Fraud Cases in Auditing


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CPAs responsibilities to detect fraud in audits, required approaches, types of financial statement frauds and specific case examples of different types of financial statement fraud

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  • Auditing for Financial Statement Fraud January 25, 2005 Dr. Raymond S. Kulzick, CPA, CFE [email_address]
  • Auditing for Financial Statement Fraud January 25, 2005 Dr. Raymond S. Kulzick, CPA, CFE [email_address]
  • Auditing for Financial Statement Fraud January 25, 2005 Dr. Raymond S. Kulzick, CPA, CFE [email_address]
  • Fraud Cases in Auditing

    1. 1. Auditing for Fraud – Cases and Applications <ul><li>Presentation for </li></ul><ul><li>Miami-Dade Chapter - FICPA </li></ul><ul><li>June 23, 2009 </li></ul><ul><li>Dr. Raymond S. Kulzick, CPA, CFE, CFF, CDFA, FCPA </li></ul><ul><li>St. Thomas University </li></ul><ul><li>Kulzick Consulting, PA </li></ul><ul><li>Information in this presentation is believed to be reliable at the time of the presentation; but the authors do not assume any responsibility for its use and it should not be relied upon as authoritative. </li></ul><ul><li>Illustrations are for educational purposes only and do not include all facts & circumstances. </li></ul>
    2. 2. Ray Kulzick Kulzick Consulting, PA <ul><li>Forensic Accounting </li></ul><ul><li>Divorce </li></ul><ul><li>Fraud </li></ul><ul><li>Business Damages </li></ul><ul><li>Data Analysis for Litigation </li></ul>
    3. 3. Outline <ul><li>Fraud </li></ul><ul><li>Audit & Accounting Standards </li></ul><ul><li>SAS 99 Required Approach </li></ul><ul><li>Understanding the Risks </li></ul><ul><li>Financial Statement Fraud </li></ul><ul><li>Cases & Examples </li></ul><ul><ul><li>5 major types of financial statement fraud </li></ul></ul><ul><li>Conclusions </li></ul>
    4. 4. Financial Statement Fraud <ul><li>“Intentional misstatements or omissions of amounts or disclosures in financial statements designed to deceive FS users where the effect causes the FS not to be presented … in conformity with … GAAP.” – SAS 99 </li></ul><ul><li>“We lie about what we owe and we lie about what we earn.” – Barry Minkow 1/05 </li></ul>
    5. 5. Misappropriation of Assets <ul><li>“Theft of a entity’s assets.” – SAS 99 </li></ul><ul><li>May lead to financial statement fraud if material, in which case SAS 99 covers. </li></ul><ul><ul><li>Adelphia </li></ul></ul><ul><ul><li>Greater Miami Chamber of Commerce $1.9 million over 3 years </li></ul></ul>
    6. 6. Importance of Fraud <ul><li>ACFE 2008 (U.S. including government) </li></ul><ul><ul><li>Total fraud losses estimated at $994 billion </li></ul></ul><ul><li>KPMG 2008 (U.S. including government) </li></ul><ul><ul><li>74% personally observed “misconduct”, 46% of a significant nature </li></ul></ul><ul><li>PWC 2007 (40 countries) </li></ul><ul><ul><li>43% of companies had a significant loss in the last 2 years, averaging $2.4 million + $550 thousand post-fraud costs </li></ul></ul><ul><li>E&Y 2008 (Global) </li></ul><ul><ul><li>23% had someone solicited to pay a bribe in last 2 years </li></ul></ul><ul><li>Oversight Systems 2007 (U.S.) </li></ul><ul><ul><li>76% feel fraud is more prevalent today than it was in 2002 </li></ul></ul>
    7. 7. Audit and Accounting Standards <ul><li>SAS 99 – Consideration of Fraud in a Financial Statement Audit </li></ul><ul><li>SSAE 10 – Reporting on Internal Control </li></ul><ul><li>SSAE 15 – Internal Control w/FS Audit </li></ul><ul><li>SAS 104-111 – Risk Assessment Standards </li></ul><ul><ul><li>Understanding Entity & Controls links to Risk Assessment links to Audit Procedures (110) </li></ul></ul>
    8. 8. Audit and Accounting Standards <ul><li>SSARS 10 – Performance of Review Engagements </li></ul><ul><ul><li>Inquiries to include fraud </li></ul></ul><ul><ul><li>Representation letter to include fraud </li></ul></ul><ul><li>SSARS 1 – Compilation & Review of FS </li></ul><ul><ul><li>For Compilations – CPA MUST: </li></ul></ul><ul><ul><ul><li>Have a basic understanding of the company, its accounting system and its industry </li></ul></ul></ul>
    9. 9. Current Economic Issues <ul><li>January, 2009 – AICPA issued a audit risk alert on Going Concern Issues in the current environment. </li></ul><ul><li>March, 2009 – AICPA Audit Practice Bulletin: </li></ul><ul><ul><li>“ The audit profession should continue to exercise vigilance and rigor under the current economic climate.” </li></ul></ul><ul><ul><li>Specific suggestions in Appendix, including fraud considerations </li></ul></ul>
    10. 10. 8 Steps for SAS 99 <ul><li>Discussion among engagement personnel </li></ul><ul><li>Obtaining the information needed to identify the risks of material misstatement due to fraud </li></ul><ul><li>Identifying risks that may result in a material misstatement due to fraud </li></ul>
    11. 11. 8 Steps for SAS 99 <ul><li>Assessing identified risks after assessing and taking into account controls </li></ul><ul><li>Responding to the results of the assessment </li></ul><ul><li>Evaluating audit evidence </li></ul><ul><li>Communicating about possible fraud </li></ul><ul><li>Documenting the auditor’s consideration of fraud </li></ul>
    12. 12. Understand the Risks - Business and Industry <ul><li>What does the business do? </li></ul><ul><li>How does it do it? </li></ul><ul><li>How do competitors do it? </li></ul><ul><li>What is the competitive situation? </li></ul><ul><li>Who are the customers? </li></ul><ul><li>Why do they buy from this company? </li></ul><ul><li>Who are the vendors? </li></ul><ul><li>What are the vendor customs in this industry? </li></ul>
    13. 13. Understand the Risks – External Trends <ul><li>In the industry </li></ul><ul><li>Competitors strategies </li></ul><ul><li>In the macro environment </li></ul><ul><li>Vendors </li></ul><ul><li>Customers </li></ul>
    14. 14. Understand the Risks – Likely Users and Uses <ul><li>Investors? </li></ul><ul><li>Banks and lenders? </li></ul><ul><li>Surety companies? </li></ul><ul><li>Parent company? </li></ul><ul><li>Joint venture or other partners? </li></ul><ul><li>Options and/or bonuses? </li></ul><ul><li>Acquisitions? </li></ul><ul><li>Regulators? </li></ul><ul><li>Progress payments? </li></ul>
    15. 15. FS Fraud Within Statements <ul><li>Revenues </li></ul><ul><li>-COS </li></ul><ul><li>Gross margin </li></ul><ul><li>-Expenses </li></ul><ul><li>Operating income </li></ul><ul><li>-Interest & taxes </li></ul><ul><li>Net income </li></ul><ul><li>Current assets </li></ul><ul><li>+Fixed Assets </li></ul><ul><li>Total Assets </li></ul><ul><li>Current liabilities </li></ul><ul><li>+Long-term liabilities </li></ul><ul><li>Total liabilities </li></ul><ul><li>Equity </li></ul>
    16. 16. FS Fraud Between Statements <ul><li>Debits </li></ul><ul><li>Good </li></ul><ul><li>Assets </li></ul><ul><li>Bad </li></ul><ul><li>Cost of sales </li></ul><ul><li>Expenses </li></ul><ul><li>Credits </li></ul><ul><li>Good </li></ul><ul><li>Revenue </li></ul><ul><li>Equity </li></ul><ul><li>Bad </li></ul><ul><li>Liabilities </li></ul>
    17. 17. Five Major Types of Financial Statement Fraud <ul><li>Fictitious revenues </li></ul><ul><li>Timing differences </li></ul><ul><li>Concealed liabilities & expenses </li></ul><ul><li>Improper disclosures </li></ul><ul><li>Improper asset valuations </li></ul>
    18. 18. 1-Fictitious revenues Enron <ul><li>Traded gas and derivative contracts </li></ul><ul><ul><li>“ Harshest” employee pay system – internal competition </li></ul></ul><ul><ul><li>2000 huge increase in derivative holdings </li></ul></ul><ul><ul><li>Constantly growing earnings – met all projections </li></ul></ul><ul><li>100s of Special Purpose Entities used to hide massive amounts of debt and generate fictitious profits </li></ul><ul><ul><li>Met “letter of the law” of GAAP at the time </li></ul></ul><ul><ul><li>Impact: debt became revenue </li></ul></ul><ul><ul><li>Minimal disclosure </li></ul></ul><ul><li>Derivative holdings valued using in-house speculative methodology </li></ul><ul><ul><li>Minimal disclosure </li></ul></ul><ul><ul><li>Impact: asset write-ups became trading profits </li></ul></ul><ul><li>2001 collapsed </li></ul>
    19. 19. Rayco Construction Co <ul><li>Built football stadiums </li></ul><ul><ul><li>Decline in new contracts </li></ul></ul><ul><ul><li>EBITDA covenant in credit line </li></ul></ul><ul><li>Decreased cost to complete estimates & shifted completed project costs to open projects </li></ul><ul><ul><li>% of completion method </li></ul></ul><ul><ul><li>Costs remain same, revenue is increased </li></ul></ul><ul><li>Not discovered </li></ul><ul><li>Following year, massive losses </li></ul><ul><ul><li>Loans worked out, company recovered </li></ul></ul>
    20. 20. 2-Timing differences Medford Machining Co. <ul><li>Custom machines to mfg firearms </li></ul><ul><ul><li>Complex product, required customer acceptance </li></ul></ul><ul><li>Booked revenue when shipped </li></ul><ul><li>Discovered in 2001 by auditor </li></ul><ul><ul><li>Testing internal controls in revenue cycle </li></ul></ul><ul><ul><li>Shipping cut-off testing </li></ul></ul><ul><li>$21 million restatement of 1999-2000 </li></ul>
    21. 21. Sunbeam Corp. <ul><li>1996 Chain Saw Al arrives </li></ul><ul><ul><li>Overstates losses, creates reserves </li></ul></ul><ul><li>1997 produces $60m profit (claim $189m is fraud) </li></ul><ul><ul><li>Reverses reserves </li></ul></ul><ul><ul><li>Bill and hold channel stuffing </li></ul></ul><ul><ul><li>Contingent sale of $11m of spare parts (cost $2 million) </li></ul></ul><ul><ul><ul><li>Al reduces profit from $9 million to $6 </li></ul></ul></ul><ul><ul><ul><li>AA agrees, “not material,” so OK </li></ul></ul></ul><ul><li>Late 1998, falls apart, SEC begins investigation </li></ul><ul><ul><li>Dunlop pays $500k fine </li></ul></ul><ul><ul><li>AA pays $110 million settlement </li></ul></ul><ul><li>2001 Bankruptcy </li></ul>
    22. 22. U. S. Foodservice (Ahold) <ul><li>$700 million in vendor rebates booked before earned from 2000 to 2003 </li></ul><ul><li>Deloitte did internal control audit in 2001 </li></ul><ul><ul><li>Found lack of internal controls on rebates </li></ul></ul><ul><li>Deloitte external audit found in 2003 </li></ul><ul><ul><li>13 vendor employees colluded & returned fraudulent confirmations </li></ul></ul><ul><li>Part of $1.2 billion Ahold international fraud </li></ul><ul><li>Deloitte successfully defended based on 2007 Tellabs decision that narrowed 3 rd party liability in federal investor class action suits (2009) </li></ul>
    23. 23. Krispy Kreme Doughnuts <ul><li>Heavily reliant on growth of franchises </li></ul><ul><ul><li>Sales dropped off in 2003 </li></ul></ul><ul><li>Wholesale customers doubled shipped last Friday & Saturday of 2004 </li></ul><ul><li>PWC did not review heavy year-end shipments (and subsequent returns) </li></ul><ul><ul><li>Whistleblower caused SEC investigation </li></ul></ul><ul><li>PWC did later refuse to sign off on franchise buyback “profit” </li></ul>
    24. 24. 3-Concealed liabilities & expenses Private Plumbing Industries, Inc. <ul><li>Plumbing distributor </li></ul><ul><ul><li>In 2000 squeezed by recession </li></ul></ul><ul><li>Booked rebates from vendors early </li></ul><ul><li>Auditors caught </li></ul><ul><ul><li>Amounts “not material,” but audited anyway </li></ul></ul><ul><ul><li>Analytics based on prior years percentage rebates revealed large increase </li></ul></ul><ul><li>Result was loss versus claimed profit </li></ul>
    25. 25. Worldcom <ul><li>Major telecommunications company </li></ul><ul><ul><li>Competitors profits dropping rapidly </li></ul></ul><ul><ul><li>Worldcom reports increasing profits </li></ul></ul><ul><li>$3.8 billion in line costs capitalized in 2001 </li></ul><ul><ul><li>Payments to other co. for use of their lines </li></ul></ul><ul><ul><li>Had been doing since 1999 </li></ul></ul><ul><li>AA auditors did not investigate red flags </li></ul><ul><ul><li>Costs ran over 50%, was 42% in 2001 </li></ul></ul><ul><ul><li>Mgmt said sales mix had changed – no support </li></ul></ul><ul><li>Whistleblowers took to SEC </li></ul><ul><li>AA settlement for $65 million </li></ul>
    26. 26. Adelphia Communications <ul><li>Cable television company </li></ul><ul><ul><li>Public, but family controlled (4 on board) </li></ul></ul><ul><li>Operated through over 200 subsidiaries </li></ul><ul><li>$2 billion+ debt in unconsolidated subsidiaries </li></ul><ul><ul><li>Parent is guarantor </li></ul></ul><ul><ul><li>No disclosures </li></ul></ul><ul><li>Deloitte clean opinions in 1999 and 2000 </li></ul><ul><ul><li>Recommended footnote for 2000, backed off </li></ul></ul><ul><ul><li>“ Suspended” 2001 audit, later fired </li></ul></ul><ul><li>$167 million malpractice settlement </li></ul>
    27. 27. CUC International, Inc. <ul><li>Diversified services company </li></ul><ul><ul><li>Numerous acquisitions </li></ul></ul><ul><ul><li>Entrenched management </li></ul></ul><ul><li>$252 million fraud involving mismatch of deferred revenue and expenses </li></ul><ul><li>1997 merged with HFS to form Cendant </li></ul><ul><li>Post-merger audit of CUC by former HFS management disclosed fraud </li></ul><ul><ul><li>Stock dropped $14 billion in one day </li></ul></ul><ul><ul><li>Largest fraud at that date </li></ul></ul><ul><li>Ernst settlement $335 million </li></ul><ul><ul><li>Walter Forbes (chair) sentenced to12+ years and $3.27 billion </li></ul></ul><ul><ul><li>Kirk Shelton (vice chair) sentenced to 10 years and $3.27 billion </li></ul></ul>
    28. 28. Aurora Foods <ul><li>$800 million manufacturer & marketer of branded foods </li></ul><ul><ul><li>Duncan Hines, Mrs. Paul’s, Lender’s, etc. </li></ul></ul><ul><li>IPO in July, 1998 </li></ul><ul><li>Fraud began in mid-1998 </li></ul><ul><ul><li>Promotional credits not reflected in A/Receivable </li></ul></ul><ul><ul><li>$38m in 1998; $43m in 1999 1 st 3 quarters </li></ul></ul><ul><ul><li>Turned off computer system that generated these as credits on billings and changed to manual postings </li></ul></ul><ul><li>Discovered by PWC in 1999 statements (Feb, 2000) – 10-Qs were not audited </li></ul><ul><li>Investigation by Deloitte </li></ul>
    29. 29. 4-Improper disclosures Cardinal Health, Inc. <ul><li>Drug wholesaler </li></ul><ul><ul><li>Manufacturers cutting out wholesalers </li></ul></ul><ul><ul><li>Lawsuit by company against vitamin manufacturers </li></ul></ul><ul><li>Booked anticipated legal settlements in 2000, 2001 and early 2002 as offsets to cost of sales </li></ul><ul><ul><li>Journal entries </li></ul></ul><ul><ul><li>No disclosure, enabled them to meet analyst projections </li></ul></ul><ul><li>E&Y did not discover (was successor to AA) </li></ul><ul><li>SEC opened an investigation in 2003, lawsuits followed </li></ul>
    30. 30. 5-Improper asset valuations Prime Plumbing, Inc. <ul><li>Plumbing Distributor & Retailer </li></ul><ul><ul><li>2 warehouses, 30 showrooms </li></ul></ul><ul><ul><li>Fraudulent inventory in showrooms </li></ul></ul><ul><li>Auditors audited inventory only at warehouses for more than 5 years </li></ul><ul><ul><li>50% of inventory in showrooms </li></ul></ul><ul><ul><li>Individual showrooms deemed “not material” </li></ul></ul><ul><li>2001 auditors finally discovered </li></ul><ul><ul><li>Obtained sq footage for each showroom </li></ul></ul><ul><ul><li>Analyzed inventory per sq foot </li></ul></ul>
    31. 31. Parmalat <ul><li>International dairy products company </li></ul><ul><ul><li>Based in Italy, rapid expansion </li></ul></ul><ul><ul><li>Many foreign subs losing money, high debt level </li></ul></ul><ul><li>€ 4 billion cash deposit in Cayman bank did not exist </li></ul><ul><li>Both Grant Thornton (1999 and earlier) and Deloitte (2000) issued clean opinions </li></ul><ul><ul><li>Confirmation sent through company’s mail </li></ul></ul><ul><ul><li>Fraudulent confirmation accepted </li></ul></ul><ul><li>Largest fraud in Europe to date </li></ul>
    32. 32. Refuse Collection Services, Inc. <ul><li>Wisconsin waste service company </li></ul><ul><ul><li>1997 acquired company in adjacent area </li></ul></ul><ul><ul><li>Recorded goodwill of $350,000 </li></ul></ul><ul><li>1998 through 2001 the acquired division reported losses </li></ul><ul><ul><li>Efforts to reduce losses were unsuccessful </li></ul></ul><ul><ul><li>Auditors accepted management’s forecasts and projections of future profits </li></ul></ul><ul><li>Goodwill finally written off in 2002 </li></ul>
    33. 33. Mueller Microbrewery <ul><li>Midwest brewery </li></ul><ul><ul><li>Declining sales in 2001 </li></ul></ul><ul><ul><li>Actual numbers would have violated loan covenants </li></ul></ul><ul><li>Added $135,000 to fixed assets </li></ul><ul><ul><li>Used journal entries crediting various expense accounts </li></ul></ul><ul><ul><li>Some in small assets, known to be “not material” in past audits </li></ul></ul><ul><ul><li>Some in a large addition </li></ul></ul><ul><li>Auditor questioned missing support on large item </li></ul><ul><ul><li>Accepted that papers must have been “lost” </li></ul></ul><ul><li>Discovered following year by bank </li></ul>
    34. 34. Brown Packaging Co. <ul><li>Cardboard packaging to major manufacturers </li></ul><ul><ul><li>Very cyclical business </li></ul></ul><ul><li>Used long lives when times lean </li></ul><ul><ul><li>e.g., 39 years for leasehold improvements </li></ul></ul><ul><ul><li>Short lives when times good, accelerated dep. </li></ul></ul><ul><li>Audited during due diligence when sold in 2001 </li></ul><ul><ul><li>$5 million write-off on leaseholds </li></ul></ul><ul><ul><li>Additional $7 million on other assets </li></ul></ul>
    35. 35. John-Tee Plumbing Distributors <ul><li>Plumbing distributor </li></ul><ul><ul><li>Grew to 10 warehouses over 20+ years </li></ul></ul><ul><li>Never wrote off or reserved for obsolete inventory </li></ul><ul><ul><li>Auditors never tested for nor adjusted </li></ul></ul><ul><li>New auditors </li></ul><ul><ul><li>Observed, researched and documented all inventory </li></ul></ul><ul><ul><li>$ 500,000 write-off for obsolescence </li></ul></ul>
    36. 36. E. S. Bankest LLC <ul><li>Miami factoring company </li></ul><ul><ul><li>Joint venture created in 1998 </li></ul></ul><ul><ul><li>Espirito Santo Bank & Orlansky brothers </li></ul></ul><ul><li>$170m fraudulent receivables – main asset </li></ul><ul><li>BDO Seidman clean opinions 1998-2002 </li></ul><ul><li>2003 went into receivership </li></ul><ul><ul><li>Receiver (Lewis Freeman) </li></ul></ul><ul><ul><li>Visited companies with large A/R </li></ul></ul><ul><ul><li>Either non-existent, related parties, or very small </li></ul></ul><ul><li>$522 million malpractice award </li></ul><ul><ul><li>Under Florida law, jury verdict cannot bankrupt a company - collectibility in doubt </li></ul></ul>
    37. 37. Conclusions <ul><li>Materiality is not based on transactions </li></ul><ul><li>Management sometimes lies </li></ul><ul><li>Don’t audit something you don’t understand </li></ul><ul><li>Just because it isn’t consolidated doesn’t mean its not important </li></ul><ul><li>Look at the big picture – where’s the risk? </li></ul><ul><li>Do the financials “present fairly” to third party users? </li></ul>
    38. 38. <ul><li>Thank you! </li></ul><ul><li>Questions? </li></ul><ul><li>Ray Kulzick – 305.812.4998 </li></ul><ul><li>Kulzick Consulting, PA </li></ul><ul><li>[email_address] </li></ul>
    39. 39. Ray Kulzick Kulzick Consulting, PA <ul><li>Forensic Accounting </li></ul><ul><li>Divorce </li></ul><ul><li>Fraud </li></ul><ul><li>Business Damages </li></ul><ul><li>Data Analysis for Litigation </li></ul>
    40. 40. <ul><li>Master of Accounting – 30 credits </li></ul><ul><ul><li>Specialization in Forensic Accounting </li></ul></ul><ul><ul><li>Specialization in Tax </li></ul></ul><ul><li>MBA – 42 credits </li></ul><ul><ul><li>Specialization in Accounting </li></ul></ul><ul><ul><li>Joint JD degree program </li></ul></ul><ul><li>MS in Management – 36 credits </li></ul><ul><ul><li>Specialization in Management Accounting </li></ul></ul><ul><li>Graduate Certificates – 12 credits </li></ul><ul><ul><li>Forensic Accounting </li></ul></ul><ul><ul><li>Taxation </li></ul></ul><ul><ul><li>Management Accounting </li></ul></ul>