Business Financial Crime: Financial Statement Fraud II

Prevention and Detection

2

3

Earnings Management

Operating & discretionary accounting methods to adjust earnings to a desired outcome; the incentives of management to modify earnings in their own best interests

Earnings manipulation includes aggressive earnings management and fraud

4

Why Earnings Management?

“It pays to do it, it’s easy to do,and it’s unlikely that you’ll get caught (Schilit)

Opportunism: self-interest with guile—violating normal ethical boundaries for personal gain

Executive incentives include bonuses and stock options

5

Incentives for F.S. FraudIncentives to commit financial statement fraud are very strong. Investors want decreased risk and high returns.Risk is reduced when variability of earnings is decreased.Rewards are increased when income continuously improves.

Which firm will have the higher stock price?

Firm A Firm B

6

An Accepted Practice

March 31, 1997

LEARN TO PLAY THE EARNINGS GAME (AND WALL STREET WILL LOVE YOU)

“The pressure to report smooth, ever higher earnings has never been fiercer. You don't want to miss the consensus estimate by a penny--and you don't have to.”

Fortune Magazine

7

An Accepted Practice “In January 1997, for the 41st time in the 42 quarters

since it went public, Microsoft reported earnings that met or beat Wall Street estimates.

General Electric, a company whose name invariably comes up when you ask Wall Streeters about earnings management, says it does what it does because the stock market demands it. "We think consistency of earnings and no surprises is very important for us," says Dennis Dammerman, the company's CFO.

FORTUNE's 1997 Most Admired list, seven--Coca-Cola, Merck, Microsoft, Johnson & Johnson, Intel, Pfizer, and Procter & Gamble--have missed fewer than five quarters in the past five years”

8

Earnings Management Environment Incentives: self-interest & greed Institutional environment includes

corporate governance, auditing, regulation & standard setting, attorneys, investment bankers, & whistleblowers

9

The Corporate Governance Environment Corporate governance practices signal the

potential for earnings management—permissive structures indicate that manipulation is more likely

The board of directors sets overall policy & provided oversight for operating activities

Historically, boards were composed mainly of owners, managers & other insiders

It is now clear that a majority of independent board member is essential for effective oversight

10

Concerns with the Board of Directors Is the CEO also the chairman of the board? Evidence of CEO oversight abuse Are a majority of board members

independent? What are the board committees & is there

evidence that they’re active & effective Evaluate board compensation—is it based

on performance & active participation

11

Concerns with Executive Compensation

Evaluate the compensation committee for independence & competence

Analyze the executive compensation (especially the CEO) by component: base pay, bonuses, stock options (& other forms of ownership-related compensation) & perks

Is compensation based on performance? Evaluate based on earnings & stock price performance

Particular concerns are for over-compensation of CEO for poor performance & impact of previous accounting-related abuses

12

Concerns with Auditing

Evaluate the audit committee for independence, competence with financial information, how many times the committee meets & other evidence of diligence

Review audit procurement practices, including the external auditor (usually a Big 4 firm), non-audit fees, the audit opinion & timeliness of reports

13

Stock Options

Options grant the holder the right to purchase stock at a set price (exercise price) over some fixed time period, usually the closing price at the issue date

Options are a one-directional participation in the success of the company—the employee benefits (will exercise the options) only if the stock price goes up. If the price goes down, there is no loss the the employee

Ideally options give employees the incentives to behave as owners of the company

14

Alternative to Stock Options

The use of stock options has been criticized since the recent scandals

Many companies are moving to alternative methods of employee participation in ownership, including restricted stock, phantom stock & stock appreciation rights

15

Environment for Earnings Management Strong CEO with substantial perks Board made up primarily of insiders Poor board committee structure Audit problems Executive compensation problems Investment banking problems

16

Effects of Financial Statement Fraud  Undermines the reliability, quality, transparency,

and integrity of the financial reporting process Jeopardizes the integrity and objectivity of the

auditing profession, especially auditors and auditing firms

Diminishes the confidence of the capital markets, as well as market participants, in the reliability of financial information

Makes the capital markets less efficient

17

Effects of Financial Statement Fraud  Results in huge litigation costs Destroys careers of individuals involved in

financial statement fraud. Causes bankruptcy or substantial

economic losses by the company engaged in financial statement fraud

18

Effects of Financial Statement Fraud  Causes devastation in the normal

operations and performance of alleged companies

Raises serious doubt about the efficacy of financial statement audits

Erodes public confidence and trust in the accounting and auditing profession

19

Detection

Red Flags Financial Analysis Trend Analysis

20

Red Flags – Fictitious Revenues  Rapid growth or unusual profitability, especially

compared to that of other companies in the same industry

Recurring negative cash flows from operations or an inability to generate cash flows from operations while reporting earnings and earnings growth

Significant transactions with related parties or special purpose entities not in the ordinary course of business or where those entities are not audited or are audited by another firm

21

Red Flags – Fictitious Revenues  Significant, unusual, or highly complex

transactions, especially those close to period end that pose difficult “substance over form” questions

Unusual growth in the number of days’ sales in receivables

A significant volume of sales to entities whose substance and ownership is not known

22

Red Flags – Timing Differences  Rapid growth or unusual profitability, especially

compared to that of other companies in the same industry

Recurring negative cash flows from operations or an inability to generate cash flows from operations while reporting earnings and earnings growth

Significant, unusual, or highly complex transactions, especially those close to period end that pose difficult “substance over form” questions

Unusual increase in gross margin or margin in excess of industry peers

Unusual growth in the number of days’ sales in receivables

Unusual decline in the number of days’ purchases in accounts payable

23

Red Flags – Concealed Liabilities 

Recurring negative cash flows from operations or an inability to generate cash flows from operations while reporting earnings and earnings growth

Assets, liabilities, revenues, or expenses based on significant estimates that involve subjective judgments or uncertainties that are difficult to corroborate

Non-financial management’s excessive participation in or preoccupation with the selection of accounting principles or the determination of significant estimates

24

Red Flags – Concealed Liabilities 

Unusual increase in gross margin or margin in excess of industry peers

Allowances for sales returns, warranty claims, and so on that are shrinking in percentage terms or are otherwise out of line with industry peers

Unusual reduction in the number of days’ purchases in accounts payable

Reducing accounts payable while competitors are stretching out payments to vendors

25

Red Flags –  Improper Asset Valuation  Unusual growth in the number of days’ sales in

receivables Unusual growth in the number of days’ purchases in

inventory Allowances for bad debts, excess and obsolete

inventory, and so on that are shrinking in percentage terms or are otherwise out of line with industry peers

Unusual change in the relationship between fixed assets and depreciation

Adding to assets while competitors are reducing capital tied up in assets

26

Red Flags –  Improper Asset Valuation  Recurring negative cash flows from operations or an

inability to generate cash flows from operations while reporting earnings and earnings growth

Significant declines in customer demand and increasing business failures in either the industry or overall economy

Assets, liabilities, revenues, or expenses based on significant estimates that involve subjective judgments or uncertainties that are difficult to corroborate

Non-financial management’s excessive participation in or preoccupation with the selection of accounting principles or the determination of significant estimates

Unusual increase in gross margin or margin in excess of industry peers

27

Red Flags – Other  Domination of management by a single person or small

group (in a non-owner managed business) without compensating controls

Ineffective board of directors or audit committee oversight over the financial reporting process and internal control

Ineffective communication, implementation, support, or enforcement of the entity’s values or ethical standards by management or the communication of inappropriate values or ethical standards

Rapid growth or unusual profitability, especially compared to that of other companies in the same industry

28

Red Flags – Other  Significant, unusual, or highly complex transactions,

especially those close to period end that pose difficult “substance over form” questions

Significant related-party transactions not in the ordinary course of business or with related entities not audited or audited by another firm

Significant bank accounts or subsidiary or branch operations in tax haven jurisdictions for which there appears to be no clear business justification

Overly complex organizational structure involving unusual legal entities or managerial lines of authority

29

Red Flags – Other Recurring attempts by management to

justify marginal or inappropriate accounting on the basis of materiality

Formal or informal restrictions on the auditor that inappropriately limit access to people or information or the ability to communicate effectively with the board of directors or audit committee

30

Deterrence of Financial Statement Fraud  Reduce pressures to commit financial

statement fraud Reduce the opportunity to commit

financial statement fraud Reduce rationalisation of financial

statement fraud

31

Reduce Pressures to Commit Financial Statement Fraud  Establish effective board oversight of the “tone at the

top” created by management. Avoid setting unachievable financial goals. Avoid applying excessive pressure on employees to

achieve goals. Change goals if changed market conditions require it Ensure compensation systems are fair and do not create

too much incentive to commit fraud. Discourage excessive external expectations of future

corporate performance. Remove operational obstacles blocking effective

performance

32

Reduce the Opportunity to Commit Financial Statement Fraud  Maintain accurate and complete internal accounting records. Carefully monitor the business transactions and

interpersonal relationships of suppliers, buyers, purchasing agents, sales representatives, and others who interface in the transactions between financial units.

Establish a physical security system to secure company assets, including finished goods, cash, capital equipment, tools, and other valuable items.

Maintain accurate personnel records including background checks on new employees.

Encourage strong supervisory and leadership relationships within groups to ensure enforcement of accounting procedures.

Establish clear and uniform accounting procedures with no exception clauses.

33

Reduce rationalisation of Financial Statement Fraud  Promote strong values, based on integrity,

throughout the organization. Have policies that clearly define prohibited

behaviour with respect to accounting and financial statement fraud.

Provide regular training to all employees communicating prohibited behaviour.

34

Reduce rationalisation of Financial Statement Fraud  Have confidential advice and reporting

mechanisms to communicate inappropriate behaviour.

Have senior executives communicate to employees that integrity takes priority and that goals must never be achieved through fraud.

Ensure management practices what it preaches and sets an example by promoting honesty in the accounting area.

The consequences of violating the rules and the punishment of violators should be clearly communicated

35

Corporate Governance

The board of directors and the structure in place to oversee the management of an organisation

Importance of outside, independent directors

Key committees include the audit committee & compensation committee

36

Cultivating a Vigorous Whistleblower Program Encourage the development of a culture in which

employees view whistleblowing as a valuable contribution to an attractive workplace of integrity and their own futures. Employees should not feel like “tittle-tatlers” or

“sneaks” for communicating potential fraud. The automatic and direct submission to the audit

committee, of all complaints involving senior management (without filtering by management or other entity personnel) is essential.

37

Developing a Broad Information and Feedback Network Develop an extensive information network including:

Internal auditors Independent auditors Compensation committee Key employees Company lawyers HR director Compliance officer Risk management officers Divisional managers and controllers

“Management by walking about” Consider meeting periodically with representatives from each

of the groups to discuss matters affecting the financial reporting process.

38

Occupational Fraud Survey

Association of Certified Fraud Examiners

2006

39

Survey The data strongly supported Sarbanes-Oxley’s requirement

for audit committees to establish confidential reporting mechanisms. Occupational frauds in the study were much more likely to be detected by a tip than through other means such as internal audits, external audits, and internal controls.

Among frauds committed by owners and executives, which tend to be the most costly, over half of all cases were identified by a tip.

Confidential reporting mechanisms reduce fraud losses significantly. The median loss among organisations that had anonymous reporting mechanisms was $56,500.

In organisations that did not have established reporting procedures, the median loss was more than twice as high.

40

Survey More effective internal controls are needed to detect

fraud. Internal controls ranked fourth – behind By Accident – in terms of the number of frauds detected in the study.

Furthermore, the frauds that were detected by internal controls tended to be relatively small, with a median loss of $40,000, which was by far the lowest of any detection method.

More effective types of internal controls are needed to detect fraud, especially larger frauds that may involve senior personnel overriding or circumventing traditional internal controls.

41

42

43

44

45

Losses associated with owner/exec schemes tend to be larger than for any other group, yet these schemes are much less likely to be detected through normal audits or control functions. This highlights the importance of establishing anonymous reporting mechanisms, conducting anti-fraud training and fostering open channels of communication.

46

47

48

49

Limiting Fraud Losses Anonymous Fraud Hotlines

The survey found that anonymous reporting mechanisms showed the greatest impact on fraud losses.

organisations that did not have reporting mechanisms suffered median losses that were over twice as high as organisations where anonymous reporting mechanisms had been established.

50

Limiting Fraud Losses This was consistent with the data gathered showing that

the most common way for frauds to be discovered is through tips.

Obviously, hotlines and other reporting mechanisms are designed to facilitate tips on wrongdoing.

The fact that tips were the most common means of detection, combined with the fact that organisations which had reporting mechanisms showed the greatest reduction in fraud losses, indicates that this is an extremely valuable anti-fraud resource, and gives further support to Sarbanes-Oxley’s mandate for confidential reporting mechanisms.

51

Limiting Fraud Losses

Internal Audits

About 57% of the victim organisations in the study had internal audit or internal fraud examination departments.

These organisations suffered a median loss of $80,000, compared with the median loss of $130,000 in organisations where there was no internal audit department.

52

Limiting Fraud Losses The absence of a measurable impact as a result of external

audits is consistent with the data gathered on fraud detection, which showed that external audits generally ranked low – behind By Accident – as a means of catching fraud.

53

Cultural Differences?

“A Theory of Corporate Scandals:

Why the U.S. and Europe Differ” (Coffee, 2005)

54

A Theory of Corporate Scandals

Gatekeeper Failure Across Ownership Regimes Both ownership regimes – dispersed and concentrated –

show evidence of gatekeeper failure. The U.S./U.K. system of dispersed ownership is vulnerable to gatekeepers not detecting inflated earnings

Concentrated ownership systems fail to the extent that gatekeepers miss (or at least fail to report) the expropriation of private benefits.

A key difference is that in dispersed ownership systems the villains are managers and the victims are shareholders

In concentrated ownership systems the controlling shareholders overreach minority shareholders.

55

A Theory of Corporate Scandals

As a result, controlling shareholders in Europe do not obsess over the day-to-day market price

They rationally do not engage in tactics to prematurely recognise revenues to spike their stock price.

Therefore lesser use of equity compensation and lesser interest in the short-term stock price

Explain in part why there were less accounting irregularities in Europe than in the U.S. during the last few years

56

References

Association of Certified Fraud Examiners (2006) Occupational Fraud Survey.

Coffee, J. (2005) A Theory of Corporate Scandals: Why the US and Europe Differ, working paper Columbia Law School.

Giroux, G (2004) Detecting Earnings Management, Wiley.

Quffa, H.C. (2006) Financial Statement Fraud, http://www.passia.org/seminars/2006/FinancialStatementFraudretrieved 20th November 2007.