Title
Slide
Detecting Corporate Fraud
Roddy Boyd, founder
Southern Investigative Reporting
Foundation
Sam Antar, Convicted...
Title
Slide
Roddy Boyd
Southern Investigative Reporting Foundation
Twitter: @BoydRoddy
Phone 917-514-3897
Title
Slide
Convicted felon, former CPA, and former
CFO of Crazy Eddie. Teaches law
enforcement, professional organization...
Title
SlideAnswer: Management’s Intentional
Misrepresentation of Financial Statements
For The Purpose Of Obtaining An Inte...
Title
Slide“It Pays To Do it, It’s Easy To Do and It’s
Unlikely They Will Be Caught.”
Source: Howard Schilit, Financial Sh...
Title
Slide100% of All Financial Crime Violates This Precept
Common Sense: The First
Rule of Financial Fraud
Detection
Title
Slide—Merrill & Law of Large Numbers: http://tinyurl.com/mmt4snz
—AOL’s Miracle Growth: http://tinyurl.com/kd78vjg
—...
8
Caveat reporter
• No one red flag always indicates fraud.
• Not every example that raises eyebrows
amounts to fraud.
• M...
Who’s Who: What to look for
Check it out
•Education, especially:
• Specialized degrees/expertise
• Attendance vs. degree
•...
19
Who’s Who: What to look for
Don’t forget the help
•Lawyers
•PR firms
•Consultants
•Exceptions?
• Crisis PR firms
• Defe...
Who’s Who: Next steps
Who to background
•Executives
•Directors
•Major investors
•Lawyers
•PR people
•Consultants (especial...
Ties that bind:
Related party transactions
Photo by Flickr user Simon James
Ties: What to look for
• Commodity transactions
• Why is the insider the best choice?
• Confusion, dead-ends, obfuscation
...
Ties: What to look for
Less worrisome (maybe):
•“The father of Mr. Dimon has been employed by the Firm as a
broker since 2...
Eliyahu “Eli” Weinstein
Sentenced to 22 Years in Prison for $200 Million Ponzi Scheme
“He also realized, authorities say, ...
Ties that bind: Next steps
• Location, location, location
• Google
• State corporation filings
• Secretary of state, state...
Ties that bind: “Certain
Relationships”Exercise
• Nanoviricides http://tinyurl.com/lcwtg2s
• DHB Industries http://tinyurl...
Who’s Who: Buried treasure
“In December 2008, the Company purchased an extensive
collection of historical maps of the Amer...
• Background MicroStrategy CEO Michael Saylor
• Open proxy & calculate value of holdings
• Look at compensation structure
...
9
Get a grip: The 10s
Primary financial and operational disclosures for established
public companies. http://tinyurl.com/4...
10
Get a grip: What to look for
• Frequent reshuffling
• Strategies
• Core products & services
• Restructuring
• Poor ackn...
11
Get a grip: What’s core?
Everyone knows General Electric
•Power turbines
•Jet engines
•Medical imaging
•Dishwashers
•Su...
12
Get a grip: Go Wayback
InternetArchive.org
•(Almost) Nothing on the Internet ever dies
•Why no cure for AIDS & the comm...
13
Measuring up: The filings
10-K
•Audited
•More comprehensive
•More history
10-Q
•Unaudited
•Narrower in focus
•Less hist...
14
Measuring up: Financials
The basics:
•Income statement
• Profit & loss
• Revenue (sales)
• Net income (earnings)
•Balan...
Measuring up: Receivables
Accounts receivable
Money owed to the company, generally by customers
•Big swings
• in dollar te...
Measuring up: Inventories
Inventory:
Raw materials, work-in-process goods and completely finished goods
held for sale
•Big...
Measuring up: Payables
Accounts payable
Money the company owes, generally to
suppliers
•Profitable company with rapidly in...
Measuring up: Arthrocare
• ArthroCare Spine segment revenues (Sept. 30 quarter)
• to $11.4 million from $5.9 million
• to ...
Measuring up: Arthrocare
• Accused of “parking” millions of dollars in merchandise with
distributors
• to meet/beat foreca...
Measuring up: Receivables
Channel Stuffing
“A deceptive business practice used by a company to inflate its
sales and earni...
Measuring up: Receivables
How to you detect channel
stuffing?
The SEC has recognized that, “a growing
DSO figure is often ...
Measuring up: Receivables
Accounts receivable: If a company is taking longer periods of time to
collect on accounts receiv...
Measuring up: Receivables
What is DSO?
Days- Sales-Outstanding (DSO). It measures how long it takes a
company to collect o...
Measuring up: Receivables
Why a rising DSO is a red flag?
As a company pushes more
unnecessary inventory into the
distribu...
Measuring up: Receivables
Example:
“By allowing distributors to delay payment or
not pay their invoices in full, McAfee
ac...
Measuring up: Orthofix International N.V.
•Founded in 1980
•Operationally based in Lewisville, Texas
•Global medical devic...
Measuring up: Orthofix International N.V.
SEC Filings Reveal Red Flags - Rising DSO
Quarter
Ended:
Net DSO
Quarter
Ended:
...
Measuring up: Orthofix International N.V.
“… certain revenues recognized during 2011 and 2012,
upon further evaluation, sh...
Measuring up: Inventories
Inventories: If a company is taking longer periods of sell
(turnover its inventory) it is a red ...
Crazy Eddie Inventory Fraud
Crazy Eddie inventory inflation: $3 million in 1985, $13 to $16 million in
1986, and $28.5 to ...
Red Flags, But No One Listened
Then too, while we are at it, inventory
controls seem a wee bit casual, what
with the compa...
Red Flags, But No One Listened
And so it was that Mr. O'glove had never met, much less been charmed by, the fast-
talking ...
Finding fraud: Compare the footnotes
Crazy Eddie changed one word in footnotes to overstate income by $20 million
Annual R...
Finding fraud: Compare the numbers
Sharp drop in accounts payable to inventory ratio resulting from
phony discounts and tr...
Measuring Up: Overstock.com
Always check what they say against what they disclose
BYRNE: We're profitable.
BUTTNER: Your r...
Measuring Up: Overstock.com
Overstock was never profitable
We have a history of losses and we may continue to incur operat...
Measuring Up: Overstock.com
Always check what they do against what they said
"…I think 'EBITDA' is the stupidest thing I e...
Measuring Up: Overstock.com
What is EBITDA?
The acronym EBITDA refers specifically to earnings before interest, tax,
depre...
Measuring Up: Overstock.com
Result: Overstock.com inflated EBITDA
Measuring Up: Overstock.com
Always check what they disclose against the rules:
In Q4 2008, Overstock.com reported a $1.014...
Measuring Up: Overstock.com
The rules
Under GAAP, we are required to use an accrual basis of
accounting.
Income is recogni...
Measuring Up: Overstock.com
Measuring up: Form 4
Always read the explanations very carefully
On 12/21/11, Robert Pedersen, CEO ZAGG, sold 345,200 shar...
Measuring up: Form 4
Stock Pledges are required to be disclosed in proxy reports
Item 403 -- Security Ownership of Certain...
Measuring up: Form 4
August 14, 2012, Robert Pedersen sold 515,500 shares at an average price of
$8.22 per share
Explanati...
Measuring up: Form 4
On August 28, 2012, Zagg held a conference call with investors and admitted:
…departure was entirely ...
Measuring up: Form 4
SEC investigating ZAGG and Pedersen:
“In the fourth quarter of 2012, the Company received requests to...
Measuring Up: Warranty Reserves
A warranty reserve as a liability account is set up to measure expected
warranty claims ar...
Measuring Up: Warranty Reserves
Green Mountain Coffee Q1 2012 10-Q Report
Measuring Up: Warranty Reserves
Green Mountain Coffee Q1 2013 10-Q Report
Red flags: Director departures
• Sudden resignations
• http://tinyurl.com/m9stmt7 and http://tinyurl.com/ld3yssk
• Detaile...
Red flags: Auditor oddities
• Big company, small auditor
• Audit vs. consulting fees
• Sudden departures
Red flags: Next steps
• PCAOB (Public Company Accounting Oversight Board)
• http://pcaobus.org
• Audits the auditors
• Ins...
Do audits really protect investors?
PCAOB Inspection Reports of “Big 4” accounting
firms for 2012
What they say:
• Ernst &...
Do audits really protect investors?
No Transparency
•The audit engagement partner’s name is not identified in audit report...
Do audits really protect investors?
Puda Coal
The issue, Judge Katherine B. Forrest of Federal District Court in Manhattan...
Shabby Audits: Autonomy
History:
•October 2011: HP acquires Autonomy for $11.1 billion
•November 2012: HP announced a non-...
Blind Reliance on 2 Audit Firms
The technology giant said that an internal investigation had revealed "serious
accounting ...
How is most fraud discovered?
Source: Association of Certified Fraud Examiners, Report to the Nations
Who are the Whistleblowers?
XXX’s:
1. Ex-lovers: Divorced spouses, former girlfriends and boyfriends.
2. Ex-business assoc...
Beware: Most White-Collar Criminal Are Invisible
Source: Association of Certified Fraud Examiners, Report to the Nations 2...
Slump in FBI White Collar Crime Prosecutions
Source:
Transactional Records
Access Clearinghouse
(TRAC)
Slump in FBI White Collar Crime Prosecutions
Source:
Transactional Records
Access Clearinghouse
(TRAC)
Income Statement Fraud
Falsifying/Misrepresenting Sales or Expenses
• Booking Fake Sales
• Delaying, Not Reporting Expense...
The Most Creative Dumbasses
In The Room
Enron’s 1996 Revenues: $13.2 Billion
Enron’s 1999 Revenues: $40.1 Billion
Enron’s ...
Worldcom: Buying your way into jail
Multiple Acquisitions Hide No Organic Growth
Free Cash Flow Tells Real Story
Source: F...
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Detecting Corporate Fraud: Tips from a Crook and a Sleuth by Roddy Boyd and Sam E. Antar

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The Donald W. Reynolds National Center for Business Journalism presented the free, three-hour workshop, "Detecting Corporate Fraud: Tips from a Crook and a Sleuth," before the Investigative Reporters and Editors Conference on June 25, 2014.

Roddy Boyd, investigative reporter and founder of the Southern Investigative Reporting Foundation, led this investigative training with Sam E. Antar, former CFO of Crazy Eddie, Inc. and convicted felon.

To access all training materials provided during the series of "Detecting Corporate Fraud" workshops, please visit http://bit.ly/cofraud14.

For information about business journalism training and resources, please visit http://businessjournalism.org.

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Detecting Corporate Fraud: Tips from a Crook and a Sleuth by Roddy Boyd and Sam E. Antar

  1. 1. Title Slide Detecting Corporate Fraud Roddy Boyd, founder Southern Investigative Reporting Foundation Sam Antar, Convicted Felon Former Crazy Eddie CFO and CPA IRE Conference June 25, 2014
  2. 2. Title Slide Roddy Boyd Southern Investigative Reporting Foundation Twitter: @BoydRoddy Phone 917-514-3897
  3. 3. Title Slide Convicted felon, former CPA, and former CFO of Crazy Eddie. Teaches law enforcement, professional organizations, businesses, and colleges and universities about white-collar crime and how to catch the crooks. Assists law firms on fraud cases. Sam Antar Twitter: @samantar Email: sam@whitecollarfraud.com
  4. 4. Title SlideAnswer: Management’s Intentional Misrepresentation of Financial Statements For The Purpose Of Obtaining An Internal Objective Question: What is Corporate Financial Fraud?
  5. 5. Title Slide“It Pays To Do it, It’s Easy To Do and It’s Unlikely They Will Be Caught.” Source: Howard Schilit, Financial Shenanigans, 2002 Why Do Companies Lie To Investors?
  6. 6. Title Slide100% of All Financial Crime Violates This Precept Common Sense: The First Rule of Financial Fraud Detection
  7. 7. Title Slide—Merrill & Law of Large Numbers: http://tinyurl.com/mmt4snz —AOL’s Miracle Growth: http://tinyurl.com/kd78vjg —Brookfield’s “Paper”$: http://tinyurl.com/m5vd5kz Common Sense “Cheats”
  8. 8. 8 Caveat reporter • No one red flag always indicates fraud. • Not every example that raises eyebrows amounts to fraud. • Michelle Leder’s “mosaic” principle. • Talk to the company. Image: Rutger van Waveren, http://flic.kr/p/bfBSC
  9. 9. Who’s Who: What to look for Check it out •Education, especially: • Specialized degrees/expertise • Attendance vs. degree • Diploma mills & dubious online schools •Litigation • Corporate • Personal • Professional Photo by Flickr user un.sospiro
  10. 10. 19 Who’s Who: What to look for Don’t forget the help •Lawyers •PR firms •Consultants •Exceptions? • Crisis PR firms • Defense lawyers • etc. Scenario: Ditching the troubled founder •Really? •Relatives & associates •LLCs The blame game Pinning operational problems on others •Short-sellers •The media (that’s us) •Regulators
  11. 11. Who’s Who: Next steps Who to background •Executives •Directors •Major investors •Lawyers •PR people •Consultants (especially in technical industries) •LLCs & similar entities •Reynolds Center on backgrounding people & businesses: http://bit.ly/1js5XOJ
  12. 12. Ties that bind: Related party transactions Photo by Flickr user Simon James
  13. 13. Ties: What to look for • Commodity transactions • Why is the insider the best choice? • Confusion, dead-ends, obfuscation • Layers of LLCs or other private companies • Especially if they tie back to the same people • Especially if those people are executives, directors or big investors Exceptions? • Private-equity investors • Founders & founding families
  14. 14. Ties: What to look for Less worrisome (maybe): •“The father of Mr. Dimon has been employed by the Firm as a broker since 2009, and for 2012 received compensation of $1,599,616, including annual salary, commissions, and an equity award.” — JPMorgan Chase proxy (2013) •Previously a broker for Bank of America Still… •That’s up from $447,000 in 2011.
  15. 15. Eliyahu “Eli” Weinstein Sentenced to 22 Years in Prison for $200 Million Ponzi Scheme “He also realized, authorities say, that pouring some of the money he swindled back into local charities and religious organizations would help him maintain his community standing and possibly help him secure future deals.” Source: Jason Grant, The Star-Ledger, February 25, 2014
  16. 16. Ties that bind: Next steps • Location, location, location • Google • State corporation filings • Secretary of state, state incorporation office, etc. • Legal databases • Court documents Photo by Flickr user Daniel Moyle
  17. 17. Ties that bind: “Certain Relationships”Exercise • Nanoviricides http://tinyurl.com/lcwtg2s • DHB Industries http://tinyurl.com/mbr73wc
  18. 18. Who’s Who: Buried treasure “In December 2008, the Company purchased an extensive collection of historical maps of the American Southwest from [Chairman & CEO] McClendon for $12.1 million, which represented his cost. A dealer who had assisted Mr. McClendon in acquiring this collection over a period of six years advised the Company that the replacement value of the collection in December 2008 exceeded the purchase price by more than $8 million. The maps have been displayed at the Company’s Oklahoma City headquarters for a number of years, during which the Company has been insuring the maps in exchange for their display. ... Our employees and visitors appreciate the maps … The Company was interested in continuing to have use of the map collection and believed it was not appropriate to continue to rely on cost-free loans of artwork …” — 2009 proxy
  19. 19. • Background MicroStrategy CEO Michael Saylor • Open proxy & calculate value of holdings • Look at compensation structure • Run keyword search: “aircraft,” “tax” • “Insta-Enterprise”: http://tinyurl.com/olmo7qm
  20. 20. 9 Get a grip: The 10s Primary financial and operational disclosures for established public companies. http://tinyurl.com/4px4l 10-K •Annual •Audited •Comprehensive 10-Q •Quarterly (3x a year) •Unaudited •More incremental Image: Heather, http://flic.kr/p/9rpM2p
  21. 21. 10 Get a grip: What to look for • Frequent reshuffling • Strategies • Core products & services • Restructuring • Poor acknowledgement of costs or risks • Repeated stock issuance (dilution) • Unexplained & poorly explained capital raises
  22. 22. 11 Get a grip: What’s core? Everyone knows General Electric •Power turbines •Jet engines •Medical imaging •Dishwashers •Subprime debt?! (http://tinyurl.com/opgcn3b) •Today: $46B = 31%
  23. 23. 12 Get a grip: Go Wayback InternetArchive.org •(Almost) Nothing on the Internet ever dies •Why no cure for AIDS & the common cold? • http://tinyurl.com/mevqfww
  24. 24. 13 Measuring up: The filings 10-K •Audited •More comprehensive •More history 10-Q •Unaudited •Narrower in focus •Less history Earnings release •Heavy on the PR •Compare to 10-K or 10-Q S-1 •New companies Other options •Google Finance •Yahoo! Finance •Etc.
  25. 25. 14 Measuring up: Financials The basics: •Income statement • Profit & loss • Revenue (sales) • Net income (earnings) •Balance sheet • Assets & liabilities •Cash-flow • Circulatory system Other resources: •Reynolds Center 10-Q financial basics: http://bit.ly/1jskFFp •Mark Tatge’s “Funny Money: How companies play games with numbers”: http://slidesha.re/1jsjG8c
  26. 26. Measuring up: Receivables Accounts receivable Money owed to the company, generally by customers •Big swings • in dollar terms • as a percent of revenue •Collectibility •Concentration of risk • Risk factors •Footnotes • Rising A/R should mean rising delinquencies, amounts past due for 90+ days • Or company may be hiding uncollectible sales • Overstatement of revenues
  27. 27. Measuring up: Inventories Inventory: Raw materials, work-in-process goods and completely finished goods held for sale •Big swings • in dollar terms • as a percent of cost of goods sold •Risk of write-down in valuation due to obsolescence •Footnotes • Rising inventories could mean increased risk of unsaleable goods and eventual write-down or inflation of inventory to overstate profits
  28. 28. Measuring up: Payables Accounts payable Money the company owes, generally to suppliers •Profitable company with rapidly increasing A/P • Implies the company may not be paying its bills • The opposite can imply that a company is understating liabilities Photo by Flickr user 401(k) 2012
  29. 29. Measuring up: Arthrocare • ArthroCare Spine segment revenues (Sept. 30 quarter) • to $11.4 million from $5.9 million • to 15.1% of sales from 9.4% • Extremely competitive market for spinal devices • Competitors are bigger and well funded • Johnson & Johnson, Stryker • Kickback allegations • Channel stuffing • Disclosure
  30. 30. Measuring up: Arthrocare • Accused of “parking” millions of dollars in merchandise with distributors • to meet/beat forecasts • booked $37 million in sales to one distributor • but only $50,000 in net sales History: • Investors raised questions. • Arthrocare bought the distributor. • Over time, $400 million in stock losses • Two former SVPs pleaded guilty to conspiracy to commit securities and wire fraud in 2013. • Executives convicted, await sentencing.
  31. 31. Measuring up: Receivables Channel Stuffing “A deceptive business practice used by a company to inflate its sales and earnings figures by deliberately sending retailers along its distribution channel more products than they are able to sell to the public.” (Source: Investopedia) Channel stuffing provides an immediate boost to revenues and earnings. However, it results in a revenue shortfall in the following period. To maintain the scheme, companies need to increase the amount of channel stuffing by growing amounts growing amounts in subsequent periods.
  32. 32. Measuring up: Receivables How to you detect channel stuffing? The SEC has recognized that, “a growing DSO figure is often a telltale sign that a company’s receivables are impaired due to channel stuffing.” (Source: SEC v Korkuc)
  33. 33. Measuring up: Receivables Accounts receivable: If a company is taking longer periods of time to collect on accounts receivable, it is a red flag for a possible revenue overstatement How long does it take a company to collect payments on accounts receivable? Days- Sales -Outstanding (DSO): End of Quarter or Avg. Accounts Receivable X Number of Days in Period Sales During Period
  34. 34. Measuring up: Receivables What is DSO? Days- Sales-Outstanding (DSO). It measures how long it takes a company to collect on accounts receivable: Accounts Receivable X Number of Days in Period Sales During Period Note: Can use end of period accounts receivable or average of beginning and ending accounts receivable
  35. 35. Measuring up: Receivables Why a rising DSO is a red flag? As a company pushes more unnecessary inventory into the distribution channels, it becomes harder and harder to collect revenue, both because the company is forced to offer increasingly generous credit and collection terms to customers to induce excess sales and because distributors are themselves unable to sell to end-customers, limiting their ability to pay.
  36. 36. Measuring up: Receivables Example: “By allowing distributors to delay payment or not pay their invoices in full, McAfee accumulated on its balance sheet millions of dollars of aging receivables. Consequently, “days sales outstanding” (“DSO”) – the average number of days that it takes a company to collect its accounts receivable – was directly affected.” – (Source: SEC v McAfee)
  37. 37. Measuring up: Orthofix International N.V. •Founded in 1980 •Operationally based in Lewisville, Texas •Global medical device company with six offices worldwide and an international distribution presence. •Publicly traded on the NASDAQ exchange (stock ticker “OFIX”) •June 2012: Pleaded guilty to obstructing a federal audit after it failed to disclose that it routinely falsified Certificates of Medical Necessity •July 2012: Agreed to a deferred prosecution agreement regarding violations of Foreign Corrupt Practices Act by Mexican subsidiary
  38. 38. Measuring up: Orthofix International N.V. SEC Filings Reveal Red Flags - Rising DSO Quarter Ended: Net DSO Quarter Ended: Net DSO Quarter Ended: Net DSO Quarter Ended: Net DSO 03/31/13 120.5 12/31/12 122.4 09/30/12 124.0 06/30/12 114.1 03/31/12 99.8 12/31/11 88.2 09/30/11 89.6 06/30/11 88.5 03/31/11 87.8 12/31/10 85.2 09/30/10 87.2 06/30/10 82.7 03/31/10 88.4
  39. 39. Measuring up: Orthofix International N.V. “… certain revenues recognized during 2011 and 2012, upon further evaluation, should not have been recognized or should not have been recognized during the periods in which they were recognized.” – (Source: 8-K, 08/06/13) “The Company has received requests from the SEC Enforcement Staff for documents and other information concerning various accounting practices, internal controls and business practices. Such requests cover the years ended December 31, 2011 and 2012, and in some instances, prior periods.” – (Source: 10-K report for 2013)
  40. 40. Measuring up: Inventories Inventories: If a company is taking longer periods of sell (turnover its inventory) it is a red flag for possible inventory inflation or future write-downs due to obsolescence How long does it take a company turnover its inventory? Days-Sales-Inventory (DSI): Average Inventory X Number of Days in Period Cost of Sales During Period Note: Average inventory is total of beginning and ending balances divided by 2
  41. 41. Crazy Eddie Inventory Fraud Crazy Eddie inventory inflation: $3 million in 1985, $13 to $16 million in 1986, and $28.5 to $37 million in 1987 Source: Second set of books maintained by Sam E. Antar
  42. 42. Red Flags, But No One Listened Then too, while we are at it, inventory controls seem a wee bit casual, what with the company not keeping records based on product groups. The company “believes” that television and video products account for the largest percentage of sales. Oh, by the way, Crazy’s shopping around for a new chief financial officer. (Source: Not-So- Crazy Eddie: Hard-Sell Retailer Going Public, by Gigi Mohan, Barron's National Business and Financial Jun 4, 1984)
  43. 43. Red Flags, But No One Listened And so it was that Mr. O'glove had never met, much less been charmed by, the fast- talking chief of Crazy Eddie. In fall 1986, he noticed that for the fiscal half ended Aug. 31, Crazy Eddie's sales had risen 41%, while inventories had mushroomed 147%. Previously, sales and inventories had generally moved in unison. "It was obvious to me that the company was having big problems despite other sanguine analyses on Wall Street," he said in a 1987 interview. Mr. O'glove is generally credited with being the first to sense trouble at Crazy Eddie. In hindsight, his suspicions seem almost naive. According to allegations in lawsuits filed by shareholders and by current management, those bloated inventory figures in fall 1986 were reflections of nothing less than a scheme to defraud Crazy Eddie and its shareholders. (Source: Calculated Madness: The Rise and Fall of Crazy Eddie Antar, by Gary Belsky and Phyllis Furman, Crain’s New York Business, June 5, 1989)
  44. 44. Finding fraud: Compare the footnotes Crazy Eddie changed one word in footnotes to overstate income by $20 million Annual Report Fiscal year 1986: "Purchase discounts and trade allowances are recognized when received." Discounts and trade allowances were not recognized until a credit memo was received from a vendor even if the discount was earned. Annual Report Fiscal year 1987: "Purchase discounts and trade allowances are recognized when earned." Crazy Eddie immediately recognized discounts and trade allowances when earned. Change in policy enabled Crazy Eddie to recognize discounts and trade allowances faster and inflate income by booking $20 million in fictitious charges to vendors.
  45. 45. Finding fraud: Compare the numbers Sharp drop in accounts payable to inventory ratio resulting from phony discounts and trade allowances booked by Crazy Eddie
  46. 46. Measuring Up: Overstock.com Always check what they say against what they disclose BYRNE: We're profitable. BUTTNER: Your real, honest-to-goodness profit, not pro forma? BYRNE: None of that stuff. (Source: Your World with Neil Cavuto, December 11, 2001)
  47. 47. Measuring Up: Overstock.com Overstock was never profitable We have a history of losses and we may continue to incur operating and net losses for the foreseeable future. We incurred net losses of $13.8 million in the fiscal year ended December 31, 2001. As of December 31, 2001, our accumulated deficit was $44.1 million. We will need to generate significant revenues to achieve and maintain profitability, and we may not be able to do so. Even if we do achieve profitability, we may not be able to sustain or increase profitability on a quarterly or annual basis in the future. If our revenues grow more slowly than we anticipate, or if our operating expenses exceed our expectations, our financial results would be severely harmed. Source: Overstock.com S-1 filed on March 5, 2002
  48. 48. Measuring Up: Overstock.com Always check what they do against what they said "…I think 'EBITDA' is the stupidest thing I ever heard emanate from Wall Street (no small feat)....“ Source: Email to Tim Mullaney from Business Week, January 10, 2006 From Q2 2007 to Q2 2008, started reporting EBITBA, but used the wrong calculation (Source: Various 8-K, 10-Q, and 10-K reports filed with the SEC)
  49. 49. Measuring Up: Overstock.com What is EBITDA? The acronym EBITDA refers specifically to earnings before interest, tax, depreciation and amortization. (Source: SEC Comment Letter to CGG Veritas) "Earnings" means net income as presented in the statement of operations under GAAP. (Source: SEC Compliance and Disclosure Interpretations) Overstock.com’s EBITDA calculation Our measure of “EBITDA” is a non-GAAP financial measure. EBITDA, which we reconcile to “Operating loss” in our income statement, is earnings before interest, taxes, depreciation, amortization and stock-based compensation. (Source: Various Overstock.com 10-Q and 10-K reports)
  50. 50. Measuring Up: Overstock.com Result: Overstock.com inflated EBITDA
  51. 51. Measuring Up: Overstock.com Always check what they disclose against the rules: In Q4 2008, Overstock.com reported a $1.014 million net profit. “After a tough three years, returning to GAAP profitability is a relief.” ~ CEO Patrick Byrne (Source: Press release 01/30/09) Earnings call after press release: “This included a one-time gain of $1.8 million relating to payments from partners who were under-billed earlier in the year.” ~ CFO Steve Chesnut (Source: Transcript)
  52. 52. Measuring Up: Overstock.com The rules Under GAAP, we are required to use an accrual basis of accounting. Income is recognized when it is earned and not when it is later billed or when amounts are collected. The “one-time gain of $1.8 million relating to payments from partners who were under-billed earlier in the year” was earned before Q4 2008 and should have been recognized in prior periods. Since the accounting error is material under SAB No. 99, Overstock.com is required to restate prior period financial reports under SFAS No. 154 and cannot use a “one-time gain” to correct its error. – (Source: White Collar Fraud, 02/04/09)
  53. 53. Measuring Up: Overstock.com
  54. 54. Measuring up: Form 4 Always read the explanations very carefully On 12/21/11, Robert Pedersen, CEO ZAGG, sold 345,200 shares at an average price of $7.5248 per share: Explanation of Responses: 1. The shares were sold to meet an immediate financial obligation. Question: What is an immediate financial obligation? Source: Form 4 filed on 12/23/11
  55. 55. Measuring up: Form 4 Stock Pledges are required to be disclosed in proxy reports Item 403 -- Security Ownership of Certain Beneficial Owners and Management (b) (3), indicate, by footnote or otherwise, the amount of shares that are pledged as security Source: Securities Lawyer’s Deskbook
  56. 56. Measuring up: Form 4 August 14, 2012, Robert Pedersen sold 515,500 shares at an average price of $8.22 per share Explanation of Responses: 1.The shares were sold to meet margin calls on the Reporting Person's account. Source: Form 4 filed 08/17/12 On August 17, 2012, Pedersen “resigned in order to focus on his family, his church and a family foundation.” Source: CEO of Utah’s ZAGG quits unexpectedly, Salt Lake Tribune 08/17/12
  57. 57. Measuring up: Form 4 On August 28, 2012, Zagg held a conference call with investors and admitted: …departure was entirely related to the margin calls situation that started last December and unfortunately surfaced again two weeks ago. Question: If Zagg knew about Pedersen’s stock pledges and margin calls in December 2011, when didn’t the stock pledge in a proxy report filed on April 27, 2012?
  58. 58. Measuring up: Form 4 SEC investigating ZAGG and Pedersen: “In the fourth quarter of 2012, the Company received requests to provide documentation and information to the staff of the SEC in connection with a non-public investigation being conducted by the SEC’s Salt Lake City office. The Company believes the investigation includes a review of the facts and circumstances surrounding some of the same issues raised by the plaintiffs in the above lawsuits; specifically, whether the Company failed to disclose Mr. Pedersen's margin account sales or the alleged existence of a plan to have Mr. Hales succeed Mr. Pedersen as the Company’s CEO. The Company responded to these requests and is cooperating fully with the staff. The Company has chosen to disclose this non-public investigation due to the highly public nature of the lawsuits described above, which the Company intends to defend vigorously.”” Source: Zagg 10-Q report for quarter ended 03/31/14
  59. 59. Measuring Up: Warranty Reserves A warranty reserve as a liability account is set up to measure expected warranty claims arising from current sales. •Beginning Balance •Provision for Warranty Expense (Increases the Reserve Account and Reduces Current Period Income) •Warranty Usage (Reduces Warranty Reserve Account and cash or accounts receivable – no effect on income) •Ending Balance If a company “overestimates” its reserve in one period, it can create illusory profits in a future period to “correct” the overstatement.
  60. 60. Measuring Up: Warranty Reserves Green Mountain Coffee Q1 2012 10-Q Report
  61. 61. Measuring Up: Warranty Reserves Green Mountain Coffee Q1 2013 10-Q Report
  62. 62. Red flags: Director departures • Sudden resignations • http://tinyurl.com/m9stmt7 and http://tinyurl.com/ld3yssk • Detailed complaint letters • Accounting problems • Regulatory inquiries • Board cliques • Companies sometimes file responses
  63. 63. Red flags: Auditor oddities • Big company, small auditor • Audit vs. consulting fees • Sudden departures
  64. 64. Red flags: Next steps • PCAOB (Public Company Accounting Oversight Board) • http://pcaobus.org • Audits the auditors • Insight into an accounting firm’s quality • Audit clients usually not named • Always call departing directors • Especially if there’s a letter • Short interest • If many investors are selling the shares short, why? • Talk to investors, bullish and bearish.
  65. 65. Do audits really protect investors? PCAOB Inspection Reports of “Big 4” accounting firms for 2012 What they say: • Ernst & Young: 51 audits inspected /deficiencies (49%) • Pricewaterhouse Coopers: 52 audits inspected/21 deficiencies (40%) • KPMG: 48 audits inspected/17 deficiencies (35%) • Deloitte & Touche: 51 audits inspected/13 deficiencies (25%) Update: Deloitte & Touche: 51 audits inspected/15 deficiencies (25%) – 2013 Inspection Report
  66. 66. Do audits really protect investors? No Transparency •The audit engagement partner’s name is not identified in audit reports. The accounting firm signs the audit report. •The CEO and CFO of a public company signs the financial reports. •Neither the company in question nor audit engagement partner are identified in PCAOB Inspection Reports.
  67. 67. Do audits really protect investors? Puda Coal The issue, Judge Katherine B. Forrest of Federal District Court in Manhattan stated in an opinion filed on Tuesday, was not whether the auditor could have done a better job, but whether “a reasonable auditor would have” checked the records that showed a fraud had been committed. “ Could more have been done? Clearly yes,” the judge wrote. “Did more need to be done, and would auditors conducting a P.C.A.O.B.-compliant audit have done more? Neither the court nor any reasonable juror at a trial has any way to answer this question.” (Source: Auditor Moore Stephens Said Not at Fault; Puda Coal Investor Suit Is Dismissed by Floyd Norris, New York Time, June 19, 2014)
  68. 68. Shabby Audits: Autonomy History: •October 2011: HP acquires Autonomy for $11.1 billion •November 2012: HP announced a non-cash impairment charge of $8.8 billion related to Autonomy ($5 billion linked to serious accounting improprieties) HP investigation concluded: •Autonomy made 80% less profits and 54% less revenues than originally reported
  69. 69. Blind Reliance on 2 Audit Firms The technology giant said that an internal investigation had revealed "serious accounting improprieties" and "outright misrepresentations" in connection with U.K. software maker Autonomy, which H-P acquired for $11.1 billion in October 2011. "There appears to have been a willful sustained effort" to inflate Autonomy's revenue and profitability, said Chief Executive Meg Whitman. "This was designed to be hidden.“ Ms. Whitman said Tuesday the company relied on Autonomy's regular auditor Deloitte and had hired KPMG for an additional review before the deal closed. (Source: H-P Says It Was Duped, Takes $8.8 Billion Charge, by Ben Worthen, Wall Street Journal, 11/20/12)
  70. 70. How is most fraud discovered? Source: Association of Certified Fraud Examiners, Report to the Nations
  71. 71. Who are the Whistleblowers? XXX’s: 1. Ex-lovers: Divorced spouses, former girlfriends and boyfriends. 2. Ex-business associates: Former customers and vendors 3. Ex-employees: Fired employees, laid off employees, and employees who quit working for the entity. Beware: Most whistleblowers are not motivated by altruism. They have axes to grind. They come forward because of their personal agendas.
  72. 72. Beware: Most White-Collar Criminal Are Invisible Source: Association of Certified Fraud Examiners, Report to the Nations 2012
  73. 73. Slump in FBI White Collar Crime Prosecutions Source: Transactional Records Access Clearinghouse (TRAC)
  74. 74. Slump in FBI White Collar Crime Prosecutions Source: Transactional Records Access Clearinghouse (TRAC)
  75. 75. Income Statement Fraud Falsifying/Misrepresenting Sales or Expenses • Booking Fake Sales • Delaying, Not Reporting Expenses • Paper Gains (“Level III”)
  76. 76. The Most Creative Dumbasses In The Room Enron’s 1996 Revenues: $13.2 Billion Enron’s 1999 Revenues: $40.1 Billion Enron’s 2000 Revenues: $101 Billion
  77. 77. Worldcom: Buying your way into jail Multiple Acquisitions Hide No Organic Growth Free Cash Flow Tells Real Story Source: Financial Shenanigans, Howard Schilit
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