Spotting Financial Distortions: A Primer for Attorneys The Web - - PDF document
Spotting Financial Distortions: A Primer for Attorneys The Web Conference Series For Corporate Counsel January 17, 2007 To ask a question using the question pane Enter your question into the text area and click Ask. The presenter will
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2006 Year in Review book coming in January Today’s summary in March InsideCounsel Advance copy for today’s participants
SOX: Results so far Recent fraud statistics Identification and detection techniques Common fraud scenarios Client considerations Protiviti’s 2007 Fraud Risk Management Survey Accounting issues to watch in 2007 Areas of focus / key take-aways
– Almost 3,600 filed internal control reports – Over 580 companies, or 16.2 percent, reported material weaknesses
– Over 2,900 companies filed internal control reports – 215 ( 7.4%) reported material weaknesses
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200 400 600 800 1000 1200 1400 1600 1800 2000 2001 2002 2003 2004 2005 2006 (forecasted)
Source: Audit Analytics.com – April 25 and June 9, 2006
Wall Street Journal – May 8, 2006
27.7% Down 5.7% 25.7%
Russell 3000 share index
17.7%
Companies that reported no internal-control weaknesses in 2004 or 2005 Companies reporting internal-control weaknesses in 2004, but no weakness in 2005 Companies reporting internal-control weaknesses in both 2004 and 2005
Share price performance
with internal-control rules called for under the Sarbanes-Oxley Act *
* From March 31, 2004 to March 31, 2006
Three contributing factors cited:
– All means by which one individual can get an advantage over another by false suggestions or suppression of the truth. It includes all surprise, trick, cunning or dissembling, and any unfair way by which another is cheated.
– Any illegal acts characterized by deceit, concealment or violation of
violence or of physical force. Frauds are perpetrated by parties and
loss of services; or to secure personal or business advantage.
– An intentional act that results in a material misstatement in financial statements that are the subject of an audit. Two types of misstatements are relevant to the auditor’s consideration of fraud: (1) fraudulent financial reporting and (2) misappropriation of assets.
Asset Misappropriation (91.5%)
Corruption (30.8%)
Fraudulent Financial Statements (10.6%)
Note: The sum of percentages in this chart exceeds 100% because a number of cases involved multiple schemes that fell into more than one category.
Source: Association of Fraud Examiners ‘2006 Report to the Nation’
Note: Total exceeds 100% because some survey participants cited more than one method for initial discovery of the frauds
Source: Association of Fraud Examiners ‘2006 Report to the Nation’
Tips (34.2%) By accident (25.4%) Internal Audit (20.2%) Internal controls (19.2%) External Audit (12%) Notification by law enforcement (3.8%)
Mining Agriculture, Fishing and Hunting Communications/Publishing Arts, Entertain. and Recreation Transportation and Warehousing Wholesale Trade Real Estate Oil and Gas Utilities Construction Service (professional, scientific or technical) Service (general) Education Retail Insurance Health Care Manufacturing Government and Public Admin Banking/Financial Services
Industry
$17,000,000 1 $71,000 8 $225,000 16 $175,000 22 $109,000 27 $1,000,000 30 $200,000 30 $154,000 32 $124,000 34 $500,000 35 $300,000 58 $163,000 60 $100,000 73 $80,000 75 $100,000 78 $160,000 89 $413,000 101 $82,000 119 $258,000 148
Median Loss # Cases
Source: Association of Fraud Examiners ‘2006 Report to the Nation’
Examples include: – Embezzlement – Theft of Company Property – T&E Fraud – Vendor Kickbacks – Diversion of Corporate Opportunities – Unauthorized Use of Property
Examples include: – Financial Statement Fraud – Bribery – Price Fixing – Contract Bidding Fraud Examples include: – Duplicate Invoices – Altered Payee on Checks – Commission Schemes – Related Party Transactions – Supplier Fraud – Contractor Fraud
2.6% 2.2% 1.6% N/A 1% Board of Directors 31.8% 14.9% 57.4% 43% 31% Accounting 34.4% 27.9% 26.4% 17.8% 25.7% Executive / Upper Management 1.9% 13.8% 1.1% 5.6% 6.3% 6.3% 1.9% 3.3% N/A 2.6% 4.5% 7.8%
Corruption
0.6% N/A 0.9% 3.3% Information Technology 1.9% 4.7% 5.6% 3.8% Finance 3.9% 4.7% 11.2% 4.8% Customer Service N/A 18.7% N/A N/A 0.9% 1.9% N/A N/A N/A
Cash Larceny
2.4% 7.6% 1.9% 7.1% 3.3% 5.2% 1.4% 1.4% N/A
Billing Schemes
Expense Reimbursement
Check Tampering Department
0.6% N/A Internal Audit N/A N/A Warehousing / Inventory 14.3% 3.1% Sales 2.6% N/A Research & Development 0.6% 0.8% Purchasing 1.9% N/A Marketing / Public Relations 1.3% 0.8% Manufacturing & Production 1.9% N/A Legal 1.3% 0.8% Human Resources
Source: Association of Fraud Examiners ‘2006 Report to the Nation’
N/A 1.4% 1% 1.1% 3.1% Board of Directors 25% 42.4% 47.6% 11.1% 17.3% Accounting 48.2% 23% 19.4% 23.7% 50% Executive / Upper Management N/A 19.4% N/A 2.2% N/A 1.4% N/A 0.7% N/A 0.7% 0.7% 7.9%
Skimming
N/A N/A 4.2% N/A Information Technology 12.5% 1% 3.2% 8.2% Finance 5.4% 9.7% 12.1% 1% Customer Service 7.9% 17.4% 2.6% 4.2% 1.6% 8.9% 0.5% 1.6% N/A
Non-Cash Misappropriations
1% 11.2% N/A 3.1% 1% 1% 2% 1% N/A
Financial Statement Fraud
Wire Transfer Schemes Payroll Schemes Department
N/A N/A Internal Audit N/A 1% Warehousing / Inventory 7.1% 5.8% Sales N/A 3.9% Research & Development N/A N/A Purchasing 1.8% 1% Marketing / Public Relations N/A 3.9% Manufacturing & Production N/A 2.9% Legal N/A 2.9% Human Resources
Source: Association of Fraud Examiners ‘2006 Report to the Nation’
P r e v e n t D e t e r D e t e c t E v a l u a t e Mitigate M
i t
P r e v e n t D e t e r D e t e c t E v a l u a t e Mitigate M
i t
Percentage-of-completion
On false estimations
Collusion
To non-existent customers Record fictitious revenue
Recording revenue instead of
liability when cash received
Side agreements
Record revenue when:
Obligation exists to provide
future services
Buyer right-of-return No buyer obligation-to-pay Inability of buyer to pay Goods don’t meet buyer
specifications Record revenue when:
Customer has options to
terminate, void or delay sale
Channel stuffing Bill and hold Holding books open until
after period end
Side agreements Back-Dating sales
agreements and documents Ship goods before sale is complete Recognize unearned revenue Materially overstate revenues
Examples Fraud Risk Sub-Category Common Fraud Scenario
Inappropriate methods Excessive lives
Depreciating or amortizing costs too slowly
Bad debts Bad loans Excess and obsolete
inventory
Bad investments
Continuing to carry worthless assets
Start-up costs R&D costs Normal period expenses Overstating goodwill in an
acquisition Improper capitalization Shifting current period expenses to future periods Materially understate expenses
Supplier credits and rebates Kickbacks
On receipt of vendor credits
Like-kind exchanges with
intent to record a gain
Barter transactions
On exchange of similar assets Record fictitious revenue (cont’d) Materially overstate revenues (cont’d)
Examples Fraud Risk Sub-Category Common Fraud Scenario
Hiding losses under
discontinued operations Misuse of discontinued operations
Mixing gains from recurring
and non-recurring activities
Mingling operating and non-
Restructuring charges vs.
Not segregating unusual and non- recurring gains/losses from normal operating results
Bad investments – stock Bad investments -
acquisitions
Fixed assets – under-
performing plants, etc. Failing to record asset impairments to reduce to net- realizable value
Bad debts Bad loans Excessive and obsolete
inventory Failing to record loss contingencies to reduce to net- realizable value Overstating assets Materially misleading presentation of financial position and/or results of
Examples Fraud Risk Sub-Category Common Fraud Scenario
Where are the weakest links in the system’s
What deviations from conventional good accounting
How are off-line transactions handled and who has
What would be the simplest way to compromise the
What control features in the system can be
What is the nature of the work environment?
weaknesses
resources – Senior management – Key financial positions – Key employees
– Turnover – Cut-backs / lay-offs
quarter variations
transactions
decentralized
complaints
public accountants
regulatory agencies
with reconciling financial statements to underlying support
separately from all other invoices)
you exercised that right)?
delayed or do they always involve significant and conflicting reconciling items?
high up in the organization?
Search for duplicate payments Analyze voids and refunds by employee, using
Search for duplicate addresses within files: Payroll,
Analyze use of override transactions Analyze file maintenance on employee accounts Look for patterns List large payments to individuals
Risk management and assessment in general Fraud risk management in particular:
– Audit Committee’s role in the oversight of fraud risk monitoring activities – Risk (and mitigation/testing) of management being able to
fraud – Monitoring activities at all levels of the organization as employees, supervisors and senior management perform their daily activities – and how those are assessed.
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and screening procedures
ethics
strategy
and ethics programs
sessions
resourcing
and procedures
case management
prosecution and recovery guidelines
controls and monitoring
disclosure guidelines
awareness workshops
programs
Fraud risk management involves the strategies, techniques, programs and controls utilized by an organization to evaluate, mitigate and monitor its risk to fraud and misconduct. This includes, but is not limited to:
Control Environment
influences control consciousness of its people
components of internal control
– Integrity and ethical values – Commitment to competence – Board of Directors and Audit Committee – Management’s philosophy and
– Assignment of authority and responsibility – Human resource policies and practices
COSO: Internal Control – Integrated Framework
Prevention
/ Conduct”)
environment
retaining appropriate employees
programs
Code of Conduct or Ethics
management processes
recovery guidelines Prevention
/ Conduct”)
environment
retaining appropriate employees
programs
Code of Conduct or Ethics
management processes
recovery guidelines
Detection
measurement of fraud risk (“fraud risk assessment”)
to mitigate identified fraud risk
at entity and process level
activities
techniques
– Internal control weaknesses / breaches – Non-response to Code confirmation / affirmation – Reported issues
Detection
measurement of fraud risk (“fraud risk assessment”)
to mitigate identified fraud risk
at entity and process level
activities
techniques
– Internal control weaknesses / breaches – Non-response to Code confirmation / affirmation – Reported issues Deterrence
and/or Audit Committee – Fraud risk assessment and related measures – Code confirmation / affirmation process – Management’s involvement in financial reporting process and
– Process to receive, retain and treat complaints of fraud / unethical conduct – Internal and external audit effectiveness
– Evaluation of adequacy / effectiveness of internal controls
Deterrence
and/or Audit Committee – Fraud risk assessment and related measures – Code confirmation / affirmation process – Management’s involvement in financial reporting process and
– Process to receive, retain and treat complaints of fraud / unethical conduct – Internal and external audit effectiveness
– Evaluation of adequacy / effectiveness of internal controls
corresponding anti-fraud programs and controls are agreed upon, monitored and measured by Board and senior management on an on-going basis
agreed upon, monitored and measured by Board and senior management
and controls exist
controls
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defined, suggesting room for improvement in many organizations
definition of fraud in policy
reported
– One-third of F1000 have no documented protocols and procedures for investigations – One-half of F1000 have no incident response plan.
– Fraud not considered “high risk” – “No fraud here” mentality – Or, “don’t know”
New proxy rules will have companies summarizing, under counsel’s scrutiny, more
information about executive compensation and inclusion within the proxy. Companies may discover things that heretofore had either been un-reported or mis- categorized.
“Mop-up” on stock compensation as it relates to back-dating. Ongoing issues on either options or their replacements/successors: deferred
compensation plans, restricted stock, etc. Executive Executive Compensation Compensation
Again, caused by a new accounting pronouncement. As companies approach placement of pension numbers (more of them) on balance
sheet, there may be some who discover that what they previously reflected may not conform to the old rules (especially amounts that should be in comprehensive income, tax-effected, time-sensitive valuations, etc.). Pension Accounting Pension Accounting
Advent of FIN 48 will have companies focus on accounting, including past
accounting) for uncertain tax positions, such as: – aggressive positions – “audit roulette” – transfer pricing – the “s” word [shelters] Income Taxes Income Taxes
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