financial fraud

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Anatomy of Financial Statement Fraud

GURUPRASAD V B. Com, ACA, ACMA,ACS, CMA(USA), MIPA(Australia), ACSI (UK)

Associate Member-ACFE(USA)

September 03, 2014 The Institute of Chartered Accountants of India, Bangalore Branch

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Anatomy of Financial Statement Fraud Objectives

Introduce to the attendees what is Financial Statement Fraud

Types of Financial Statement Fraud

Why do CEOs CFOs commit Financial Statement Fraud

Three methods of committing Financial Statement Fraud

Anatomy of Financial Statement Fraud and their Red Flags

Cases on Financial Statement Fraud

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What do these entities share in Common? ENRON CORPORATION U.S.A

XEROX U.S.A

ADELPHIA COMMUNICATION CORPORATION U.S.A

SINO FOREST CORPORATION - CHINA

SATYAM COMPUTER SERVICES -INDIA

REEBOK INDIA- INDIA

OLYMPUS CORPORATION -JAPAN

WORLDCOM INC U.S.A

HEALTHSOUTH CORPORATION U.S.A

TYCO INTERNATIONAL LTD - SWITZERLAND

HEATH INTERNATIONAL HOLDINGS INSURANCE LTD AUSTRALIA

BOND CORP - AUSTRALIA

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Anatomy of Financial Statement Fraud Companies Act 2013

Sec 447 Any person who is found to be guilty of fraud shall be punishable with

imprisonment for a term which shall not be less than 6 months but which may extend to 10 years and shall also be liable to fine which shall not be less than the amount involved in the fraud but which may extend to three times the amount involved in the fraud.

Sec 448 if in any return, report, certificate, financial statement, prospectus,

statement or other documents required by, or for, the purpose of any provisions of this Act or the rules made there under, any person makes a statement,- a) Which is false in any material particulars, knowing it to be false, or b) Which omits any material fact, knowing it to be material, he shall be liable under Sec 447.

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What is Financial Statement Fraud?

As per the Association of Certified Fraud Examiners, U.S.A

It is deliberate misrepresentation of the Financial

condition of an enterprise, accomplished through the

intentional misstatement or omission of amounts or

disclosures in the financial statements to deceive

financial statement users.

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It involves mainly

Fictitious Revenues being recorded Overstatement of revenues and gains

Improper Assets Valuation Overstatement of Assets

Concealing of Liabilities and Expenses Understatement of Liabilities and Expenses

Timing Differences Cut- off fraud

Improper Disclosures

Overstatement of Operating Cash flows

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Types of Financial Statement Fraud

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Why do CEOs, CFOs Commit Financial Statement Fraud

The Business Owners, CEOs, CFOs generally Cook the Books and Bake the Ledgers for the key reasons like:

To Conceal true business performance either to overstate or understate results of the Organisation.

To preserve personal status Senior people with strong egos may not be willing to admit that their strategy has failed.

To maintain personal wealth/income- To protect the existing Salary, Stock options, Commission, Bonus etc.

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Three methods

1. Playing with the Accounting System as a tool

2. By-passing the Accounting System

3. Going beyond the Accounting System

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Overstating Revenues and Gains

Income Statement

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Revenues

- Expenses

+ Gains

- Losses

= Earnings

Understating Expenses and Losses

Income Statement

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Revenues

- Expenses

+ Gains

- Losses

= Earnings

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Balance Sheet Impact

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Assets =

+ Owners Equity

Liabilities

Assets =

Liabilities

+ Owners Equity

Assets =

Liabilities

+ Owners Equity

Anatomy of Financial Statement Fraud Fictitious Revenue

Fabricated revenues involves recording of sale of goods and

services that did not happen.

It not only involve fake or phantom customers but also can

involve legitimate customer by preparing a fictitious invoice.

At the beginning of the accounting year, the year end sale is

reversed to help conceal the fraud, but this may lead to a revenue

shortfall in the new accounting year, creating a need to more

fictitious sales.

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Red Flags of Fictitious Revenue

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

Unusual increase in the number of days sales receivable.

A significant volume of sales to entities whose substance and ownership is unknown.

Significant transactions with related parties or special purpose entities or with those entities that are not audited.

Rapid growth or unusual profitability compared to other entities in the same industry.

Anatomy of Financial Statement Fraud Improper Assets Valuation

Manipulation of Inventory valuation is done by:

failing to write down to its current value as per Accounting Stds

manipulating physical inventory count

inflating the unit costs used to value inventory

Creating fictitious inventory by creating fake documents like Receiving reports, inventory count sheets.

Manipulation of Accounts Receivable balance is done by:

recording fictitious receivables

failure to write off bad debts deliberately

failure to provide adequate provision for doubtful receivables.

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Anatomy of Financial Statement Fraud Red Flags of Improper Assets Valuation

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

Significant decline in demand for products and increasing business failures in either the industry or due to recession.

Unusual increase in gross margin or margin compared to peers.

Unusual growth in the number of days purchases in inventory and/ or in the number of days of sales in receivables

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Anatomy of Financial Statement Fraud Concealed Liabilities and Expenses

With relatively little effort, pre-tax income will increase by full amount of the expense or liability which has not been recorded.

Easier to commit than falsifying many sales transactions.

Common methods for concealing Liabilities and Expenses are:

1. Liability/expense omissions

2. Capitalised expenses

3. Expensing Capital Expenditure

4. Either failure to record or understate the warranty costs and liabilities

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Anatomy of Financial Statement Fraud Common Red Flags in Concealed Liabilities and

Expenses

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


Unusual reduction in the number of days purchases remain in Creditors account.

Allowance for Sales Returns, warranty claims etc are shrinking in % terms or are otherwise out of line with peers.

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Anatomy of Financial Statement Fraud Timing Differences

It involves recording of revenue/expenses in improper periods.

This is done by shifting revenues or expenses between one period and the next, increasing or decreasing earnings as desired.

Premature recognizing of revenue in violation of Accounting Standards.

Manipulating the percentage of completion and the estimated costs to complete a construction contract to recognize revenue prematurely and conceal contract overruns in the case of Long Term Contracts.

Recording expenses in the wrong period due to pressures to meet budget projections and goals or due to lack of accounting controls.

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Common Red Flags in Timing Difference

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


Significant, unusual or highly complex transactions especially close to accounting period end that pose difficult substance over form questions.

Unusual growth in the number of days sales in receivables.

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

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Anatomy of Financial Statement Fraud Improper Disclosures

Management has an obligation to disclose all significant

information appropriately in the financial statement and in the

Management Discussion & Analysis. Further it should not be

misleading.

Improper Disclosures relating to financial statement usually involve:

1. Liability omissions

2. Subsequent Events

3. Related Party transactions

4. Management Fraud

5. Accounting changes

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Anatomy of Financial Statement Fraud Common Red Flags in Improper Disclosures

Domination of management by a single person or small group.

Ineffective Board of Directors or Audit Committee oversight over the

financial reporting process and internal control.

Ineffective communication, implementation or enforcement of the

entitys value or ethical standards by management. Absence of tone at

the top.

Significant, unusual or highly complex transactions especially close to

accounting period end that pose difficult substance over form questions.

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Anatomy of Financial Statement Fraud Common Red Flags in Improper Disclosures

.. Continued

Overly complex organisational structure involving unusual legal

entities or management lines of authority.

Excluding certain company-owned units in consolidation so as to

improve reported earnings.

Significant related party transactions not in the ordinary course

or with related parties not subject to audit

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Anatomy of Financial Statement Fraud OVERSTATEMENT OF OPERATING CASH FLOWS

A company may try to make itself better by classifying cash receipts as operating activities instead of financing or

classifying cash payments as investing rather than operating.

A company may borrow money using Debtors as a Collateral and report this as Operating instead of Financing.

It may also classify a normal operating expenditure as a Capital Expenditure.

In this manner, operating cash flow is overstated and investing cash flow is understated.

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Anatomy of Financial Statement Fraud DISCUSSION ON REAL CASES OF FINANCIAL STATEMENT FRAUD

SATYAM COMPUTER SERVICES LIMITED India

OLYMPUS CORPORATION - Japan

WORLDCOM INC U.S.A

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Satyam Computer Services Limited

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In Million US $ 31, March 2008

31, March 2007

% Change

Revenue 2138.10 1461.40 46%

Trade Receivable- Short Term (a)

598.80 396.10 51%

Trade Receivable- Long Term (b)

38.20 21.20 80%

Unbilled Revenue (c ) 81.50 38.60 111%

Bank Deposits (d) 894.80 782.70 14%

Total (a+b+c+d) 1613.30 1238.60 374.70%

Satyam Computer Services Limited

According to the United States Securities Exchange Commission law suit, SCS Ltd overstated revenue by US$430.4 million in FYE March 31,2008.

90% of reported Cash and Bank Balance did not exist.

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Satyam Computer Services Ltd Ramalinga Raju on

January 7,2009 made shocking disclosure to the Board of

Directors of Satyam that the financial statement

contained:

o Inflated Cash and Bank Balance of Rs.50.4 Billion,

o Non-existent accrued interest of Rs.3.76 Billion,

o An understated liability of Rs.12.30 Billion on

account of funds arranged by Raju.

o An overstated Debtors position of Rs.4.90 Billion.

Ramalinga Raju

Anatomy of Financial Statement Fraud Olympus Corporation Japan

Olympus Corporation founded in 1919 is a Japanese manufacturer of camera and medical imaging equipment.

Olympus incurred significant financial losses, which ballooned between 1997 and 1998.

It kept the loss off its own book by transferring financial assets that had declined in value to special purpose entities that were not consolidated in Olympuss Financial Statement.

Special purpose entities accounted these financial assets of Olympus at book value instead of fair market value.

The funds used by these other entities came from bank borrowing arranged by Olympus. Olympus therefore did not report any gain or loss.

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Olympus Corporation Japan

Olympus understated its liabilities and overstated owners equity for many years.

when they repurchased the special purpose entities and were forced to record the liability, they overstated the Goodwill (assets). This Goodwill was then reported as being impaired overtime to spread out the losses.

Large payments were made to financial advisors who assisted in US$ 2.2 Billion acquisition of Gyrus with the understanding that they would use these fees to settle the account with the SG Bond of the Cayman Islands.

KIKUKAWA


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WorldCom Inc. USA

WorldCom materially overstated the income it reported on its financial

statements by approximately $9 billion, mainly using two methods.

First, WorldCom reduced its operating expenses by improperly releasing as a

credit to operating expenses certain provisions previously established for line

costs and for taxes.

Second, the company improperly reduced its operating expenses by

recharacterising certain expenses as capital assets.

Much of the $9 billion related to improper accounting for

line costs, which were among WorldComs major operating

Expenses. Bernard Ebbers

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Deterrence of Financial Statement Fraud

Any Fraud has three components popularly called as Fraud Triangle propounded by Dr. Donald Cressey comprising of Perceived Pressure, Perceived Opportunity and Rationalisation.

Dr. Donald Cressey

Anatomy of Financial Statement Fraud For Deterring Financial Statement Fraud, the

Management has to:

1. Reduce the Situational Pressures that Encourage

Financial Statement Fraud.

2. Reduce the Opportunity to Commit Financial

Statement Fraud.

3. Reduce the Rationalisation of Financial Statement

Fraud.

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The Association of Certified Fraud Examiners, USA

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Mr. Ramalinga Raju confessed in the Year to

the Board of Directors that the Company

Cooked the Books and hence the Financial

Statement are not reliable.

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(Match the Following)

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Sl No

Entity Nature of Financial Statement Fraud committed

1 Olympus Corporation

Overstatement of Revenue and Accounts Receivables

2 Satyam Computer Services Ltd

Capitalized revenue expenses

3 WorldCom Inc Understated its liabilities by concealing it off the books.

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Sl No.

Entity Nature of Financial Statement Fraud committed

1 Olympus Corporation

Understated its liabilities by concealing it off the books.

2 Satyam Computer Services Ltd

Overstatement of Revenue and Accounts Receivables

3 WorldCom Inc Capitalized revenue Expenses


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Satyam Computer Services overstated its Revenue as per SEC,

USA for the Financial Year ended March 31,2008 by

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Satyam Computer Services overstated its Revenue as per SEC,

USA for the Financial Year ended March 31,2008 by


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financial fraud

Documents

financial statement

guilty of fraud

financial statements

financial condition

healthsouth corporation

enron corporation u

xerox u

ceos cfos