Fraud Cases in Auditing

Copyright 2005-2009 - R. S. Kulzick

Auditing for Fraud –Cases and Applications

Presentation forMiami-Dade Chapter - FICPA

June 23, 2009

Dr. Raymond S. Kulzick, CPA, CFE, CFF, CDFA, FCPASt. Thomas UniversityKulzick Consulting, PA

Information in this presentation is believed to be reliable at the time of the presentation; but the authors do not assume any responsibility for its use and it should not be relied upon as

authoritative.Illustrations are for educational purposes only and do not include all facts & circumstances.


Ray Kulzick Kulzick Consulting, PA

Forensic Accounting Divorce Fraud Business Damages Data Analysis for

Litigation


Outline

Fraud Audit & Accounting Standards SAS 99 Required Approach Understanding the Risks Financial Statement Fraud Cases & Examples

5 major types of financial statement fraud Conclusions


Financial Statement Fraud

“Intentional misstatements or omissions of amounts or disclosures in financial statements designed to deceive FS users where the effect causes the FS not to be presented … in conformity with … GAAP.” – SAS 99

“We lie about what we owe and we lie about what we earn.” – Barry Minkow 1/05


Misappropriation of Assets

“Theft of a entity’s assets.” – SAS 99 May lead to financial statement fraud if

material, in which case SAS 99 covers. Adelphia Greater Miami Chamber of Commerce

$1.9 million over 3 years


Importance of Fraud

ACFE 2008 (U.S. including government) Total fraud losses estimated at $994 billion

KPMG 2008 (U.S. including government) 74% personally observed “misconduct”, 46% of a

significant nature PWC 2007 (40 countries)

43% of companies had a significant loss in the last 2 years, averaging $2.4 million + $550 thousand post-fraud costs

E&Y 2008 (Global) 23% had someone solicited to pay a bribe in last 2 years

Oversight Systems 2007 (U.S.) 76% feel fraud is more prevalent today than it was in 2002


Audit and Accounting Standards

SAS 99 – Consideration of Fraud in a Financial Statement Audit

SSAE 10 – Reporting on Internal Control SSAE 15 – Internal Control w/FS Audit

SAS 104-111 – Risk Assessment Standards Understanding Entity & Controls links to Risk

Assessment links to Audit Procedures (110)


Audit and Accounting Standards

SSARS 10 – Performance of Review Engagements Inquiries to include fraud Representation letter to include fraud

SSARS 1 – Compilation & Review of FS For Compilations – CPA MUST:

Have a basic understanding of the company, its accounting system and its industry


Current Economic Issues

January, 2009 – AICPA issued a audit risk alert on Going Concern Issues in the current environment.

March, 2009 – AICPA Audit Practice Bulletin: “The audit profession should continue to exercise

vigilance and rigor under the current economic climate.”

Specific suggestions in Appendix, including fraud considerations


8 Steps for SAS 99

1. Discussion among engagement personnel

2. Obtaining the information needed to identify the risks of material misstatement due to fraud

3. Identifying risks that may result in a material misstatement due to fraud


8 Steps for SAS 99

4. Assessing identified risks after assessing and taking into account controls

5. Responding to the results of the assessment

6. Evaluating audit evidence7. Communicating about possible fraud8. Documenting the auditor’s

consideration of fraud


Understand the Risks -Business and Industry

What does the business do? How does it do it? How do competitors do it? What is the competitive situation? Who are the customers? Why do they buy from this company? Who are the vendors? What are the vendor customs in this industry?


Understand the Risks – External Trends

In the industry Competitors strategies In the macro environment Vendors Customers


Understand the Risks – Likely Users and Uses Investors? Banks and lenders? Surety companies? Parent company? Joint venture or other partners? Options and/or bonuses? Acquisitions? Regulators? Progress payments?


FS FraudWithin Statements

Revenues

-COS

Gross margin

-Expenses

Operating income

-Interest & taxes

Net income

Current assets

+Fixed Assets

Total Assets

Current liabilities

+Long-term liabilities

Total liabilities

Equity


FS FraudBetween Statements

Debits

Good

Assets

Bad

Cost of sales

Expenses

Credits

Good

Revenue

Equity

Bad

Liabilities


Five Major Types ofFinancial Statement Fraud

1. Fictitious revenues

2. Timing differences

3. Concealed liabilities & expenses

4. Improper disclosures

5. Improper asset valuations


1-Fictitious revenues Enron Traded gas and derivative contracts

“Harshest” employee pay system – internal competition 2000 huge increase in derivative holdings Constantly growing earnings – met all projections

100s of Special Purpose Entities used to hide massive amounts of debt and generate fictitious profits Met “letter of the law” of GAAP at the time Impact: debt became revenue Minimal disclosure

Derivative holdings valued using in-house speculative methodology Minimal disclosure Impact: asset write-ups became trading profits

2001 collapsed


Rayco Construction Co Built football stadiums

Decline in new contracts EBITDA covenant in credit line

Decreased cost to complete estimates & shifted completed project costs to open projects % of completion method Costs remain same, revenue is increased

Not discovered Following year, massive losses

Loans worked out, company recovered


2-Timing differencesMedford Machining Co.

Custom machines to mfg firearms Complex product, required customer acceptance

Booked revenue when shipped Discovered in 2001 by auditor

Testing internal controls in revenue cycle Shipping cut-off testing

$21 million restatement of 1999-2000


Sunbeam Corp. 1996 Chain Saw Al arrives

Overstates losses, creates reserves 1997 produces $60m profit (claim $189m is fraud)

Reverses reserves Bill and hold channel stuffing Contingent sale of $11m of spare parts (cost $2 million)

Al reduces profit from $9 million to $6 AA agrees, “not material,” so OK

Late 1998, falls apart, SEC begins investigation Dunlop pays $500k fine AA pays $110 million settlement

2001 Bankruptcy


U. S. Foodservice (Ahold) $700 million in vendor rebates booked before

earned from 2000 to 2003 Deloitte did internal control audit in 2001

Found lack of internal controls on rebates Deloitte external audit found in 2003

13 vendor employees colluded & returned fraudulent confirmations

Part of $1.2 billion Ahold international fraud Deloitte successfully defended based on 2007 Tellabs decision that narrowed 3rd party liability in federal investor class action suits (2009)


Krispy Kreme Doughnuts Heavily reliant on growth of franchises

Sales dropped off in 2003

Wholesale customers doubled shipped last Friday & Saturday of 2004

PWC did not review heavy year-end shipments (and subsequent returns) Whistleblower caused SEC investigation

PWC did later refuse to sign off on franchise buyback “profit”


3-Concealed liabilities & expensesPrivate Plumbing Industries, Inc.

Plumbing distributor In 2000 squeezed by recession

Booked rebates from vendors early Auditors caught

Amounts “not material,” but audited anyway Analytics based on prior years percentage rebates

revealed large increase

Result was loss versus claimed profit


Worldcom

Major telecommunications company Competitors profits dropping rapidly Worldcom reports increasing profits

$3.8 billion in line costs capitalized in 2001 Payments to other co. for use of their lines Had been doing since 1999

AA auditors did not investigate red flags Costs ran over 50%, was 42% in 2001 Mgmt said sales mix had changed – no support

Whistleblowers took to SEC AA settlement for $65 million


Adelphia Communications Cable television company

Public, but family controlled (4 on board) Operated through over 200 subsidiaries $2 billion+ debt in unconsolidated subsidiaries

Parent is guarantor No disclosures

Deloitte clean opinions in 1999 and 2000 Recommended footnote for 2000, backed off “Suspended” 2001 audit, later fired

$167 million malpractice settlement


CUC International, Inc. Diversified services company

Numerous acquisitions Entrenched management

$252 million fraud involving mismatch of deferred revenue and expenses

1997 merged with HFS to form Cendant Post-merger audit of CUC by former HFS management disclosed

fraud Stock dropped $14 billion in one day Largest fraud at that date

Ernst settlement $335 million Walter Forbes (chair) sentenced to12+ years and $3.27 billion Kirk Shelton (vice chair) sentenced to 10 years and $3.27 billion


Aurora Foods

$800 million manufacturer & marketer of branded foods Duncan Hines, Mrs. Paul’s, Lender’s, etc.

IPO in July, 1998 Fraud began in mid-1998

Promotional credits not reflected in A/Receivable $38m in 1998; $43m in 1999 1st 3 quarters Turned off computer system that generated these as credits

on billings and changed to manual postings Discovered by PWC in 1999 statements (Feb, 2000) – 10-Qs

were not audited Investigation by Deloitte


4-Improper disclosuresCardinal Health, Inc.

Drug wholesaler Manufacturers cutting out wholesalers Lawsuit by company against vitamin manufacturers

Booked anticipated legal settlements in 2000, 2001 and early 2002 as offsets to cost of sales Journal entries No disclosure, enabled them to meet analyst projections

E&Y did not discover (was successor to AA) SEC opened an investigation in 2003, lawsuits followed


5-Improper asset valuationsPrime Plumbing, Inc.

Plumbing Distributor & Retailer 2 warehouses, 30 showrooms Fraudulent inventory in showrooms

Auditors audited inventory only at warehouses for more than 5 years 50% of inventory in showrooms Individual showrooms deemed “not material”

2001 auditors finally discovered Obtained sq footage for each showroom Analyzed inventory per sq foot


Parmalat International dairy products company

Based in Italy, rapid expansion Many foreign subs losing money, high debt level

€4 billion cash deposit in Cayman bank did not exist

Both Grant Thornton (1999 and earlier) and Deloitte (2000) issued clean opinions Confirmation sent through company’s mail Fraudulent confirmation accepted

Largest fraud in Europe to date


Refuse Collection Services, Inc.

Wisconsin waste service company 1997 acquired company in adjacent area Recorded goodwill of $350,000

1998 through 2001 the acquired division reported losses Efforts to reduce losses were unsuccessful Auditors accepted management’s forecasts and

projections of future profits

Goodwill finally written off in 2002


Mueller Microbrewery

Midwest brewery Declining sales in 2001 Actual numbers would have violated loan covenants

Added $135,000 to fixed assets Used journal entries crediting various expense accounts Some in small assets, known to be “not material” in past

audits Some in a large addition

Auditor questioned missing support on large item Accepted that papers must have been “lost”

Discovered following year by bank


Brown Packaging Co.

Cardboard packaging to major manufacturers Very cyclical business

Used long lives when times lean e.g., 39 years for leasehold improvements Short lives when times good, accelerated dep.

Audited during due diligence when sold in 2001 $5 million write-off on leaseholds Additional $7 million on other assets


John-Tee Plumbing Distributors

Plumbing distributor Grew to 10 warehouses over 20+ years

Never wrote off or reserved for obsolete inventory Auditors never tested for nor adjusted

New auditors Observed, researched and documented all

inventory $ 500,000 write-off for obsolescence


E. S. Bankest LLC

Miami factoring company Joint venture created in 1998 Espirito Santo Bank & Orlansky brothers

$170m fraudulent receivables – main asset BDO Seidman clean opinions 1998-2002 2003 went into receivership

Receiver (Lewis Freeman) Visited companies with large A/R Either non-existent, related parties, or very small

$522 million malpractice award Under Florida law, jury verdict cannot bankrupt a company -

collectibility in doubt


Conclusions

Materiality is not based on transactions Management sometimes lies Don’t audit something you don’t understand Just because it isn’t consolidated doesn’t mean its

not important Look at the big picture – where’s the risk? Do the financials “present fairly” to third party

users?


Thank you!

Questions?

Ray Kulzick – 305.812.4998Kulzick Consulting, [email protected]


Ray Kulzick Kulzick Consulting, PA

Forensic Accounting Divorce Fraud Business Damages Data Analysis for

Litigation


Master of Accounting – 30 credits Specialization in Forensic Accounting Specialization in Tax

MBA – 42 credits Specialization in Accounting Joint JD degree program

MS in Management – 36 credits Specialization in Management Accounting

Graduate Certificates – 12 credits Forensic Accounting Taxation Management Accounting

Documents

Fraud Cases in Auditing