Not worth the paper they're printed on
Phony estimates in financial statements
Detecting financial statement fraud is more complex than ever. Convoluted mergers and acquisitions and recent court rulings on goodwill and loan loss reserves complicate fraud examinations. But here are ways to investigate the books and the personalities behind the numbers.
The setting: a corporate chieftain’s mahogany-paneled office.
“What do you have for me?” the CEO asks.
“A potential acquisition that could help cover our tracks on other matters,” his CFO replies and hands over a spreadsheet. “One complication: They might’ve been goodwill hunting without a license.”
“Imagine that,” the CEO says, smirking as he eyes the numbers.
“They took a possibly bogus charge after buying a competitor, but it dovetailed nicely with the commodities nosedive. Bold and smooth. Not on par with our game, of course.”
“So few are,” the CEO says. “If you think we can use them more than they might try to use us, kick legal into due dillie mode and draft a pitch for my review. I don’t want this to distract our beloved board members from their gourmet lunch next quarter. And unless I say otherwise, you and I will communicate about this entirely offline.”
“Will do. At a minimum, it should pay off as well as the Asian takeover we did two years ago. Yeah, they hosed us for $8 mil. But we wrote off 23, and no one questioned it. I love my powerboat.”
“Sweet. I want an even bigger margin on this one. Make it happen.”
LAYERS OF DECEPTION
The above conversation never took place. But there’s nothing imaginary about the attitudes and techniques it illustrates.
“It would be an understatement to say that fraudsters are creative and opportunistic,” says Alton Sizemore, CFE, CPA. “That’s why two-way fraud schemes are more common than some investigators realize.”
After a 25-year FBI career, Sizemore is director of investigations for Forensic Strategic Solutions, a forensic accounting firm with offices in Birmingham, Dallas and Washington, D.C.
“Should we care if one crook bilks another?” he asks. “Absolutely. The cheated one will find an innocent victim to absorb his loss.”
Fraudsters don’t worry that much about losing money when they acquire a company that might have fraudulently overstated its assets and hidden liabilities to spur a run-up in its market value, Sizemore adds. Honest acquirers would run in the opposite direction. But fraudsters see it primarily as an opportunity to commit a bigger fraud of their own, in which they write off much more than they overpaid. And their subsequent goodwill write-down offsets and helps conceal embezzlements from their company. [The American Institute of CPAs’ Statement on Standards for Valuation Services No. 1 defines goodwill as “… that intangible asset arising as a result of name, reputation, customer loyalty, location, products, and similar factors not separately identified.”]
“Even when results don’t fulfill the fraudsters’ expectations, they don’t take the hit; shareholders do,” Sizemore says. “It’s always heads, they win; tails, others lose.”
SMOKE OR FIRE?
It can, however, be hard to tell if either or both participants in a merger and acquisition (M&A) deal have misstated their financials. A current high-profile dispute exemplifies this, with each party to a massive acquisition accusing the other of false statements.
In 2011, HP bought U.K. software maker Autonomy for $10 billion. But the following year, HP stunned the markets when it wrote off most of the deal’s value, alleging in a statement that $5 billion of its charge was due to “a willful effort on behalf of certain former Autonomy employees to inflate the underlying financial metrics of the company in order to mislead investors and potential buyers.”
Autonomy’s erstwhile head fired back that HP was trying to find a scapegoat for its own incompetence. “I utterly reject all allegations of impropriety,” wrote former Autonomy CEO Dr. Michael R. Lynch in an open letter to HP’s board. “Can HP really state that no part of the $5 billion write-down was, or should be, attributed to HP’s operational and financial mismanagement of Autonomy since the acquisition?” he asked.
The U.S. Department of Justice and the U.K. Serious Fraud Office are looking into the matter. When pressed to publicly reveal specifics underlying its fraud allegations against Autonomy, HP announced it won’t do so until the dispute reaches court.
“While Dr. Lynch is eager for a debate,” HP announced in its statement, “we believe the legal process is the correct method in which to bring out the facts and take action on behalf of our shareholders. In that setting, we look forward to hearing Dr. Lynch and other former Autonomy employees answer questions under penalty of perjury.”
With so little to go on, it’s hard to say whether HP can prove Autonomy committed financial statement fraud. But HP’s deliberate pace and apparent confidence imply it just might have accomplished two tasks essential to successful litigation in this context:
If either of these elements is missing from HP’s case, it will fail. So, what are some of the best ways for CFEs, working as or with forensic accountants, investigators and attorneys, to help their employers or clients prepare if they ever face a day in court like that awaiting HP?
- Identifying specific accounting and/or financial reporting standards that Autonomy violated.
- Obtaining hard evidence of those alleged violations.
FINDING THE EVIDENCE
“Financial statement fraud often involves so-called ‘topside’ journal entries that produce a desired, but not necessarily accurate or legitimate, effect on the numbers,” says Gerry Zack, CFE, CPA, CIA, founder and president of Zack, P.C., an audit, anti-fraud and risk advisory firm near Washington, D.C.
For example, Zack explains, all accounts receivable activity takes place in a subsidiary ledger — its totals feed the general ledger, which flows into the financial statements. However, as their name implies, topside journal entries aren’t made in subsidiary ledgers. That’s because fraudulent transactions in subsidiary ledgers are visible to many employees. So, when possible, fraudsters post their bogus journal entries topside.
Fraudsters also try to hide their activities from auditors. With companies routinely posting enormous numbers of transactions, auditors can examine only limited samples whose monetary value equals a set, undisclosed minimum amount. But if fraudsters somehow learn the auditor’s materiality threshold, it’s a simple matter for them to keep all their fraudulent transactions below that amount and greatly reduce the chance the auditors will ever notice their illegitimate entries.
To satisfy the markets, Zack says, the perpetrators of one of the largest frauds in U.S. history made hundreds of journal entries just below the materiality threshold their company’s auditors observed. The infamous company’s name? HealthSouth.
RATIOS TELL THE TALE
HealthSouth’s avoidance of its auditor’s materiality factor is something Forensic Strategic Solutions’ Sizemore will never forget. As the Birmingham, Ala., FBI office’s assistant special agent in charge, he managed the 2003 HealthSouth investigation. Sizemore’s account of the $2.7 billion financial statement fraud (“Sniffing for Cooked Books,” ACFE article, Aug. 2010) illustrates the detective power of financial statement ratio analysis.
Sizemore describes another financial statement fraud auditors should have detected. Just for Feet was a discount shoe retailer, headquartered in Birmingham, with outlets in 40 states. By the time the scheme ended, the per-share price of Just for Feet stock had plunged from $29 to $1.25. A competitor acquired the company after five of its top executives cooperated with investigators and were convicted of felonies.
As in the HealthSouth fraud, there were numerous conspicuous indications of potential fraud. “Noticing some of them required no more than common sense,” Sizemore says. “For example, with a $400 million inventory, Just for Feet could offer every size, make and model of all major brand shoes. But not everyone needs size 13 green tennis shoes. So those models sat on the shelf and became obsolete. When Just for Feet’s CPA firm did the annual audit, it estimated the value of obsolete inventory at $150,000 instead of at $100 million, which would have been a conservative estimate. Red flags don’t come any bigger or brighter than that, but the auditors ignored it on Just for Feet’s financial statements, and investors were duped.”
CFEs can learn much from studying the audit process and its objectives, Sizemore says. The better they understand it, the more capable they’ll be of independently obtaining and analyzing information, such as comparing their company’s financial ratios to industry standards and prior periods and business cycles.
“Approach that task with professional skepticism,” he advises. “If a ratio value doesn’t make sense to you, seek out the people responsible for it — up or down the information supply chain — until you get a clear and reasonable explanation. If someone tells you they plug in a number to make the financial statements look better, you have an issue for law enforcement.” (For more information on ratio analysis, see the ACFE’s 2013 Fraud Examiners Manual, 1.243, 1.244.)
CFEs not trained as auditors can gain greater insight into that profession by exploring the auditing standards issued and enforced by the U.S. Public Company Accounting Oversight Board (PCAOB), a private-sector nonprofit entity, created by the U.S. Sarbanes-Oxley Act, with quasi-governmental regulatory powers and responsibilities. (See the resources list at the end of this article for a list of those standards most pertinent to material misstatements in financial reports.)
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