“Arresting Financial Fraud:
The Inside Story From The FBI”
The views expressed by the presenters do not necessarily represent
the views, positions, or opinions of either the AICPA
or the presenter’s respective organization
Course Objectives
This program is designed to help you:
 Understand the U.S. Department of Justice’s
three-part definition of corporate fraud;
 Understand the scope of the problem;
 Identify common accounting schemes;
 Work effectively with law enforcement; and
 Better understand the impact of recently
enacted legislation
Slide 2
Today’s Speakers
Grant Ashley, CPA
Assistant Director,
Criminal Investigative Division
Federal Bureau of Investigation
Keith Slotter, CPA
Chief,
Financial Crimes Section
Federal Bureau of Investigation
--------
--------
Gary Dagan, CPA
Chief,
Economic Crimes Unit
Federal Bureau of Investigation
John F. Hudson, CPA
Moderator
Hudson Consulting Group, LLC
Slide 3
Corporate Fraud - Background
 Following the corporate scandals of 2002, the
Department of Justice issued a three-part
formal definition which describes the illegal
activities that encompass corporate fraud.
 These three parts are:

Accounting Fraud

Self-Dealing by Corporate Insiders

Obstructive Conduct
Slide 4
Dept. of Justice Definition
– Corporate Fraud
 Part One – Accounting Fraud (“Cooking the
Books”)

The falsification of financial information, including
false accounting entries, bogus trades designed to
inflate profits or hide losses, and false transactions
designed to evade regulatory oversight.
Slide 5
Restatements by Reason
1997 - June 2002
40%
37.9
35
Per GAO Report
on Financial Restatements
Figure 3
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25
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15
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Slide 6
&D
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Why is Revenue Recognition
So Important?
In its October 2002 Report on Financial Statement
Restatement, the GAO concluded that:
 Almost 38% of the 919 announced restatements
between 1997 and June 30, 2002 involved revenue
recognition.
 Revenue recognition was the primary reason for
restatements in each year.
 Over 50% of the immediate market losses following
restatements were attributable to revenue recognition
related restatements.
 Approximately 50% of the SEC’s enforcement cases
have involved revenue recognition issues.
Slide 7
Why is Revenue Recognition
So Important?
 Restatements for improper revenue recognition
also result in larger drops in market capitalization
than any other type of restatement:
 8 out of the top 10 market value losses in 2000 related
to revenue problems.
 Of the 10 companies, the top 3 lost US$20 billion in
market value in just 3 days due to revenue recognition
problems.
Slide 8
Some Examples of
Revenue Recognition Schemes
 Phantom Sales
 Parked Inventory Sales
 Swap (i.e., “Round Trip”) Transactions
 Channel Stuffing
 Accelerated Revenue
 Undisclosed Side Deals
 Undisclosed Contingencies
 Backdated Contracts
Slide 9
Some Examples of Expense & Liability
Recognition Schemes
 Capitalizing Expenses
 Deferring Expenses
 Unrecorded Expenses
 “Big Bath” Accounting
 “Cookie Jar” Reserves
 Creative Acquisition Accounting
Slide 10
Cooking The Books
– Selected Recipes
 Parked Inventory Sales – Recording sales for goods
shipped to a site (warehouse, parking lot) controlled
by the seller to provide the appearance a valid sale
occurred.
 Swap Transactions – A scheme in which two
conspiring companies exchange payments and
services solely for the purpose of inflating revenues.
 Channel Stuffing – Overselling products to customers
with a hidden understanding that the customer will
receive deep discounts on the full invoice price at a
future date.
Slide 11
Cooking The Books
– Selected Recipes
 Side Deals – An arrangement in which the buyer of
goods is given the right to cancel the sales contract,
return products or receive rebates in future periods.
Although the sale is booked, the side deals are
hidden from auditors.
 Accelerated Revenue – Improperly recording
revenues in the current fiscal period which are
applicable to future periods. Examples are
unshipped merchandise and percentage of
completion contracts.
Slide 12
Cooking The Books
– Selected Recipes
 Capitalizing Expenses – The improper reclassification
of an expense to an asset. This scheme is typically
conducted through a series of journal entries at the
end of a fiscal period in order to inflate the financial
statements.
 Deferred Expenses – Recording expenses applicable
to the current fiscal period at some date in the future.
Typically, this scheme continues to perpetuate itself
in future periods.
Slide 13
Dept. of Justice Definition
– Corporate Fraud
 Part Two – Self-dealing by corporate insiders
(“Me First”), including . . .
 Insider trading
 Kickbacks
 Misuse of corporate property for personal gain
 Individual tax violations related to self-dealing
Slide 14
The Fundamentals
of Corporate Governance
 Lessons often forgotten . . .
 A corporation is owned and controlled by the
individual shareholders.
 The corporation is NOT the personal property of
the individual executives of the company.
 Self-dealing places the greed of individual
executives ahead of the shareholders.
Slide 15
Examples of Self-Dealing
 Executive loans with no intentions to ever
repay.
 Extraordinary personal expenses charged to
the company.
 Failure to report forgiven loans or reimbursed
personal expenses as taxable income.
Slide 16
Examples of Self-Dealing
 Awarding business contracts in return for
personal compensation.
 Receiving shares of stock in other companies
in return for business transactions (shares
are often placed in the name of another
family member to avoid detection).
Slide 17
Examples of Self-Dealing
 Insider Trading
 Buying or selling personally owned shares of stock
prior to a major announcement that is expected to
affect the stock price (i.e., positive or negative
earnings, new products, change in management,
mergers & acquisitions).
Slide 18
Dept. of Justice Definition
– Corporate Fraud
 Part Three – Obstruction of Justice (“The
Cover-up”)
 Obstruction of justice designed to conceal the
previously noted criminal conduct (accounting
fraud & self-dealing), particularly when that
obstruction impedes the regulatory inquiries of the
Securities and Exchange Commission or other
agencies.
Slide 19
Obstructive Conduct
 Shredding documents
 Erasing computer files
 Creating or altering documents to justify
illegal conduct
 Purposely failing to provide all documents
and files requested in a subpoena
Slide 20
Obstructive Conduct
 Providing false testimony in SEC depositions
 Lying to criminal investigators
 Influencing another witness
 Threatening another witness
 Failing to maintain records for a prescribed
period of time
Slide 21
Record Retention
Expectations of the CPA
 In 2002, a new criminal law (title 18, section
1520) was enacted which requires any
accountant who conducts an audit of a public
company to maintain all audit workpapers
from this engagement for a period of five
years.
Slide 22
Corporate Fraud Victims
 Individual shareholders
 Employee pension plans
 Mutual funds
 Financial institutions (lenders)
 Market stability & reliance
Slide 23
Locations of
Corporate Fraud Investigations
 New York, NY
 Boston
 Chicago
 Detroit
 Los Angeles
 Houston
 San Francisco
 And …
 San Diego
Slide 24
(Continued) Locations of
Corporate Fraud Investigations
 Birmingham
 Omaha
 Charleston (SC)
 Erie (PA)
 Anchorage
 Johnson City (TN)
 Columbus (OH)
 Oklahoma City
 Honolulu
Slide 25
Corporate Fraud …
Is A National Problem
Slide 26
Industry Trends
In Current Investigations
 Energy
 Software
 Telecommunications  Internet
 Retail
 Banking
 Medical
 Cable TV
 Insurance
 Charities
Slide 27
Typical Scenario
 In far too many cases, accounting fraud
began as a “one time act” to help meet the
quarterly revenue targets.
 However, the “just one time” syndrome
perpetuates itself into future quarters until the
fraud becomes out of control.
Slide 28
Case Study Example
Corporate Fraud:
Walter Pavlo’s Insider Perspective . . .
Slide 29
Case Study Example
Let’s look at an interview with Walter Pavlo . . .
Slide 30
Perspective
 Some corporate executives have compared
accounting fraud to a gambling or drug
addiction. Although they believe it can be
stopped at any time, their circumstances
dictate otherwise.
 Phony accounting from prior periods
combined with current losses has a snowball
effect.
Slide 31
Motives For Corporate Fraud
 Executive bonuses are tied to profits.
 Executives maintain their prominent positions
within the corporation.
 Stock value remains artificially inflated based
on phony financial performance indicators.
 Personal greed is the underlying factor.
Slide 32
Impact
 Corporate fraud has negatively impacted the
financial services sector. Its effect on the
banking, insurance, and securities industries
undermines the fundamental core of the
United States economy.
Slide 33
Overall Scope
of Corporate Fraud
 Not limited to any geographic area or market
segment.
 Despite media attention on several select
companies, the FBI is currently pursuing 139
cases of corporate fraud.
 Many companies are lesser known but effect
on shareholders is the same.
Slide 34
Corporate Fraud Investigations
 At least 16 cases with losses > $1 Billion
 50 cases with losses > $100 Million
 Since January 2002 – 187 executives
charged with corporate fraud violations.
 3-6 new cases opened each month
Slide 35
Participants In Corporate Fraud
Vary But May Include . . .
 Chief Executive Officer
 Chief Financial Officer
 Line Accountants
 Sales Personnel
 Shipping Personnel
 Corporate Attorneys
 Collusive Customers
Slide 36
A Common Myth
 I work in a small local CPA firm. Corporate
fraud is only a concern for the big, national
accounting firms.
 I have very few (or no) publicly-traded audit
clients. Therefore, the issue of corporate
fraud has no effect on my practice.
Slide 37
A Common Myth
 Should You Be Concerned About Corporate
Fraud . . .
 Do you conduct audits?
 Do your clients have employees?
 Do you prepare tax returns?
 Do you conduct forensic examinations?
 Do outside parties rely on your client’s financial
statements?
 Do your clients transact business with other
companies?
Slide 38
A Common Myth
If you answered “Yes” to any of these
questions, you can be affected by corporate
fraud.
Because . . .
Slide 39
Why You Should Be Concerned . . .
 As you certainly know, audited financial
statements have end users, like investors and
creditors, who rely on them.
 Employee theft and self-dealing is a
corporate fraud violation.
 Individual tax violations from self-dealing is
corporate fraud.
 One company may assist another company in
committing accounting fraud if there’s an
incentive.
Slide 40
Role of the CPA
 Independence remains a crucial element In
conducting effective audits
 Objectivity and professional skepticism are also
important
 CPAs must avoid placing themselves in the
position of “protecting” a client under
investigation.
Slide 41
Role of the CPA
 A major public misperception of the CPA is
that if a CPA performs a financial statement
audit, he or she will detect any fraud that may
exist.
 While an auditor does have responsibilities
for detecting material fraud, audits are
conducted to issue an opinion on the fairness
of the financial statements.
Slide 42
Statement on Auditing
Standards No. 99:
“Consideration of Fraud
in a Financial Statement Audit”
Evolution of the Fraud Standard
- Number of Paragraphs
140
58
Paragraphs
120
100
80
60
12
40
20
33
0
15
16
84
41
0
SAS 16 (1977)
SAS 53 (1989)
Basic Statement
SAS 82 (1997)
SAS 99 (2002)
Appendices
What’s New in the Auditor’s
Fraud Detection Responsibilities?
 Evaluating how the entity responds to identified
fraud risks
 More emphasis on professional skepticism
 Discussions among engagement personnel
 Expanded inquiries of management and others
within the entity.
 Reorganized and modified fraud risk factor
examples (the “Fraud Triangle”).
 Expanded fraud risk assessment approach
Slide 45
What’s New in the Auditor’s
Fraud Detection Responsibilities?
 Expanded guidance on revenue recognition as
a likely risk.
 Linkage between identified risks and the
auditor’s response.
 Responses to address the risk of management
override of controls.
 Documentation (expanded requirements).
Slide 46
The Government’s
Response To Corporate Fraud
Slide 47
The Sarbanes-Oxley Act:
Why & How
 Focused on restoring investor confidence by:
 Placing greater accountability on corporate
officers;
 Forcing timely flow of information (both good new
and bad news);
 Forcing greater separation of duties between
auditors, consulting, and management; and
 Limiting self-regulation of the accounting
profession and standards-setting process.
Slide 48
The Sarbanes-Oxley Act:
Why & How
 Pursues these goals by amending existing
laws, or creating new ones, which:
 Requires officers, under possible civil and/or criminal
penalty, to certify accuracy and representation of its financial
conditions, disclosure controls and procedures, and assess
its effectiveness on internal control structure and procedures
over financial reporting;
 Requires quarterly review of internal controls;
 Places limitations on audit firm’s ability to provide some
services and requires board approval of all non-audit
services; and
 Brings PCAOB into existence.
Slide 49
The Sarbanes-Oxley Act:
Why & How
In essence, it endeavors to restore investor
confidence by changing the corporate mindset and actions towards controls and
disclosures.
Slide 50
The Sarbanes-Oxley Act of 2002
 Major Provisions
 Creates a new criminal violation (18 USC 1348)
for securities fraud schemes.
 CEOs and CFOs must provide a Statement of
Certification that the financial statements fairly
present the financial condition of the company.
 Provides increased jail sentences for
executives who engage in corporate fraud.
Slide 51
The Sarbanes-Oxley Act of 2002
 Major Provisions
 CPAs must retain audit workpapers for 5 years.
Failure to do so is a criminal violation (18 USC
1520).
 Several new amendments added to obstructive
conduct.
Slide 52
The FBI Response
 Corporate Fraud Hotline
Initiated February 2003: 888-622-0117
2,000 calls logged to date
Callers can be anonymous
Several new cases opened based on caller
information
Several existing cases were enhanced
Public cooperation is essential
Slide 53
The FBI Response
 Reserve Team
Consists of special agents and financial
analysts with accounting skills.
Temporarily assigned to corporate fraud cases
across the country to efficiently conduct
investigation.
Emphasizes timely results through the use of
seasoned investigators with strong interview &
interrogation skills.
Slide 54
The FBI Response
 Accountants Are Essential
Currently 1,334 FBI Special Agent Accountants
501 are Certified Public Accountants
336 are FBI Financial Analysts
In the upcoming year, 15% of all new special
agents hired will be accountants. Since its
inception, the FBI has continuously hired
accountants for diverse investigative roles.
Slide 55
The FBI Response
 Corporate Fraud Investigative Partnerships
Securities and Exchange Commission (SEC)
National Association of Securities Dealers (NASD)
U.S. Postal Inspection Service (USPIS)
U.S. Department of Labor
Internal Revenue Service
Commodity Futures Trading Commission (CFTC)
Federal Energy Regulatory Commission (FERC)
Defense Criminal Investigative Service (DCIS)
Slide 56
The FBI Response
 These investigative partnerships were formed
to capitalize on agency expertise in areas
like:
 Securities;
 Pensions;
 Taxation;
 Energy regulation; and
 Government contracts
Slide 57
My Client Is Under Investigation
 What you should know . . .
 CPA firms of all sizes are affected.
 FBI – CPA roles are NOT adversarial.
 Expect subpoenas for workpapers.
 Expect interviews of audit personnel.
Slide 58
(Continued) My Client
Is Under Investigation
 What You Should Know . . .
 Client offices may be searched.
 These are normal investigative procedures.
 It is not the CPA’s role to protect a client in a
criminal investigation.
 Remember – independence still applies.
Slide 59
Criminal Justice and the CPA
 CPAs are hired by the government in
accounting fraud cases. Their findings are
important in identifying the extent of the fraud.
 CPAs are hired by the government as expert
witnesses in criminal trials.
Slide 60
Criminal Justice and the CPA
 When providing assistance to the
Government:
 How did you document answers from key
personnel during the audit?
 Audit workpapers are valuable pieces of evidence.
CPAs often document statements by corporate
executives during an audit. These statements
may later contradict the position of these
executives in criminal cases.
Slide 61
Cooperatively . . .
The FBI and the CPA Profession
can tackle corporate fraud. It’s
in everyone’s best interest.
Slide 62
Arresting Financial Fraud:
The Inside Story From The FBI
Summary & Questions
Arresting Financial Fraud:
The Inside Story From The FBI
Thank You
For Participating!
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