledger and financial statements Manipulation of accounts receivable Use of formulas to artificially inflate customers� accounts �Rebucketing� of the age of customers� accounts �Credit-to-clear� process to secretly write off uncollectible accounts receivable Understatement of liabilities False statements to everyone who inquired

5. 5 How Did Alice Discover the Tea Party? Uncovering the Fraud

6. 6 Events Leading to Discovery Alice has a lot of questions about A/R Mad Hatter & March Hare are terminated Accounting staff inform Alice that certain accounts can not be reconciled $10 million �suspense� account is created White Rabbit is engaged to take a look National Accounting Firm called in to re-audit financial statements for several periods A/R subledgers (not MS Excel) can not be produced for a variety of reasons (all lies) Suspect collections are a problem (hidden) March Hare terminated for cause (lying to Alice) Mad Hatter requests severance (believes all evidence is destroyed or hidden so well it will not be discovered) White Rabbit uncovers the mechanics of how the fraud was perpetrated National Accounting firm: - declares �massive financial statement fraud� - records $18 million loss - deems goodwill in acquired company worthless ($10 million asset) A/R subledgers (not MS Excel) can not be produced for a variety of reasons (all lies) Suspect collections are a problem (hidden) March Hare terminated for cause (lying to Alice) Mad Hatter requests severance (believes all evidence is destroyed or hidden so well it will not be discovered) White Rabbit uncovers the mechanics of how the fraud was perpetrated National Accounting firm: - declares �massive financial statement fraud� - records $18 million loss - deems goodwill in acquired company worthless ($10 million asset)

7. 7 Fraud Investigation Tools Uncovering the Mechanics of the Fraud

8. 8 Accounting Staff Interviews Topside entries Falsification of supporting documentation Altering bank reconciliations to achieve pre-determined cash balances 3rd Re-Bucketing

9. 9 Comparison of Documents Accounts receivable reports given to Alice, National Bank and National Accounting Firm with actual sub-ledgers Bank reconciliations given to National Accounting Firm with actual bank reconciliations kept by accounting staff Saw this in earlier slides: - Showed re-bucketing and inflation of AR - Showed reduction of O/S checks and addition of held checksSaw this in earlier slides: - Showed re-bucketing and inflation of AR - Showed reduction of O/S checks and addition of held checks

10. 10 A Little Luck Recovery of an allegedly �crashed� database: �Credit-to-clear� 2nd re-bucketing scheme True amount and age of �current� accounts Discovery of the �garage tapes� Specific mechanics of using formulas and re-bucketing in MS Excel to create A/R detail Early evidence of the collections problems Garage tapes: - statement that paralegal created �the List� - angered employee of Alice - set out to find proof of creation - talked to a friend (ex-employee) - had old back-up tapes in garage - contents on tapes not found on hard drivesGarage tapes: - statement that paralegal created �the List� - angered employee of Alice - set out to find proof of creation - talked to a friend (ex-employee) - had old back-up tapes in garage - contents on tapes not found on hard drives

11. 11 Mr. Expert�s Findings Detected method of manipulation for the 9/30/99 accounts receivable Provided exhibits documenting the method Dismissed the apparent fraud as correcting the detail for �system problems� and �human error�

12. 12 Pattern Detected Pattern of manipulation for all periods readily detectible: After discovery of �the Lists�� creation; and After Mr. Expert laid out his findings on the 9/30/99 accounts receivable manipulation

13. 13 Data Mining From transactional/accounting databases Used to extract evidence of claims made during staff interviews: Existence and magnitude of topside entries 1st, 2nd and 3rd Re-bucketings made within the accounting systems �Credit-to-clear� transactions Age of actual invoices written off through �credit-to-clear�

14. 14 Application of the Fraud Triangle Pressure, Opportunity and Rationalization of Defrauding Alice Donald Cressey Doctorate in criminology during the 1940s Focused on embezzlers Interviewed about 200 inmates in the Midwest Developed hypothesis (read from book) Hypothesis has become better known as �the Fraud Triangle�Donald Cressey Doctorate in criminology during the 1940s Focused on embezzlers Interviewed about 200 inmates in the Midwest Developed hypothesis (read from book) Hypothesis has become better known as �the Fraud Triangle�

15. 15 Lessons Learned � Internal (Validating SOX) Don�t put all the �eggs in one basket� Don�t allow personal guarantees to minimize due diligence work If it sounds like an excuse, it probably is Don�t minimize oversight based on financial performance An internal audit function is crucial; don�t expect external audit to replace the need for good governance and internal controls Use computer assisted audit techniques Excuses � continual excuses should raise a white flag - in this case: systems errors, human error, etc. - after a while, investigate Incentive to commit fraud (especially if something is already being hidden) Audit failures do occur Excuses � continual excuses should raise a white flag - in this case: systems errors, human error, etc. - after a while, investigate Incentive to commit fraud (especially if something is already being hidden) Audit failures do occur

16. 16 Lessons Learned � External (Validating SAS 99) If it looks like an Excel document, it probably is Don�t let immateriality override fraud indicators Understand how numbers end up in the financial statements Talk to the accounting staff, not just the CFO and Controller Perform basic audit procedures effectively Use computer assisted audit techniques Do not rely on management representations� test them Acquired company was immaterial to Alice on a consolidated basis Statements audited were clearly MS Excel documents Confirmations: - accounting firm told confirmation process would not work - �mom & pop� customers would not respond - firm based decision not to send confirmations based on this statement - audit workpapers of the prior auditors included confirmation testing (albeit with exceptions which were cleared) Management representations� I believe you, but show me!Acquired company was immaterial to Alice on a consolidated basis Statements audited were clearly MS Excel documents Confirmations: - accounting firm told confirmation process would not work - �mom & pop� customers would not respond - firm based decision not to send confirmations based on this statement - audit workpapers of the prior auditors included confirmation testing (albeit with exceptions which were cleared) Management representations� I believe you, but show me!