It's all about the revenue

By Gerry Zack, CFE, CPA, CIA

ACFE Cookbook: Explaining the many recipes for financial statement fraud

"The ACFE Cookbook" is a column devoted to examining recent cases and news involving alleged financial reporting fraud. Our focus is global, so no matter where you are, if you see news of financial reporting fraud, we'd like to hear about it for possible coverage. Send your links, news or information on public reports of alleged fraud to — ed.

This issue's cookbook is devoted to two recent and interesting cases involving revenue manipulation — the most popular method of cooking the books. But I serve up several menu options in these cases. Which would you prefer today: round-tripping, channel stuffing or perhaps an order of side deals? Let's get cooking.


Hong Kong's Securities and Futures Commission (SFC) brought this case — a major development in cross-border enforcement — against China Metal Recycling Holdings, Ltd (CMR). CMR is incorporated in the Cayman Islands and operates in Hong Kong and Macau, but its most valuable assets are located in mainland China.

Mainland China is home to approximately 60 percent of companies publicly traded in Hong Kong. Therefore, SFC's victory in February 2015 is a significant step in the watchdog agency's quest to pursue firms that are listed and traded in Hong Kong, but which are based in other countries.

The nature of the fraud appears to have involved a revenue recognition scheme referred to as round-tripping. Often when fraudsters attempt to create phony revenue they find no cash flow associated with the fictitious income. Fictitious revenue usually displays two telltale signs: 1) Cash flows from operating activities lag behind operating profits reported on the income statement, and 2) deteriorating aging in a company's accounts receivable. The bottom line is that nobody pays the company for made-up revenue.

So, fraudsters will then use round-tripping: paying someone to return the money back to them. They will classify the outbound payment as some type of asset — a loan, prepaid expense, equipment, etc. The fraudsters will then classify the incoming funds from this cooperative third party as a payment applied to the account receivable that was set up when the phony revenue was initially recorded.

This series of transactions creates the appearance that customers have paid the company for the revenue that's been recorded. The accounts receivable aging is kept in check, and the statement of cash flows appears to reflect cash flows from operating activities. This technique has fooled many investors, regulators, auditors and analysts through the years.

According to a November 2014 judgment, CMR began trading on Hong Kong's stock exchange in June 2009, and at one point employed more than 6,000 people. CMR purchased scrap metal from suppliers and either produced recycled scrap metal products or sold the scrap outright with no further processing.

The SFC began looking into CMR in December 2009 based on suspicions that the company issued false or misleading information the month prior. SFC's allegations concerned a subsidiary of CMR — identified as Central Steel Macao in the judgment — and the subsidiary's dealings with three suppliers.

According to the judgment, between 2007 and 2009, Central Steel Macao transferred funds from its bank account into those of the three suppliers. SFC alleged these transactions were disguised as steel transactions. These suppliers, in turn, transferred those funds back into Central Steel Macao's account. Round-tripped funds exceeded $277 million. As a result, CMR inflated its gross profits by 38 percent for 2007, 64 percent for 2008 and 90 percent for 2009.

In July 2013, the SFC invoked a special provision of Hong Kong's securities law to force CMR into a provisional liquidation based on evidence of accounting fraud. This then led to the February ruling, which CMR didn't contest (although former management has denied the allegations).

The ruling represents a big victory for the SFC. However, its biggest challenge might yet lie ahead — securing those CMR assets on mainland China for liquidation. But that's another story for another time. 

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