1 Forensic Accounting Presentation to BA 124 San Jose State University March 16, 2004 Jaime Jue | KPMG LLP

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Forensic Accounting

Presentation to BA 124 San Jose State University

March 16, 2004

Jaime Jue | KPMG LLP

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Topics Covered

1. Fraudulent Reporting – Numbers Can Lie

2. Case Study

3. Consideration of Fraud in a Financial Statement Audit

4. Be Careful What You Say - Examples of Bad E-mails

5. Questions and Answers

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Fraudulent Financial Reporting

Numbers Can Lie

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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

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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

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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

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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.

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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

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Fraud Risk Conditions Present when Fraud Occurs

• Incentives / Pressures• Opportunities• Attitudes / Rationalizations

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Conditions Present when Fraud Occurs

Three conditions are generally present when fraud occurs.

1. First, employees have an incentive or are under pressure, which provides a reason.

2. Second, circumstances exist – for example, when controls are ineffective or can be overridden – that provide an opportunity.

3. Third, those involved are able to rationalize committing fraud.

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But . . .

• Even honest individuals can commit fraud if under enough pressure.

• The greater the pressure, the more likely an individual will rationalize committing fraud.

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Fraud Risk – Incentives/Pressures

1. Profitability threatened by economic, industry, or entity operating conditions.

2. Management pressured to meet third-party expectations.

3. Management or board members’ personal finances threatened by the entity’s financial performance.

4. Employees pressured by management to meet financial targets.

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Fraud Risk – Opportunities

1. Complex or unstable organizational structure.

2. Deficient internal controls

3. Poor accounting system

4. Management override

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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.

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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

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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

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Disclosures

• Non-transparent

• Inadequate / Misleading

• Not GAAP Compliant

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Case Study – X-Tech Corporation

A True Story

The names have changed to protect the innocent (and the guilty…)

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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

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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

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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

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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

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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

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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

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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

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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

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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”

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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

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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

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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

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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.

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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

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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

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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

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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

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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

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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

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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

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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

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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

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Consideration of Fraud in a Financial Statement Audit

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1. The Importance of Exercising Professional Skepticism

2. Discussion among Engagement Personnel

3. Obtain Information to Identify Risks

4. Identify Risks

5. Assess Risks in light of Company Anti-Fraud Programs and Internal Controls

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6. Responding to the Results of the Assessment

7. Evaluate the Audit Evidence

8. Communication of Possible Fraud to Management, Audit Committee, and Others

9. Documenting the Auditor’s Consideration of Fraud

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Asking Questions and Analyzing Data

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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?

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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?

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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?

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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?

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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.

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Analyzing Data

Consider Comparisons between:

• Data from comparable prior periods

• Budgeted data

• Industry data or peer/competitor companies

• Analyst expectations

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Analyzing Data

Consider Comparisons between Revenue Data and:

1. Accounts Receivable (e.g. DSO)

2. Inventory levels on hand

3. Inventory in distribution channels

4. Deferred revenue

5. Unbilled receivables

6. Customer returns

7. Customer allowances

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Analyzing Data

Consider Comparisons between Revenue Data and:

8. Cost of Goods Sold

9. Selling expenses, such as commissions

10. Key performance indicators related to revenue (e.g. per sq. ft / per employee)

11. Percentage change from prior periods or from budget

12. Sales volume, as determined from recorded revenue amounts, compared to production capacity.

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Analyzing Data

Consider Disaggregating the revenue data by:

1. Relevant time period – quarter, month

2. Product line

3. Revenue time

4. Customer or customer group

5. Business segment or geographic location

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Analyzing Data

Examine three years of quarterly analysis to track:

1. Actual EPS

2. Consensus EPS

3. Dollar amount to move EPS one cent

4. Reserve or allowance account balances

5. Consider significant or unusual moves

6. Consider any insider activity in any quarter with unexplained changes

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Analyzing Data

Examine External Documents:

1. Analyst reports

2. Short-sellers reports

3. Media reports

4. Industry reports

5. Credit rating reports

6. Investor chat rooms / bulletin boards

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Analyzing Data

Items which may need further investigation:

1. Large transactions

2. Transactions with specific customers or groups of customers

3. Transactions near the end of a reporting period

4. Transactions with related parties

5. Revenue transactions with vendors

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Be Careful What You Say – E-mails Recovered

by Forensic Accountants

Examinations of employee e-mail

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Last Point – Examples of Bad E-mails

• “Separate contracts into two pieces so I can get accounting”

• “OK to cover from rainy day fund”

• “You have to agree to tie to future sales so I can get accounting”

• “Clean excess accrual to account XXXXX (a.k.a. Rainy Day Fund)”

• “Can you justify using this excess accrual somewhere else?”

• “Don’t pay until they pay us.” (concurrent transaction)

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Last Point – Examples of Bad E-mails

• “Need two cents to meet consensus earnings”

• “Can you work some magic to increase reserves

• “Clean excess reserves to liability account XYZ – future needs”

• “Call vendors for additional promotional funds”

• “Shift item to retail inventory pool” (50% v. 20% margin)

• “Hide field before giving to auditors.”

• “Don’t show to auditors”

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Questions and Answers

Disclaimer

The information contained herein is of a general nature and is not intended to address the circumstances of any particular individual or entity. Although we

endeavor to provide accurate and timely information, there can be no guarantee that such information is accurate as of the date it is received or that it will

continue to be accurate in the future. No one should act on such information without appropriate professional advice after a thorough examination of the

particular situation.

The views and opinions expressed herein are those of the authors and do not necessarily represent the views and opinions of KPMG LLP.