Forensic Accounting Presentation to BA 124 San Jose State University March 16, 2004

1. Forensic AccountingPresentation to BA 124 San Jose State UniversityMarch 16, 2004 Jaime Jue | KPMG LLP

2. Topics Covered • Fraudulent Reporting – Numbers Can Lie • Case Study • Consideration of Fraud in a Financial Statement Audit • Be Careful What You Say - Examples of Bad E-mails • Questions and Answers

3. Fraudulent Financial Reporting Numbers Can Lie

4. Fraudulent Financial Reporting • The Auditor’s Role: • The auditor has responsibility to plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether caused by error or fraud. • AICPA, Statement on Auditing Standards (SAS) No. 1, Codification of Auditing Standards and Procedures

5. Fraudulent Financial Reporting • Management’s Role: • Management is responsible for adopting sound accounting policies and for establishing and maintaining internal control that will, among other things, initiate, record, process and report transactions (as well as events and conditions) consistent with management’s assertions embodied in the financial statements. • SAS No. 1

6. Fraudulent Financial Reporting • Management’s Role Against Fraud: • Management, along with those who have responsibility for oversight of the financial reporting process (such as the audit committee [or] board of directors…), should set the proper tone, create and maintain a culture of honesty and high ethical standards, and establish appropriate controls to prevent, deter, and detect fraud. • SAS No. 1

7. What is Fraudulent Financial Reporting? • Fraudulent Financial Reporting may be accomplished by the following: • Manipulation, falsification, or alteration of accounting records or supporting documents from which financial statements are prepared • Misrepresentation in or intentional omission from the financial statements of events, transactions, or other significant information • Intentional misapplication of accounting principles relating to amounts, classification, manner of presentation, or disclosure • AICPA, Statement on Auditing Standards (SAS) No. 99, Consideration of Fraud in a Financial Statement.

8. Why is it done? • To report a smooth, regular, and increasing pattern of earnings • To enrich corporate insiders / management • To give investors / bankers / Wall Street what it wants

9. Fraud Risk Conditions Present when Fraud Occurs Incentives / Pressures Opportunities Attitudes / Rationalizations

10. Conditions Present when Fraud Occurs • Three conditions are generally present when fraud occurs. • First, employees have an incentive or are under pressure, which provides a reason. • Second, circumstances exist – for example, when controls are ineffective or can be overridden – that provide an opportunity. • Third, those involved are able to rationalize committing fraud.

11. But . . . • Even honest individuals can commit fraud if under enough pressure. • The greater the pressure, the more likely an individual will rationalize committing fraud.

12. Fraud Risk – Incentives/Pressures • Profitability threatened by economic, industry, or entity operating conditions. • Management pressured to meet third-party expectations. • Management or board members’ personal finances threatened by the entity’s financial performance. • Employees pressured by management to meet financial targets.

13. Fraud Risk – Opportunities • Complex or unstable organizational structure. • Deficient internal controls • Poor accounting system • Management override

14. What is a Typical Pattern of Fraud? • It does not start with dishonesty. • It starts with pressure. • It starts small. • Opportunities allow it to happen. • It is rationalized as appropriate. • The fraud grows over time. • There is no way out. • Adapted from Michael R. Young, Accounting Regularities and Financial Fraud, 2d, Aspen Law & Business, p. 11-13.

15. Where Can Fraud Occur? • Revenues • Premature recognition of revenue • Right of return, right of refund, or ability for customer to resell • Large, nonrecurring revenue sources • Concurrent transactions • Expenses • Capitalizing vs. expensing • Delaying expense recognition (deferral) • Acquisition and restructuring reserves used to generate income or cover period expenses

16. Where Can Fraud Occur? • Assets • Fixed Assets (impairment or write-downs) • Change in method of capitalization or depreciation • Inventories • Liabilities • “Cookie Jar”, Acquisition, or Restructuring Reserves • Off-balance sheet financing • Contingent liabilities • Allowance for doubtful accounts • Miscellaneous Accruals

17. Where Can Fraud Occur? • Disclosures • Non-transparent • Inadequate / Misleading • Not GAAP Compliant

18. Case Study – X-Tech Corporation A True Story The names have changed to protect the innocent (and the guilty…)

19. X-Tech Corp • Overview • X-Tech manufacturers and sells computer hardware used to track sales, inventory, shipments, etc. • Over $1 billion in sales • Traded on NYSE

20. X-Tech Corp • Background • Anonymous letter sent to SEC alleging X-Tech prematurely invoiced and shipped product to two large customers • X-Tech retains “ABC” law firm to conduct investigation • SEC expresses dissatisfaction with scope of ABC’s investigation • X-Tech hires second law firm (“XYZ”) and forensic accountants to conduct investigation

21. X-Tech Corp • XYZ law firm and Forensic Accountants: • Reviewed over 500,000 pages of documents • Reviewed over 400,000 restored e-mail and voice-mail messages • Reconciled SAP invoices to reported financial results • Conducted revenue testing of invoices covering 28% of reported revenue and 70% of total credit memos

22. X-Tech Corp - Interference with Investigation • Senior VP - Finance directed employees to: • Hide the existence of an important field in the SAP program • Alter documents related to quarter-end adjustments • Deliberately omit transactions in response to data request for largest transactions • Destroy documents related to side deals and manipulating quarterly numbers

23. X-Tech Corp -Summary of Forensic Findings • Revenue figures in SEC filings inaccurate for 1998, 1999, 2000, 2001, and 2002 • Revenue accelerated from future quarters to current quarters • Revenue inflated because of “round-trip” transactions • Manual accounting entries booked improperly at cycle end to improve numbers

24. Examples of X-Tech Behavior – Swing Sheets • Senior management used “Swing Sheets” comparing quarterly raw results, management forecasts, and proposed adjustments to raw results • Swing Sheets discussed in meetings separate from normal closing and staff meetings • Adjustments to hit numbers had no basis in GAAP • In Q1 2000, Swing Sheet adjustments increased EPS from $0.16 to $0.20 • Earlier $0.18 projection provided to the Board

25. Examples of X-Tech Behavior – Intimidation and Bullying • Senior management employed a harsh and dictatorial management style with unrealistic revenue goals • Practice of intimidating and pressuring workforce to make sales targets by any means • Employees publicly humiliated or lost jobs (or both) after failing to achieve sales goals set by CEO

26. Examples of X-Tech Behavior – Round-Trip Transactions • X-Tech paid reseller to purchase X-Tech product from a distributor. • X-Tech booked sale at quarter-end. • X-Tech paid reseller purchase price plus one percent. • Reseller returns product to X-Tech after quarter end. • Employees called these “Candy” deals • Example: 5 Transactions -> $18.7M in Sales

27. Examples of X-Tech Behavior – Revenue Acceleration • X-Tech took income in one quarter that should have been recorded in subsequent quarters using practices such as: • “Channel Stuffing” • “Bill and Hold” • “Cut-off”

28. Examples of X-Tech Behavior – Channel Stuffing • Examples of channel stuffing include: • Premature or excessive shipments • Shipment of products not ordered, or in excess of customer needs • Lifting credit holds and temporary increases in credit limits • Side agreements, including special out-of-policy return agreements • Conversion of accounts receivable to notes receivable

29. Examples of X-Tech Behavior – Bowling for Dollars • Sales Team had practice called “Bowling for Dollars” • X-Tech asked channel partners and end-users to accept product earlier or in greater quantity • X-Tech did not always get customer consent before modifying order • Example: X-Tech shipped product to customer for new-store rollout but store was not ready to accept product

30. Examples of X-Tech Behavior – Premature or Excessive Shipments • X-Tech customers complained that they were invoiced for products they never received. • At least once X-Tech invoiced customer for product that had not yet been assembled • X-Tech shipped more product than customer requested • X-Tech shipped at quarter end on a “slow boat” or “slow truck” to arrive after the quarter

31. Examples of X-Tech Behavior – Manipulating Shipments • X-Tech hired local shipper to pick up product from X-Tech and hold it before delivering to second carrier for customer delivery • On one occasion, X-Tech received call from customer asking why there was a tractor trailer unloading X-Tech product at customer site. • Before X-Tech responded, customer called again, inquiring about arrival of a second tractor trailer from X-Tech.

32. Examples of X-Tech Behavior – Swapping Products • X-Tech often would have difficulty finding appropriate product configuration needed to fill late-quarter orders • Sometime, product needed for order unavailable until next quarter • Under direction of senior management, X-Tech substituted product it had in stock for the product customer ordered without knowledge or permission from the customer

33. Examples of X-Tech Behavior – Lifting Credit Holds • X-Tech lifted credit limits to allow sales to be processed at quarter- and year-end • Practice contrary to X-Tech’s stated policies and without regard to customer’s ability to pay • Example: Credit limit for customer was raised from $750,000 to $35 million for two weeks – then returned to original level • In interim period, more than $28 million shipped to customer and revenue recognized

34. Examples of X-Tech Behavior – Side Agreements • X-Tech had side deals and extended payment terms to consummate sales at quarter-end • Typically side deals done orally • Allowed for abnormally long time to pay or excessive right to return

35. Examples of X-Tech Behavior – Blackout Period for Credit Processing • X-Tech restricted processing credits and returns at quarter- and year-end • A “blackout period” for the processing of credits and returns was employed for two weeks before and after close • No credits or returns could be processed without VP-Sales or Sales Director approval • Credits owed customers were not processed for months

36. Examples of X-Tech Behavior – Bill and Hold • X-Tech made a practice of “Bill and Hold” / “Ship In Place” transactions • Customer billed, but goods held at X-Tech until buyer requested delivery. • Many transactions were not authorized by the customer and occurred at the end of quarters • Authorization letters examined by forensic accountants were signed by senior executives at X-Tech or were on X-Tech letterhead

37. Examples of X-Tech Behavior – Cut-off Problems • X-Tech shipments to international customers typically governed by FOB Destination shipment terms • Under FOB terms, title and risk of loss did not pass to customer under order reached customer’s delivery location • X-Tech shipped international orders up until the last day of the quarter and recognized revenue – even though customer would not receive product until next quarter

38. Examples of X-Tech Behavior – Concurrent Transactions • X-Tech enters into transaction with Z-Tech • X-Tech purchases Z-Tech software for $10.5M (overpaying by $5.25M) • X-Tech sells $5.25M of product to Z-Tech on bill and hold transaction • Z-Tech had no customers for X-Tech product and had never bought from X-Tech before • Z-Tech software still sitting unused in a box at X-Tech • CEO exerted tremendous pressure on his staff to consummate this deal

39. Examples of X-Tech Behavior – Manipulating Ratios and Disclosures • X-Tech publicly announces improvement in its Days Sales Outstanding (DSO) in analyst calls • Did not disclose that it changed methodology for calculating DSO • Actual collection performance deteriorating. • CFO instructs staff to exclude certain factors from accounts receivable – sales tax, freight, charges, VAT, etc. • Reported DSO artificially lowered – actual DSO climbs as high as 119 days

40. Examples of X-Tech Behavior – Manipulating Journal Entries • X-Tech manually recorded approximately 10,000 journal entries • Many questionable in terms of substance or documentation • No pre-review or approval necessary before entry • No systematic post-entry review

41. Consideration of Fraud in a Financial Statement Audit

42. Consideration of Fraud in a Financial Statement Audit • The Importance of Exercising Professional Skepticism • Discussion among Engagement Personnel • Obtain Information to Identify Risks • Identify Risks • Assess Risks in light of Company Anti-Fraud Programs and Internal Controls

43. Consideration of Fraud in a Financial Statement Audit • Responding to the Results of the Assessment • Evaluate the Audit Evidence • Communication of Possible Fraud to Management, Audit Committee, and Others • Documenting the Auditor’s Consideration of Fraud

44. Asking Questions and Analyzing Data

45. Asking Questions & Analyzing Data -Key Points • Financial Statements – Understanding What is Going On Behind the Line Items • Budgets and Targets – Aggressive vs. Realistic • Earnings Estimates – Meet or Miss • Performance Relative to Competitors and Industry • External Data – What are Others Saying?

46. Asking Questions • What are the company’s financial targets? • How aggressive are the targets? • Does senior management state that the targets are reasonably achievable on analyst calls? • What is the “tone at the top” with regard to meeting targets?

47. Asking Questions • Are budgets/forecasts an integral tool to running the business? • How often are budgets and forecasts updated? • Do current budgets/forecasts reflect current business conditions? • At what point during the quarter does management know whether the company will meet or miss targeted financial performance and third party earnings expectations?

48. Asking Questions • What is the company’s history in meeting consensus earnings estimates? • Why are earnings estimates met or missed? • Is the possibility for surprises and variability in the achievement of key assumptions understood and communicated within the company?

49. Asking Questions – Outside or Third Parties • Inquiries of Outside or Third Parties allow you to: • Obtain perspectives from those not directly related to the company, • Corroborate responses received from company / management, or • Assess the possibility of collusion.

50. Analyzing Data • Consider Comparisons between: • Data from comparable prior periods • Budgeted data • Industry data or peer/competitor companies • Analyst expectations