Definition of Financial Statement Fraud

1. Presentation onFINANCIAL STATEMENT FRAUDFor: Government Finance Officers Association of Alabama Presented by: Gregory L. Prescott, CPA Senior Instructor of Accounting University of South Alabama June 21, 2007 Orange Beach, Alabama

2. Definition of Financial Statement Fraud • The deliberate falsification of the financial condition of an entity accomplished through the intentional misstatement or omission of amounts or disclosures in the financial statements in order to deceive financial statement users. (Association of Certified Fraud Examiners)

3. Costs of Financial Statement Fraud • In a 2003 KPMG Fraud Survey, the category of financial reporting frauds averaged $257.9 million in costs per organization. • A 2002 GAO report (GAO-03-138) found that in the three trading days subsequent to the initial announcement of a restatement, the companies in the study lost an average of $100 billion in market capitalization. • According to a 1999 study by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), Fraudulent Financial Reporting: 1987 – 1997, An Analysis of U.S. Public Companies, 51% of the companies studied ended up in bankruptcy or experienced an ownership change.

4. Costs of Financial Statement Fraud (continued) • External auditors, board members and senior management may be sued for investors’ losses. • Employees may lose their jobs, their pensions, any savings invested in their employer’s stock, and health care and other benefits. • Loss of investor confidence and credibility in the financial markets.

5. Reasons Cited for Committing Financial Statement Fraud • To buy more time to resolve business problems • To mask violations of financial covenants contained in loan agreements governing credit facilities • To obtain (or continue) financing that might be jeopardized if accurate financial statements were provided • To meet Wall Street analysts’ forecasts

6. Reasons Cited for Committing Financial Statement Fraud(continued) • For personal enrichment – performance-related bonuses and to keep the stock price high since many corporate officers have much of their net worth tied up in company stock, etc. • To facilitate business acquisitions on more favorable terms – i.e., transactions involving stock swaps, etc. • To preserve corporate officers’ status as business leaders, which might be lost if accurate financial statements were presented

7. The Fraud Triangle Donald Cressey conducted research in the 1950s in an effort to determine “why” fraud is committed. He interviewed approximately 200 embezzlers in prison. One of the primary conclusions of his research was that virtually every fraud had three elements in common: • Pressure or motivation; • Rationalization (of personal ethics); and • Knowledge and opportunity to commit the crime. These three points form the corners of what is known as the FRAUD TRIANGLE.

8. The Fraud Triangle (continued) PRESSURE OPPORTUNITY RATIONALIZATION FRAUD

9. Methods of Perpetrating Financial Statement Fraud#1 • Recording Revenues Before Earned It’s amazing what a debit to Accounts Receivable and a credit to Revenue can do to enhance a company’s financial condition! Guiding Principle: Revenue should be recognized after the earnings process has been completed and an exchange has occurred.

10. Common Means of Booking Revenues Before Earned • Recording revenues when future services remain to be provided • Recording revenues even though the customer is not obligated to pay • Recording revenue before shipment or before the customer’s unconditional acceptance Examples: • Havertys Furniture Stores • HVAC distributor • Sunbeam Corporation (“bill and hold” accounting)

11. Methods of Perpetrating Financial Statement Fraud #2 • Creating Fictitious Revenues This is when revenues are recorded even though a sale has not taken place. These transactions can involve real or fake customers. Guiding Principle: Revenue should be recognized after the earnings process has been completed and an exchange has occurred.

12. Common Means of Creating Fictitious Revenues • Shipping goods to fictitious customers (often “dummy” companies set up by employees); such goods are then returned during the subsequent accounting period • Recording revenues that lack economic substance (“side agreements”) • Recording refunds or volume rebates from suppliers as revenues as opposed to a reduction in cost of goods sold

13. Common Means of Creating Fictitious Revenues (continued) Examples: • California Micro Devices Corporation • International subsidiary of U.S. company

14. Methods of Perpetuating Financial Statement Fraud #3 • Boosting Profits with Nonrecurring Items Guiding Principle: It is important to segregate “operating” and “non-operating” items on the income statement.

15. Common Means of Boosting Profits with Nonrecurring Items • Increasing profits by selling undervalued assets • Including investment income or gains as part of operating revenues • Reporting investment income or gains as a reduction in operating expenses • Creating income by reclassification of balance sheet accounts

16. Common Means of Boosting Profits with Nonrecurring Items (continued) Examples: • Boston Chicken • International Business Machines • Apple Computer

17. Methods of Perpetuating Financial Statement Fraud #4 • Shifting Current Expenses into a Different Accounting Period Guiding Principle: Costs should be capitalized if they produce a future benefit and expensed if they produce no such benefit.

18. Common Means of Shifting Current Expenses into a Different Accounting Period • Capitalizing normal operating costs, particularly if the company recently changed from expensing such costs • Changing accounting policies and shifting current expenses into an earlier period • Depreciating or amortizing costs too slowly • Failing to write-down or write-off impaired assets

19. Common Means of Shifting Current Expenses into a Different Accounting Period (continued) Examples: • HealthSouth* • WorldCom *”Vice President of Tax Controversy”

20. Methods of Perpetuating Financial Statement Fraud #5 • Failing to Record or Improperly Reducing Liabilities Guiding Principle: A liability should be recognized if an entity is obligated to make a future sacrifice as a result of a past transaction or event.

21. Common Means of Failing to Record or Improperly Reducing Liabilities • Reducing liabilities by (unreasonably) changing accounting assumptions • Failing to record expenses and related liabilities when future obligations remain • Creating unrealistically high “reserves” – for instance, in connection with a restructuring – and subsequently “releasing” those reserves into income

22. Common Means of Failing to Record or Improperly Reducing Liabilities (continued) Examples: • Continental Airlines • Rent-Way

23. Methods of Perpetuating Financial Statement Fraud #6 • Shifting Current Revenue into a Subsequent Accounting Period Guiding Principle: Revenue should be recognized in the period when earned – NOT when it is most needed!

24. Common Means of Shifting Current Revenues into a Subsequent Accounting Period • Using “reserves” (or lack thereof) as a means of manipulating reported earnings • Postponing the recognition of legitimate revenues once earnings targets for the current period have been met Examples: • W. R. Grace & Company • Microsoft

25. Methods of Perpetuating Financial Statement Fraud #7 • Shifting Future Expenses into the Current or an Earlier Accounting Period Guiding Principle: Expenses should be recognized against income in the period in which the benefit is received.

26. Common Means of Shifting Future Expenses into the Current or An Earlier Accounting Period • Improperly inflating the amount included in a “special charge” • Accelerating discretionary expenses into the current period Examples: • Sunbeam Corporation • AOL

27. A Professional Ethics Comment The tale of the young HealthSouth professional and his ethical dilemma.