Management Fraud Introduction

1. Management FraudIntroduction Accounting 537

2. Management Fraud • Chapter 11 – Financial Statement Fraud • Chapter 12 – Revenue and Inventory Financial Statement Fraud • Chapter 13 – Liability, Asset, and Inadequate Disclosure Frauds Accounting 537

3. Fraudulent Manipulation of accounting numbers is frequently called “financial shenanigans”… Accounting 537

4. Why do Shenanigans Exist? Accounting 537

5. Why do Shenanigans Exist? • It pays • It’s easy • Discovery is difficult and unlikely Accounting 537

6. Collusion Forgery Complex Audit Trails Lies Silence Off-Book Frauds Misleading Documents Small Frauds What makes it hard for auditors to detect fraud? Accounting 537

7. Likely Candidates for Shenanigans • Fast-growth companies whose real growth is beginning to slow • Basket-case companies trying to survive • Newly public companies (IPO) • Private companies Accounting 537

8. What makes shenanigans possible?… Accounting 537

9. Managerial Discretion • Under US GAAP, a company’s management is given some discretion as to the timing and classification of certain financial statement items. • Unfortunately, a company’s management can use this allotted discretion to manipulate reported earnings. Accounting 537

10. Earnings Manipulation • Four basic categories… Accounting 537

11. Earnings Manipulation 1. Classification of Good News / Bad News • Analysts and investors tend to focus on income from continuing operations, a reporting company will tend to include good news in this category and keep bad news out (report it below the net-income-from-operations line). • Sell a subsidiary for a gain, put in continuing operations. • Sell the subsidiary for a loss, classify it as a discontinued operation (extraordinary or unusual or infrequent event) and report the loss below the line. Accounting 537

12. Earnings Manipulation 2. Income Smoothing • Companies go through cycles. • During the good years, some companies will create accounting reserves so in bad years they can increase their net income and effectively smooth out their reported net income over time. Accounting 537

13. Earnings Manipulation Income Smoothing Two Types:a. Between periods -takes place when a company alters the timing of expenditures or chooses an accounting method that smoothes out earnings. Ex: choosing to capitalize or expense R&D expenditures. b.Between Financial Statement Classifications - takes place when a company chooses the category of an item based on the reporting implication it will have (i.e. it will be above or below the net-income-from-continuing-operations line). Ex: selling of a subsidiary or asset as if it were a gain or loss from continuing operations or not. Accounting 537

14. Earnings Manipulation 3. Big-bath behavior This takes place when a company is having a really bad year and the income reserves are not enough to offset the bad results they are about to report. Management knows that its stock will drop and investors will not be happy. Management figures that it is the best time to get rid of all of the inconsistencies that will have a negative impact on the financial statements (impairment of assets etc.). Two benefits for a company: first, most of the bad news will be reported below the line, and second, in the future the company will appear to be more profitable than in the past. Accounting 537

15. Earnings Manipulation 4. Accounting changes A company can change its accounting methods: - Change its inventory cost flow method (LIFO to FIFO)- Capitalize instead of expense decisions- Change its depreciation method Since accounting changes are accounted for below the line (net income from operations), they can be used to manipulate the reported income from continuing operations. Accounting 537

16. “Shenanigans” • There are two basic strategies underlying accounting shenanigans: • Inflating current reported income A company can inflate its current income by inflating current revenues and gains, or deflating current expenses. • Deflating current reported income A company can deflate current revenues by deflating current revenues or gains, or inflating current expenses. Accounting 537

17. Finding Shenanigans 1. Press releases Accounting 537

18. Finding Shenanigans 2.Securities Exchange Commission filingsSecurities filings are forms such as the Form 10-K (annual), 1O-Q (quarterly), 8-K (special events) and 144 (corporate insider activity) • The auditors report— Red flags include: o Inclusion of a qualified opinion o No audit committee, or audit committee comprises mostly of related parties Accounting 537

19. Finding Shenanigans 2.Securities Exchange Commission filings • Proxy statement an SEC filing required of a US firm when soliciting shareholder votes. This statement is useful in assessing how management is paid and potential conflict-of-interest issues with auditors. The statement includes: 1. Voting procedure and information. 2. Background information about the company's nominated directors. 3. Director compensation. 4. Executive compensation. 5. A breakdown of audit and non-audit fees paid to the auditor. • Red flags include: o Pending lawsuits or other contingent liabilities o Special compensation plans or perks for officers and directors Accounting 537

20. Finding Shenanigans 2.Securities Exchange Commission filings • Footnotes to financial statements— Red flags include:o Abnormalities found in the accounting-policy descriptions o Pending lawsuits or other contingent liabilities o Off-balance-sheet transactions o Changes in accounting principles and estimations • Management discussion and analysis (MD&A) — Red flags include: o Large planned expenses o Decreased liquidity o Abnormal need for working capital Accounting 537

21. Finding Shenanigans 2.Securities Exchange Commission filings • Form 8-K — This will provide information on:o The company’s acquisition and divestitures o Change in auditor — If a company changes auditors, it could be because the previous auditor did not want to sign off on the financial statements. Accounting 537

22. Finding Shenanigans 3.Interviews with the companyQuestion management personally Accounting 537

23. Finding Shenanigans 4. Commercial databases Analysts can also make use of commercial databases such as LexisNexis and Compustat to screen for companies displaying potential warning sings of operating and accounting problems Accounting 537

24. What are the motives for financial statement fraud? High Stock Prices Competition Increased Personal Wealth Bond or Stock Offerings To Meet Expectations Accounting 537

25. Fraud Exposure Rectangle Company’s Relationship with Other Entities 2 Management & Directors 1 Financial Results & Operating Characteristics The Organization & Its Industry 3 4 Accounting 537

26. Relationships with Others • Related Party Transactions • With Financial Institutions & Bond Holders • Improper or Unrealistic Transactions • With Auditors, Attorneys, Investors, & Regulators Accounting 537

27. Organization & Industry • Structures Designed to Hide Fraud • Unduly Complex Organizations • Lack of Internal Audit • Board of Directors with Few Outsiders • Weak Audit Committees Accounting 537

28. Management & Directors Financial Statements Require Mgmt’s Participation They Work “On Behalf” of the Organization • Backgrounds • Motivations • Influence on Decision Making Accounting 537

29. Recognize the personality type… Accounting 537

30. ENDManagement FraudIntroduction Accounting 537