Chapter 13 Inadequate disclosures


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  • There are 6 main understatement of liability frauds, we will have a look at each one in turn.
  • Understatement of Accounts PayableAccounts AffectedInventory, accounts payableFraud SchemesAs aboveAnalytical symptomsAs aboveE.g. Text book has a case where a $28 million unrecorded liability was discovered by auditors. Management had altered purchasing records, bank statements and correspondence with vendors to make it look as though the amount had been paid. Will result in cost of goods sold and accounts payable balances being to low
  • Understatement of Accrued ExpensesAccounts AffectedPayroll tax expense, salary expense, various expenses, salaries payable, payroll tax payable, various accrued liabilitiesCommon fraud schemesAs aboveAnalytical SymptomsAs aboveWill result in net income being overstated and liabilities being understated
  • Recognising unearned revenue as earned revenueAccounts affectedAccounts receivable, sales revenue, unearned revenueFraud schemesAs aboveAnalytical symptomsAs aboveNeed to use a lot of judgement to determine if revenue is recorded before it is earned. Need to analyse documents such as contracts, sale agreements and other revenue related documentationDoes anybody know what a cookie jar reserve is?Like a cookie jar that has money stored in it, it represents a stash of accounting earnings that can be used to bolster perceived performance of the company in the futureXerox, Sunbeam and W.R. Grace & Co have all been charged by the SEC for the use of cookie jar provisions to manipulate earnings.Xerox had $396 million of cookie jar reserves which they released into there earnings between 1997 and 2000.If a company manipulates the time of revenue recognition, it is easy for the value of liabilities to be over or under stated.
  • Under-recording future obligationsAccounts affectedWarranty (service) expense, warranty or service payableFraud schemesAs aboveAnalytical symptomsAs aboveTo help determine if the accounts are actually to low, compare to other accounts e.g. Compare warranty to sales accountFor example, if a car is sold might be sold with a three year warranty. This obviously needs an associated warranty provision.The value of this provision can be understated by not recording any amount or recording an amount that is to low.All money back guarantees (Warehouse)  the value of this liability could be severely understated if the provision is not estimated correctly.
  • Not recording or under recording various types of debtAccounts affectedCash, notes payable, mortgagesCommon fraud schemesAs aboveAnalytical SymptomsAs aboveEnron – kept a lot of debt of books
  • Omission of contingent liabilitiesAccounts affectedLoss from contingencies, contingencies payableCommon fraud schemesAs aboveAnalytical symptomsAs aboveIf a loss is probable then the contingency needs to be recorded in the notes, however if the loss is remote then no not disclosure needed.Company is able to under estimate the probability of occurrence, then do not need to disclose in the annual report.
  • 5 keys ways in which this is done
  • Overstatement of Cash, Short-Term Investments and Marketable SecuritiesGenerally considered hard to overstate cash as bank balance can easily be confirmed. However remember the Parmalat case where the bank balance was forged. Also the Satyam case where fictitious cash balances exceeding $1 billion were recorded (we will look at this case later) Accounts InvolvedCash, Marketable Securities, and other short term assetsCommon Fraud SchemesAs aboveTransfer troubled assets to another entity and then record as an investment or receivable. Such was the case with Enron.Overstatement of Receivables and InventoryAccounts InvolvedAccounts Receivable, InventoryCommon Fraud SchemesAs aboveE.g. Phar-Mor case. One of the reasons that inventory was overstated was to off set the cash that Mickey Monus had taken out of the business to support a now-defunct World Basketball Team.
  • Overstatement of Fixed AssetsAccounts involvedLand, buildings, equipment, leasehold improvements etc.Common Fraud schemesAs above
  • Overstatement of Assets through Merger and Acquisitions of by Manipulating Intercompany Accounts or TransactionsAccounts InvolvedAny assetCommon Fraud SchemesAs aboveOverstatement of Intangible or Deferred AssetsAccounts InvolvedVarious deferred charges and intangible assets accountsCommon Fraud SchemesAs aboveIn some cases it is justified to capitalise expenditure, other cases it is clearly fraudulent.Common for management to argue that these costs are part of the development phase and should be capitalised.
  • As aboveMost annual reports contain statements from the management including the management discussion and analysis, historical performance charts, announcements of new products & strategic decisions, plans and goals for the future. Management could outright lie during these disclosures or not make these disclosures at all. key notes to help investors make informed decisions may by omitted or misstated. For example, related party transactions, contigient liabilities, contractual obligations, contingent assets that will never be realised etc
  • Background to the company
  • Background to the company
  • Background to the company
  • Suspicion that WorldCom deliberately inflated reserves to be able to dip into them to boost revenues to meet targets
  • Background to the company
  • Two audit partners on trial.One partner (S. Gopalakrishnan) is not able to get bail so remains in prisonICIA banned the other audit partner (SrinivasTalluri) for life, and imposed maximum financial penaltyThe two managers banned for life were banned for “serious and gross negligence” in conducting the audit 170 partners in total at PwC India. With partners walking out it indicates serious problems for the firm. PWC India was fined $6million, accused of routinely neglecting quality control, and violated its most fundamental duty to act as public watchdog and comply with the most elementary accounting standards
  • Chapter 13 Inadequate disclosures

    1. 1. Chapter 13 Liability, Asset and Inadequate Disclosure Fraud MEGAN FERRIS 1
    2. 2. Agenda  Identify fraudulent schemes to understate liabilities  Identify fraudulent schemes to overstate assets  Identify fraudulent schemes with inadequate disclosure fraud  Look at case in relation to asset and liability fraud  Waste Management  AIG  WorldCom  Satyam 2
    3. 3. Understatement of Liability Fraud 3
    4. 4. Understatement of Liability Fraud  Understatement of Accounts Payable  Record payables in subsequent periods or don’t record purchases  Overstate purchase returns and purchase discounts  Record payments made in later periods as being made in earlier periods  Analytical symptoms  Accounts Payable balances that appear to high  Purchase or COGS figures that appear to low  Purchase returns or discounts that appear to high 4
    5. 5. Understatement of Liability Fraud  Understatement of Accrued Liabilities  Not record accrued liabilities  Record accruals in a later period  Analytical Symptoms  Expenses and/or accrued liabilities appear to low e.g. payroll, rent, interest, utilities  Income that is to ‘smooth’ 5
    6. 6. Understatement of Liability Fraud  Recognising unearned revenue as earned revenue  Record unearned revenues as earned revenues (and vice versa with cookie jar reserves)  Analytical Symptoms  Liability balances that appear to low  Revenue accounts that appear to high 6
    7. 7. Understatement of Liability Fraud  Under-recording future obligations  Not recording warranty (service) liabilities  Under record liabilities  Record deposits as revenues  Not recording repurchase agreements and other commitments  Analytical symptoms  Warranty, repurchase or deposit accounts that appear to low  Compare to another account 7
    8. 8. Understatement of Liability Fraud  Not recording or under recording various types of debt  Borrow from related parties at less than an arms length transaction  Don’t record liabilities  Write off liabilities as forgiven  Claim liabilities as personal debt rather than debt of the entity  Analytical symptoms  Unreasonable relationship between interest and debt  Significant decreases in recorded debt  Significant asset purchases with no recorded debt  Liability balances that appear to low 8
    9. 9. Understatement of Liability Fraud  Omission of contingent liabilities  Don't record probable contingent liabilities  Record contingent liabilities at to low of an amount  Analytical symptoms  Not very useful to discover unrecorded contingent liabilities 9
    10. 10. Overstatement of Asset Fraud 10
    11. 11. Overstatement of Asset Fraud  Overstatement of Cash, Short-Term Investments and Marketable Securities  Record restricted cash as unrestricted  Misappropriate cash without managements knowledge  Misstate marketable securities with the aid of related parties  Overstatement of Receivables and Inventory  Overstate receivables and inventory in an attempt to cover cash theft or theft of other assets 11
    12. 12. Overstatement of Asset Fraud  Overstatement of Fixed Assets  Leave worthless or expired assets on the books  Under reporting depreciation expense / overstate residual value / increase the useful life  Overstate asset costs through related party transactions  Fabricating fixed assets 12
    13. 13. Overstatement of Asset Fraud  Overstatement of Assets through Merger and Acquisitions or by Manipulating Intercompany Accounts or Transactions  Use market values rather than book values to record assets  Have the wrong entity be the purchaser  Improperly allocating book value to assets  Record fictitious assets or inflate the value of assets  Overstatement of Intangible or Deferred Assets  Capitalise costs as intangible assets where they should be expensed 13
    14. 14. Ways to Detect Overstatement of Assets  Compare changes and trends in account balances  Compare changes and trends in financial statement relationships  Compare financial balances with non-financial information (e.g. compare to the actual asset)  Compare financial statement balances and policies with those used by other similar companies 14
    15. 15. Disclosure Frauds 15
    16. 16. Disclosure Frauds  Misrepresentation about the nature of the company or its products  Misrepresentations or omissions in the Management Discussion and Analysis  Misrepresentations or omissions in the footnotes to the financial statements 16
    17. 17. Ways to identify disclosure fraud  Look for inconsistencies between disclosures and information in the financial statements  Inquire of management concerning related-party transactions, contingent liabilities, and contractual obligations  Review a company’s files and records with the SEC and other regulatory agencies 17
    18. 18. Waste Management 18
    19. 19. Waste Management  Company: Houston-based publicly traded waste management company  What happened: Reported $1.7 billion in fake earnings.  Main players: Founder/CEO/Chairman Dean L. Buntrock and other top executives; Arthur Andersen Company (auditors)  How they got caught: A new CEO and management team went through the books.  Penalties: Settled a shareholder class-action suit for $457 million. SEC fined Arthur Andersen $7 million. 19
    20. 20. Waste Management  Asset Overstatement  Avoided depreciation charges by increasing useful life and salvage values  Landfill development expenses improperly capitalized  Expenses necessary to write off costs of unsuccessful and abandoned landfill projects not recorded  Failed to record expenses for decreases in the value of landfills as were filled up 20
    21. 21. Waste Management  Liability Manipulation  Failed to establish sufficient reserves (liabilities) to pay for income taxes and other expenses  Established inflated environmental reserves (liabilities) in connections with acquisitions so that excess reserves could be used to avoid recording unrelated operating expenses 21
    22. 22. AIG – American Insurance Group 22
    23. 23. AIG  Company: Multinational insurance corporation.  What happened: Massive accounting fraud to the tune of $3.9 billion was alleged, along with bid-rigging and stock price manipulation.  Main player: CEO Hank Greenberg.  How he got caught: SEC regulator investigations, possibly tipped off by a whistleblower.  Penalties: Settled with the SEC for $10 million in 2003 and $1.64 billion in 2006, with a Louisiana pension fund for $115 million, and with 3 Ohio pension funds for $725 million. Greenberg was fired, but has faced no criminal charges. 23
    24. 24. AIG  Investigations around two transactions between AIG and Berkshire Hathaway’s General Re Corp  In 2005 loans worth $500 million were dressed as revenue to boost AIGs revenue  More issues have since come to light in regards to other accounting transactions 24
    25. 25. WorldCom 25
    26. 26. WorldCom  Company: Telecommunications company; now MCI, Inc.  What happened: Inflated assets by as much as $11 billion, leading to 30,000 lost jobs and $180 billion in losses for investors.  Main player: CEO Bernie Ebbers  How he got caught: WorldCom's internal auditing department uncovered $3.8 billion of fraud.  Penalties: CFO was fired, controller resigned, and the company filed for bankruptcy. Ebbers sentenced to 25 years for fraud, conspiracy and filing false documents with regulators. 26
    27. 27. WorldCom  Internal Audit uncovered massive fraud  $3.8 billion of line expenses incorrectly recorded as capital investments  Further $3.3 billion of profits incorrectly recorded. This was done through manipulation of reserves  By the end of 2003 estimated that assets were overstated by $11 billion 27
    28. 28. Satyam 28
    29. 29. Satyam  Company: Indian IT services and back-office accounting firm.  What happened: Falsely boosted revenue by $1.5 billion.  Main player: Founder/Chairman Ramalinga Raju.  How he got caught: Admitted the fraud in a letter to the company's board of directors.  Penalties: Raju and his brother charged with breach of trust, conspiracy, cheating and falsification of records. Released after the Central Bureau of Investigation failed to file charges on time. 29
    30. 30. Letter to the BOD  The balance sheet carries as of September 30, 2008  Inflated (non-existent) cash and bank balance of Rs 5,040 crore (as against Rs 5361 crore reflected in the books)  An accrued interest of Rs 376 crore which is non-existent  An understated liability of Rs 1,230 crore on account of funds arranged by me  An over stated debtor position of Rs 490 crore (as against Rs 2651 reflected in the books)  This gap amounted to about $1.6 billion in total 30
    31. 31. Letter to the BOD  The gap in the balance sheet has arisen purely on account of inflated profits over a period of last several years  Started as marginal, and continued to grow  Justifies his actions  Nether himself or the Managing Director sold shares  Did not take a dollar /rupee nor profit from the fraud  None of the board members not their immediate family knew about the companies fraudulent financial position 31
    32. 32. “ ” It was like riding a tiger, not knowing how to get off without being eaten 32
    33. 33. Satyam’s Auditor - PWC  PwC India was the auditor of Satyam  Two audit partners on trial  Two audit managers have been banned for life  After the scandal 10% of PwC partners walked out, with many staff expected to follow  PWC India was fined $6million for:  Failing to act as a watchdog  Failing to follow most basic auditing standards  Routinely neglecting quality control 33
    34. 34. Conclusion 34
    35. 35. Conclusion  Identified fraudulent schemes to understate liabilities  Identified fraudulent schemes to overstate assets  Identified fraudulent schemes with inadequate disclosure fraud  Look at cases in relation to asset and liability fraud  Waste Management  AIG  WorldCom  Satyam 35
    36. 36. Questions? 36
    37. 37. References  AICPA (2003). Fraud at Waste Management. AICPA. Retrieved from  Albrecht, W.S; Albrecht, C.O; C.C. Albrecht and Zimbelman, M.F. 2012. Fraud Examination. Australia: South Western Cengage Learning  Callahan, D. (Nov, 2010). AIG: Before the Crash, There Was the Fraud. Retrieved from before-the-crash-there-was-the-fraud.html  Desai, M. (Sept, 2013). Satyam scam: US finds PwC 'India' guilty. Indian Express. Retrieved from  Doval, P., (Feb, 2012). ICAI bans PW India's top auditor for life in Satyam case. Times of India. Retrieved from 37
    38. 38. References  JJ, (Mar, 2007). WorldCom Scandal: A Look Back at One of the Biggest Corporate Scandals in U.S. History. Yahoo. Retrieved from  McKenna, F. (May, 2011). Satyam: Not The Only Case PwC Worried About. Forbes. Retrieved from  Raju, R (Jan, 2009). Satyam Chairman B Ramalinga Raju’s statement to the Board. Retrieved from statement.pdf  SEC (2002). Waste Management Founder, Five Other Former Top Officers Sued for Massive Fraud. SEC. Retrieved from  Tran, M., (Aug, 2002). WorldCom accounting scandal. The Guardian. Retrieved from 38