Fraudulent Financial Reporting – Identifying Red Flags

Fraudulent Financial Reporting – Identifying Red Flags

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

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

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

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

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

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

Fraudulent Financial Reporting (continued) • 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

Fraudulent Financial Reporting (continued) 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.

Fraudulent Financial Reporting (continued) 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.

Fraudulent Financial Reporting (continued) • 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

Fraudulent Financial Reporting (continued) • 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

Fraudulent Financial Reporting (continued) • 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…

Fraudulent Financial Reporting (continued) • Case study – What happens? • 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… • Senior management panics…

Fraudulent Financial Reporting (continued) • Case study – What happens? • 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… • Senior management panics… • A division head feels the pressure of the unrealistically aggressive earnings target and the potential consequence of failure…

Fraudulent Financial Reporting (continued) • Case study – What happens? • 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… • Senior management panics… • A division head feels the pressure of the unrealistically aggressive earnings target and the potential consequence of failure… • New quarter, new problem….

Fraudulent Financial Reporting (continued) • Case study – What happens? • 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… • Senior management panics… • A division head feels the pressure of the unrealistically aggressive earnings target and the potential consequence of failure… • New quarter, new problem…. • Another quarter, bigger problem….

Fraudulent Financial Reporting (continued) • Case study – What happens? • 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… • Senior management panics… • A division head feels the pressure of the unrealistically aggressive earnings target and the potential consequence of failure… • New quarter, new problem…. • Another quarter, bigger problem…. • The situation deteriorates…

Fraudulent Financial Reporting (continued) • 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

Fraudulent Financial Reporting (continued) • 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

Fraudulent Financial Reporting (continued) • 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

Fraudulent Financial Reporting (continued) • 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

Fraudulent Financial Reporting (continued) • 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

Fraudulent Financial Reporting in Purchasing • 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 (continued) • 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) • 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

Fraudulent Financial Reporting in Purchasing (continued) • 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

Fraudulent Financial Reporting in Purchasing (continued) • 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

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

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

Fraudulent Financial Reporting in Inventory (continued) • 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

Fraudulent Financial Reporting in Inventory (continued) • 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

Fraudulent Financial Reporting in Inventory (continued) • 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

Fraudulent Financial Reporting in Inventory (continued) • 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

Integrity Compliance Internal Audit Group Three Components to Managing Fraud and Misconduct Prevention Detection Investigation Fraud Investigative Unit Inclusion of these groups within an organization leads to enhanced control environment

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

Managing Fraud and Misconduct Risk (continued) • 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

Managing Fraud and Misconduct Risk (continued) • 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

Managing Fraud and Misconduct Risk (continued) • Vertical and Horizontal Analysis

Fraudulent Financial Reporting – Identifying Red Flags