Business Financial Crime: Financial Statement Fraud

Business Financial Crime: Financial Statement Fraud

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Learning Outcomes:

Appreciate financial statement fraud stemming from irregularities – not misappropriation of assets

Understand main rationale for such fraud activity in the recent past, as well as the conditions necessary for such fraud to flourish

Describe some of the main methods employed to distort reported results

Appreciate some fraud warning signs

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Enron (2002)

Admits that for over 3 years its net income was inflated by almost $600,000,000.

May have overstated assets by $24,000,000,000 according to company executives

Engaged in energy swaps to overstate revenues

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Reliant Resources Inc. 2002

Conducted fake transactions with four power companies, inflated revenue by 10% over 3-year period.

Dynegy also indicated that it conducted similar transactions.

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WorldCom Inc., 2002

Reports corrected income to reflect “Unspecified Net Loss”

Original expenses of $41.8 billion were corrected to be above $43.3 billion.

By August of 2002, found $7.1 billion in expenses and irregularities.

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Xerox Corporation, 2002

$6.5 billion recorded as equipment sales revenue in 1997 through 2000 should have been $5.1 billion in service, rental, and financing from 1997-2001.

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IBM 2002

Used a $290 million gain from sale of business 3 days prior to end of 4th Qtr of 2001 to help beat Wall Street’s profit forecast (Business Week, May 6, 2002)

This one-time, undisclosed gain was used to lower operating costs.

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Gillette (2003), James Kilts, CEO “I asked … why we made these big deals at

the end of the quarter.” “It’s you guys in Boston. You guys made us

do it.” The circle of doom:

Over-optimistic forecasts … high goalsBuild inventory, overhead, new capitalMiss targets, cut prices, cut advertising, give

incentives to distributors/retailers

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The Issue – Perpetrated by Management Different companies, different industries,

different issues, different casts of characters The major cases all have two things in common:

ALL INVOLVE MANAGEMENT OVERRIDE OF AN OTHERWISE EFFECTIVE SYSTEM OF INTERNAL CONTROL

THE BOARD OF DIRECTORS AND AUDIT COMMITTEES DID NOT DETECT THE OVERRIDE

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What is Earnings Management?

Healy and Whalen (1999):

“ Earnings management occurs when managers use judgment in financial reporting and in structuring transactions to alter financial reports to either mislead some stakeholders about the underlying economic performance of the company or to influence contractual outcomes that depend on reported accounting numbers.”

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Incentives for Earnings Management

Increase the firm's share price, particularly when the stock is about to be issued or used in a transaction.

Decrease the firm's share price prior to a management buyout.

Meet analyst or management earnings forecast. Increase managers' compensation that is tied to

earnings performance. Avoid violating debt covenants. Reduce taxes by shifting income to lower tax rate years.

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Matching Earnings Estimates

compute sales and subtract expenses to calculate the profit… OR

… start with the profit that investors are expecting and manipulate sales and expenses to make sure the numbers come out right.

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Restatements in the USA in 2004Post Sarbanes Oxley 253 of the restatements were associated with

the audited financial statements 23% increase over 2003

Revenue recognition & reserves and contingencies were the leading cause of restatements

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Errors v Irregularities

Errors Involve: Mistakes in gathering and

processing data Incorrect use of estimates Certain mistakes in

applying accounting principles

Irregularities Involve: Manipulating, altering or

falsifying records Intentional omission of

events, transactions or significant events

Misapplication of accounting principles with intent to deceive

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The Trajectory of Fraud

Fraud starts out small Increases in complexity and

aggressiveness Grows in magnitude and number of

participants No way out

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The Slippery Slope

Utilize aggressive reserves Delay/alter expense recognition Manipulate revenue recognition Make unsupportable entries Exploit acquisition reserves Fabricate additional revenues

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Utilise Aggressive Reserves

Bad debt reserves Returns & allowances Inventory obsolescence Change pension assumptions Depreciation reserves Special charges

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The Slippery Slope

Utilize aggressive reserves Delay/alter expense recognition Manipulate revenue recognition Make unsupportable entries Exploit acquisition reserves Fabricate additional revenues

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Delay or Alter Expense Recognition

Fail to write down impaired assets Investment income offsets expenses Shift expenses to earlier periods Research and Development in related

companies Capitalize operating expenses

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The Slippery Slope

Utilize aggressive reserves Delay/alter expense recognition Manipulate revenue recognition Make unsupportable entries Exploit acquisition reserves Fabricate additional revenues

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Manipulate Revenue Recognition

Channel stuffing A deceptive business practice used by a company to

inflate its sales and earnings figures by deliberately sending retailers along its distribution channel more products than they are able to sell to the public.

Side Agreements Quid pro quo Long term contracts accelerated

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The Slippery Slope

Utilize aggressive reserves Delay/alter expense recognition Manipulate revenue recognition Make unsupportable entries Exploit acquisition reserves Fabricate additional revenues

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Creative Accounting

No relationship to underlying transaction Book nonexistent inventory Fail to eliminate inter-company sales Abusing structured finance transactions

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Abusing Structured Finance TransactionsTHE PROBLEM The gap between reported operating income and

operating cash flows is substantial. The Company needs to raise substantial

amounts of cash, but is reluctant to issue additional equity.

Issuing additional debt will likely negatively impact the opinions of rating agencies.

A substantial portion of The Company’s business is dependent upon the strength of its credit rating.

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Solution? – A “prepaid” transaction

SPE

Enron Bank

Forward contract to deliver 390,000 barrels of oil over 46 months – March 99 to Dec 02

$300M+ paid to SPE by Bank for forward contract

$300M paid to Enron by SPE for forward contract

Forward contract to deliver 390,000 barrels of oil over 46 months – March 99 to Dec 02

Enron makes 46 monthly payments of £7.5m to bank totalling £345m

Bank pays Enron a floating price on the oil

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Accounting and Reporting Issues

The substance of the transaction (a loan) was ignored – it was accounted for based upon its form.

Because of its characterization as “trading" activity: The balance sheet reported this obligation as a type

of liability as opposed to debt. Additionally, reported as cash flow from operations as

opposed to financing cash flows.

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Specifics of Transaction

As a result of the “Financial Engineering”…1. Total debt is materially understated.2. Several key measures are favorably impacted, including

(1) funds flow interest coverage, (2) funds flow to total debt, and (3) debt to equity.

3. Cash flow from operations is materially overstated, lessening the overall gap with operating income.

4. Financing cash flows are materially understated.5. Enron’s credit rating remains unchanged.

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The Slippery Slope

Utilize aggressive reserves Delay/alter expense recognition Manipulate revenue recognition Make unsupportable entries Exploit acquisition reserves Fabricate additional revenues

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Exploit Acquisitions Reserves

Release questionable reserves into income

Establish sham reserves Undervalue the Target’s acquired assets

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Establish Sham Reserves

Purchaser acquires in-progress contracts with estimated profit margin of 18%

Further analysis reveals:Future Contract Revenues £25,350,000Future Contract Expenses £23,875,000Contract Profit £1,475,000Estimated Return 5.82%

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Establish Sham Reserves – The Big Bath Effect

Establish £30,000,000 reserve associated with future terminations

Establish £16,000,000 reserve associated with future plant closings

?Establish £4,000,000 reserve associated with environmental remediation

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Establish Sham Reserves

As £4,000,000 in future contract expenses get paid…

Cost of Goods Sold £4,000,000 CR P&L Acquisition Reserve £4,000,000 DR B/S

Overstates Gross Profit, Operating Income andCash Flow From Operations

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Undervalue Acquired Assets XYZ PLC purchases a target for

£250,000,000 in consideration Allocates the purchase as follows:£110,000,000 to hard assets

£40,000,000 to inventory Undervalued by 20m

£20,000,000 to IP

£80,000,000 to goodwill Overvalued by £20m

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Undervalue Acquired Assets

XYZ PLC P &L 31/12/06

Gross Operating Revenues £131,572,030 100.0%

Cost of Sales

Materials 32,894,570 25.0%

Outside Services 12,118,926 9.2%

Supplies 4,020,900 3.1%

Wages 21,334,230 16.2%

Total Cost of Sales 70,368,626 53.5%

Gross Profit 61,203,404 46.5%

Undervaluing inventoryartificially lowers the “Materials” componentof Cost of Sales

Overstates Gross Profit, Operating Income andCash Flow FromOperations

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The Slippery Slope

Utilize aggressive reserves Delay/alter expense recognition Manipulate revenue recognition Make unsupportable entries Exploit acquisition reserves Fabricate additional revenues

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Fabricate Additional Revenues

Create phony sales invoices Merger hold backs Treat borrowings as operating revenue

Operating income overstatedFalls through to profitLiabilities understatedFavourable impact on operating cash flow and

financing cash flows

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Potential Warning Signs

Balance Sheet

– Trade debtors/Accounts receivable grows substantially faster than sales

Aggressive revenue recognition

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Potential Warning Signs

Balance Sheet

– Growth in Trade Creditors/Accounts Payable substantially exceeds revenue growth

Failing to pay current expenses – will require larger cash outlays in future periods (Bonus may be tied to CFFO)

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Potential Warning Signs

Income Statement

–Majority of net income comes from onetime gains

Core business may be deteriorating

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Potential Warning Signs

Income Statement

– Operating expenses decline sharply relative to sales

Improperly capitalizing expenses or offsetting investment gains

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Potential Warning Signs

Income Statement

– Seller provides financing and/or extended payment terms

Quality of earnings may be suspect

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Potential Warning Signs

Statement of Cash Flows

– Cash flow from operations materially lags net income

Quality of earnings may be suspect

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Potential Warning Signs

Statement of Cash Flows– Company cash flows come primarily from

assets sales, borrowings or equity offerings

Sign of material weakness in core business

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Potential Warning Signs

Notes, Director’s report, Auditor’s letter

– Change in accounting principles, estimates and classification

Attempt to hide operating problems

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Potential Warning Signs

Notes, Director’s report, Auditor’s letter

– Very acquisitive in recent past

Potential for masking past poor performance and manipulating net income

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Other Warning Signs – Reported NI grows faster than CFFO. – Sales slow while inventories pile up. – Bad debt reserves cut. – Methods for calculating revenue & costs

change. – Sales are booked before payments received. – Dramatic change in gross margin. – Turnover of auditor, key execs or lawyers.

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EXECUTIVE COMPENSATION AND CORPORATE FRAUD Executives at fraud firms face greater financial

incentives to commit fraud than do executives at industry- and size-matched control firms.

The likelihood of fraud is positively related to incentives from unrestricted stock holdings

Executives at fraud firms exercise larger fractions of their vested options, sell more stock, and receive greater total compensation during the fraud years than the control executives.

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EXECUTIVE COMPENSATION AND CORPORATE FRAUD Operating performance measures suggest executives

commit corporate fraud following declines in performance.

Stock prices fall approximately twenty percent on average upon the disclosure of potential fraud, which suggests that frauds inflated stock prices during the fraud period.

The results imply that optimal governance measures depend on the strength of executives’ financial incentives, especially following periods of poor performance, and that restrictions on an executive’s ability to sell shares could deter fraud.

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Will it happen again?

Major costs such as oil costs are rising… Companies lack substantial pricing power… Pension liabilities are a big unknown… Overpayment for past acquisitions… Expensing of share options… Earnings pressure has not abated…

As A Result…

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Stripes will stillbe in fashion in2007 and beyond!

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ReferencesAICPA (2006) Fraud: Can Audit Committees Make a Difference?,

www.aicpa.org/audcommctr/spotlight/achilles_heel.htm, retrieved 12 Nov 2007.

Erickson, M., Hanlon, M. and Maydew, E. (2004) Is There a Link Between Executive Compensation and Accounting Fraud?, working paper, www.ssrn.com, retrieved 14 Nov 2007

Harfenist, J.T. (2002) Understanding Financial Statement Fraud, www.theiia.org/chapters/index.cfm/view.public_file/cid/112/fileid/7357, retrieved 12 Nov 2007.

Johnson, S.A., Ryan, H.E. and Tian, Y.S. (2005) Executive Compensation and Corporate Fraud, working paper, www.ssrn.com, retrieved 13 Nov 2007.

Shane, P. (2000) Earnings Management and Market Anomalies, Burridge Conference, leeds.colorado.edu/.../Burridge_Center_for_Securities_Analysis_and_Valuation/Forums/burridge-shane.pdf, retrieved 12 Nov 2007