7/23/2013
Financial Statement Fraud
Not Just Wall Street’s Problem
Presented by: Tiffany R. Couch, CPA/CFF, CFE
Acuity Group PLLC
Copyright 2013 Acuity Group PLLC
Agenda
 Establishing Framework
 Let’s Talk about Fraud




Revenue
Improper Asset Valuations
Concealed Liabilities and Expenses
Disclosures
 Using the Tools in your Toolbelt
Copyright 2013 Acuity Group PLLC
ESTABLISHING THE FRAMEWORK
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7/23/2013
WHY financial statement fraud?
 Financing Related
 Secure Financing
 Favorable Financing Terms
 Compliance with Financing Covenants
 Sale of Business or Stock
 Meet Goals/Objectives
 Personal
 Market/Investor Perceptions
 Cover Up Poor Financial Performance
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METHODS OF FRAUD
6.0%
26.2%
Financial Statement
Fraud ($1,000,000)
Corruption ($250.000)
67.9%
Asset Misappropriation
($120.000)
Courtesy of ACFE 2012 Report to the Nations
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REALITIES ‐ HOW IS FRAUD DETECTED?
Initial Detection of Occupational Frauds
43.3%
40.2%
Tip
7.0%
7
0%
8.3%
B Accident
By
A id t
14.4%
13.9%
Internal Audit
External Audit
Notified By Police
2012
2010
14.6%
15.4%
Management Review
3.3%
4.6%
3.0%
1.8%
0.0%
Courtesy of ACFE 2012 Report to the Nations
Recession, Recipe for Fraud?
10.0%
20.0%
30.0%
40.0%
50.0%
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7/23/2013
CLIENT PERCEPTIONS
 Audit =
 “They look at everything”
 “All audit firms are the same”
 “I’m concerned someone is stealing from me, I need an audit”
 “My CPA will find it”
 “Our last audit was clean, there’s no fraud here”
Copyright 2013 Acuity Group PLLC
AUDITOR RESPONSIBILITIES
AU SECTION 240 –
CONSIDERATION OF FRAUD IN A FINANCIAL STATEMENT AUDIT
 Responsibilities of Auditor
 Obtain reasonable (HIGH LEVEL) assurance that the financial statements as a whole are free from material misstatement, whether caused by fraud or error.
 Professional Skepticism
 Discussion among team
 Discussion with management
 Discussion with others
 Identify unusual relationships
 Evaluate Risks
Copyright 2013 Acuity Group PLLC
AUDITOR RESPONSIBILITIES
AU SECTION 240 –
CONSIDERATION OF FRAUD IN A FINANCIAL STATEMENT AUDIT
 Objectives:
 Identify & assess risks of material misstatement of financial statements due to fraud.
 Obtain sufficient appropriate audit evidence
 Respond appropriately to fraud or suspected fraud
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7/23/2013
DEFINITION
Financial Statement Fraud –
The 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.
Copyright 2013 Acuity Group PLLC
TYPICAL SCHEMES
 Fictitious Revenues
 Timing differences
 Improper Asset Valuation
 Concealed Liabilities and Expenses
 Improper/Omitted Disclosures
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CLIENT RED FLAGS
 Chronically late providing key financial information
 Audit is closely controlled by top management
A dit i l l t ll d b t g
t
 Key financial information is often incorrect
 Rush through the process
 Non‐existent inventory
Recession, A Recipe for Fraud?
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7/23/2013
REVENUE SCHEMES
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Revenue recognition – defined
 Criteria




Persuasive evidence of an agreement exists
Delivery has occurred (services completed)
Seller’s price to buyer is fixed (or able to be determined)
Collectability is reasonably assured
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Fictitious Revenue Schemes
 Fictitious Revenue




Phantom Customers
Fictitious Invoices
Sales with Conditions
Recording cash received from a lending or investment transactions as revenue
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7/23/2013
Early revenue recognition schemes
 Shipment (or customer acceptance) has not been made
 Future services not provided
 Customer has no obligation to pay
 Long Term Contracts
 Multiple Deliverables
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Deferred revenue recognition
 Creating Reserves
 Long Term Contracts
 Multiple Deliverables
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REVENUE RECOGNITION – CASE STUDY
 SCENARIO:
Case Study #1 – Capitol Motors
 CONSIDERATIONS:
• Have recognition requirements been met?
• Materiality?
 ANSWER:
Revenue should be recorded on January 2nd (or when customer takes delivery of product)
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7/23/2013
RED FLAGS of Revenue schemes
 Recurring negative cash flows from operations while reporting earnings and earnings growth
 Significant related party transactions
 Significant, unusual, complex transactions (especially close to end of period)
 Rapid growth or unusual profitability – especially compared to that of other companies in same industry
 Significant volume of sales to entities whose substance and ownership is unknown
 Unusual increase in gross margin (or gross margin as compared to industry peers)
Copyright 2013 Acuity Group PLLC
REVENUE RECOGNITION ‐ TESTING
 Pair the following with Professional Skepticism:
 Understand client
Understand client’s business
s business
 Understand client pressures (real or perceived)
 Cut‐off testing
 Reconcile goods shipped vs. goods billed
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REVENUE RECOGNITION ‐ TESTING
 Sales Transaction Procedures
 Sales order – approved credit terms?
y
, pp g
g
 Verify sales order, shipping docs & sales invoices agree
 Compare prices on invoices to published prices
 Recompute extensions on sales invoices
 Unusually large number of sales occur at end of period?
 End of Period Journal Entries
 Trace subsequent receipts
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7/23/2013
Improper asset valuations
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Lower of cost or market rule
GAAP requires that inventory be recorded at the lower of either the cost to produce it, the cost to repurchase it, or the market value of the inventory.
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Fixed assets
 Existence
 Impairment
 Non‐Asset Costs
 Financing costs
 License fees
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7/23/2013
INVENTORY VALUATION
 Existence
 Obsolescence
 Ownership
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Accounts receivable
 Fictitious
 Re‐Aged
 Bad Debt Evaluations
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ASSET VALUATION– CASE STUDY
 SCENARIO:
Case Study #2 –Inland Distributors
 WHO OWNS THESE ASSETS?
 RED FLAGS
Limited /Restricted Access
Multiple Locations
Related Party Transactions
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7/23/2013
Red flags of improper asset valuation schemes
 Assets, liabilities, revenues or expenses based on significant estimates
 Judgments or uncertainties difficult to support
 Significant declines in customer demand and/or business failures in industry or overall economy
 Unusual growth in number of days
Unusual growth in number of days’ purchases in inventory ratio
purchases in inventory ratio
 Unusual change in relationship between fixed assets and depreciation
 Adding to assets while industry peers are reduction capital tied up in assets
 Unusual growth in number days’ sales in receivables ratio
 Unusual increase in gross margin (or margin in excess of industry peers)
Copyright 2013 Acuity Group PLLC
Asset valuation ‐ testing
 Confirmations
 Existence of Assets
 Fixed Assets
 Inventory
 Investments
 Trend Bad Debt and other “Estimates”
 Timing
 Ratio Analysis  #Days Sales in Receivables
Copyright 2013 Acuity Group PLLC
Concealed liabilities and expenses
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7/23/2013
Concealed liability and expense schemes
 Liability/Expense Omission
 Failure to record
 Defer to later period
f
l
d
 Capitalized Expenses
 Returns & Allowances / Warranties
 Expensing Capital Expenditures
 Income Tax Purposes
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CONCEALED LIABILITIES– CASE STUDY
 SCENARIO:
Case Study #3 –Regina Vacuum Company
 Too Many Returns Too Many Returns – Too Little Room
 Auditor Lessons?
Know the business
Understand Financial Pressures
Interviews
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RED FLAGS OF CONCEALED LIABILITY/EXPENSE SCHEMES
 Allowance for sales returns, warranty claims, etc. are shrinking in percentage terms or are out of line with industry peers
 Non‐financial management’s excessive participation in or Non financial management’s excessive participation in or preoccupation with the selection of accounting principles or the determination of significant estimates
 Unusual reduction in # days’ purchases in accounts payable ratio
 Reducing accounts payable while industry peers are stretching out payments to vendors
 Unusual increase in gross margin (or EBITDA)…or in excess of industry peers
Copyright 2013 Acuity Group PLLC
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7/23/2013
CONCEALED LIABILITIES ‐ testing
 Confirmations
 Banks
 Vendors
 Ratio Analysis
 #Days Purchases in A/P
 Analysis of Shipping / Receiving Documents
 Interviews
 Be “Helpful”! Copyright 2013 Acuity Group PLLC
DISCLOSURES
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DISCLOSURE SCHEMES
 Liability Omissions
 Subsequent Events
S b
 Management Fraud
 Related Party Transactions
 Accounting Changes
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7/23/2013
DISCLOSURES– CASE STUDY
 SCENARIO:
Case Study #4 –Fast Eddie
 Related Party Transactions
 Auditor Lessons?
Interviews!
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RED FLAGS ‐ DISCLOSURE SCHEMES
 Domination of management by a single person or small group
 Ineffective board of directors or audit committee oversight over financial reporting and internal control
 Ineffective communication, implementation, support, or enforcement of entity’s values/ethical standards
 Rapid growth or unusual profitability, especially compared to that of Rapid gro th or n s al profitabilit especiall compared to that of other companies in similar industry
 Significant, unusual, or highly complex transactions
 Significant related party transactions
 Overly complex organizational structure
 Known history of violations of laws or regulations
 Formal or informal restrictions on auditor access to people and information
Copyright 2013 Acuity Group PLLC
DISCLOSURES ‐ testing
 Interviews
 Cross‐reference key personnel to C
f
k
l
secretary of state records
 Simple Internet searches
 Thorough review of source documents
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7/23/2013
Tools in your toolbelt
Copyright 2013 Acuity Group PLLC
Professional skepticism
 Identify red flags
 Accurately asses risks
 Adjust tests in terms of nature, timing & extent
 Nature = timing and extent of tests
 Timing = when test is conducted
 Extent = how much testing/evidence
 Gather sufficient and appropriate evidence
Copyright 2013 Acuity Group PLLC
INTERVIEWS
 Build Rapport
 Powerful Tool
 It’s okay to be Direct
 Remember the “underlings”
 Be Available
 Walkin’ and Talkin’
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7/23/2013
Power of ratio analysis
 Selected Ratios From ZZZZ Best
1985
1986
Current ratio of assets to liabilities
Working capital: Total assets
Collection ratio
Asset turnover
Debt to equity ratio
Receivables turnover
Times interest earned
Cost of sales: Sales
Gross margin percentage
Return on equity
.0977
(0.0080)
(0
0080)
26.131
1.041
1.486
6.984
43.136
.423
57.68%
46.58%
36.552
0 5851
0.5851
N/A
.144
.017
N/A
N/A
.465
53.51%
183.75%
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Data extraction software
 ACL/IDEA
 COMPARE DATABASES
 BENFORD’S LAW
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Research
 Secretary of State
 Department of Revenue
 Google
 Facebook
 LinkedIn
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7/23/2013
THANK YOU!
Courage is not the absence of fear, but rather the judgment that
something else is more important than fear. ~Ambrose Redmoon
TIFFANY R. COUCH, CPA/CFF, CFE
ACUITY GROUP PLLC
360.573.5158
tcouch@acuityforensics.com
www.acuityforensics.com
Copyright 2013 Acuity Group PLLC
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