FINANCIAL STATEMENT FRAUD

16 November 2013

About me

• 17+ years in project appraisal, audit, financial due diligence, financial feasibility, valuation and real estate finance

• 15 years in the Middle east- Oman, Bahrain and now Dubai• KPMG, Ernst & Young, Nakheel, Gulf Finance House• Teaching advanced finance and accounting courses since 1996 • Chartered Accountant and a CFA charterholder

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Genesis

• Market leader in CFA preparatory courses in the GCC• Largest prep provider for all levels of CFA in the Lower Gulf• Diverse product portfolio of Bespoke Training and Executive

Education • Trained 2,000+ finance professionals till date

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THE FRAUD TRIANGLE

The “Fraud Triangle”

Three conditions that are present when accounting fraud

occurs

Incentives or Pressures

Opportunities Rationalization

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THE HALL OF SHAME

Hall of Shame

COMPANY YEAR ISSUES IMPACT (USD)

1998 Inflated revenue550 Million over

3 years

2000

Treated lease as sales between 1997-2000

1.5 Billion

1999-2001 Channel stuffing

Restatement of P&L by 1.5

billion

1998-1999

Inflated revenue by double counting license fees from

unrecognised portion of existing contracts& full on

new contracts 500 million

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Hall of Shame

COMPANY YEAR ISSUES IMPACT(USD)

2000-2001

Inflated advertising revenue by booking banner deals & ads it sold on behalf of others as its

own NA

2002

Improperly booked construction cost overruns as revenue before

clients agreed to pay them NA

2002

Executed round trip deals by trading subsidiaries to artificially boost energy trading volume and

revenue 5.2 billion

1999-2002

Inflated revenues with bogus accounting entries from

corporate unallocated revenue accounts 3.3 billion

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Hall of Shame

COMPANY YEAR ISSUES IMPACT

(USD)

2002

Engaged in network capacity swaps with other carriers to inflate revenue.Also, recorded revenue from long term IRU contracts immediately rather than over the term of the IRUs. NA

2001-2002

Booked higher promotional payments (provided by suppliers to promote their goods) than actually received at US subsidiary FoodService. 1.0 billion

1999-2002

Recognised revenue from services to patients by billing Medicare for reimbursements where patients were not pre-certified & payment was never got 2.64 billion

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AN OLYMPIC SCANDAL

Olympus

• Major Japanese manufacturer of optical equipment • FYE 31 March 2011, sales of US$10.589 billion, and total equity of

US$3.281 billion • Assets of US$13.295 billion• Employs 40,000 people globally

CEO Michael Woodford suddenly removed from office on 14 Oct 2011, just 2 weeks after promotion

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The Firing

“Michael C. Woodford has largely diverted from the rest of the management team in regard to the management direction and method, and it is now causing problems for decision making by the management team. Hence, judging that realisation of the 2010 Corporate Strategic Plan with its slogan of "Advancing to the Next Stage of Globalisation" would be difficult to achieve by the management team led by Woodford, all the board directors attending today, except for Woodford himself who could not participate in the voting due to special interest, unanimously resolved the dismissal from his office of the representative director"

— Olympus press release

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Mr Woodford

• British born Woodford became COO and President in April 2011• On 1 Oct 2011 he was made CEO. This appointment was very unusual:

Non Japanese CEO, the first for Olynpus Unlikely choice 25 other potential candidates were ignored

So why was he elevated AND removed suddenly??

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History

• In the 1980s, many Jap corporations relied on Investments to boost profits, as exports fell due to a strong yen

• In 1991 Olympus had to take losses of ¥2.1 billion • In June 1998, Olympus was subject of rumours of sizeable trading losses

on derivatives• In Oct 1999, Olympus disclosed that it had lost nearly ¥17 billion from

interest rate and currency swaps• Olympus lost ¥2.9 billion in the Princeton Economics International Ponzi

scheme

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Why the promotion?

• He asked questions on the $ 2.2 billion acquisition of Gyrus• AXAM (Advisors) were paid $ 687 million, 31% of the value! How?:

$ 67 million in cash Olympus bought back preference shares for $ 620 million

• Olympus paid $965 million when it acquired three "small venture firms“• It wrote down $ 600 million in 2010 related to acquisitions• Woodford wrote to the Chairman, copying the Auditors (E & Y)• Woodford was promoted to CEO to shut him up! • He was a puppet COO and CEO. The real power was Tsuyoshi Kikukawa,

Chairman

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Timeline

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Why did this happen?

"Japan's corporate culture of denial, of ignoring problems and letting them fester, keeps running up against a globalized world that values agility, innovation and transparency. Olympus demonstrates all too painfully how much Old Japan tolerates a lack of accountability among senior executives; inadequate disclosure; a disinclination to challenge authority and absolute deference to corporate boards regardless of share performance”

- Bloomberg View columnist William Pesek

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TRUTH… AND UNTRUTH

Satyam Computers : The Rise

• Annual revenue rose from $ 467 million to USD 2.1 bln• Average Operating Earnings was 21%, a CAGR of 35%• Earnings Per Share rose from $ 0.12 to $ 0.62, a CAGR of 40%• Share price rose from INR 138 to INR 526, a 300% increase • SCL was the first Indian company to publish IFRS financials• SCL won the Golden Peacock award from the World Council for Corporate

Governance for Best Governed Company (2007 and 2008)• Ramalinga Raju was awarded Entrepreneur of the Year by Ernst & Young

(2008)

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Satyam Computers: The Fall

• 16 Dec 2008: Shareholders oppose takeover of Maytas Properties by SCL. Stock falls 53% on NYSE

• 23 Dec 2008: World Bank bars SCL from doing any business due to bribery. Stock falls 14%

• 28 Dec 2008: Three Directors quit• 7 Jan 2009: Ramalinga Raju resigns and admits fraud• 11 Jan 2009: Govt of India steps in and forms a new board

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Satyam Computers: The Fraud

Cash$ 1.04 bln in cash that SCL claimed to own was non existentLiabilitiesLiabilities underreported on the balance sheetRevenueRevenue overstated in almost every quarter. Fake customer identities were created and fake invoices were raised by the SLC Head of Internal Audit to create revenueProfitProfit overstated by showing interest income from fake bank accounts

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Satyam Computers: Red Flags

Financial Red Flags• $ 1.04 billion in non interest bearing deposits • Large amount of accrued interest in deposits• 35% EPS growth over five years • With $1.2 billion of cash, Satyam closed 2007-08 with $56 million of debt• Insiders lowered ownership from 17.4% in 2004 to 8.7% in 2008

Non financial Red Flags• Ramalinga Raju was the Chairman. His brother, Rama Raju, was the CEO• No audit experts on the Audit Committee• The Rajus had a history of trying to siphon out funds from SCL companies• PwC was paid twice what other firms would charge for audit• Independent directors? Krishna Palepu was Director and

Consultant, earring nearly $ 200K in 2007

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The Dirty Dozen

1. Revenue recognition2. Non recurring gain as operating 3. Understating expenses4. Understating depreciation5. Deferring expenses6. Operating expenses as non operating7. Big bath provisions8. Cookie jar accounting9. Off balance sheet liabilities10. Investments- equity accounting11. Investments- reclassifications12. Fair value accounting

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Red Flags!

1. Increasing Days Sales Outstanding 2. Increasing sales as % of cash collected3. Receivables growing faster than revenues 4. Revenue growing faster than industry average5. Falling ratio of CFO to Net Income 6. Higher 4th quarter revenue not explained by seasonality7. Decrease in provision for bad debts as % of receivables8. Decrease in provision for obsolete inventory as % of inventory9. Increasing Days Of stock in Hand 10. Sudden increase in Gross Profit or EBIT as % of Sales11. Depreciation out of line with peers12. “Mark to model” approach to fair value accounting

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Z score model

- 4.840 + SGI ( Sales Growth Index) X 0.892+ GMI (Gross Margin Index) X 0.528+ AQI (Asset Quality Index) X 0.404+ DSRI ( Days Sales in Receivables Index) X 0.920+ TATA ( Total Accruals to Total Assets) X 4.679

The red flag is a Z score greater than – 1.99. Enron had a Z score of 0.045 in its last year

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“The truth may be puzzling. It may take some work to grapple with. It may be counterintuitive. It may contradict deeply held prejudices. It may not be consonant with what we desperately want to be true. But our preferences do not determine what's true.”

― Carl Sagan

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Binod Shankar, CFA+971 50 558 2498bshankar@genesisreview.com

www.genesisreview.comGenesis Institute

Dubai | Abu Dhabi

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