Forensic Accounting Presentation to BA 124 San Jose State University March 16, 2004

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Forensic AccountingPresentation to BA 124 San
Jose State UniversityMarch 16, 2004

• Jaime Jue KPMG LLP

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Topics Covered

• Fraudulent Reporting Numbers Can Lie
• Case Study
• Consideration of Fraud in a Financial Statement
  Audit
• Be Careful What You Say - Examples of Bad E-mails
• Questions and Answers

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Fraudulent Financial Reporting

• Numbers Can Lie

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Fraudulent Financial Reporting

• The Auditors Role
• The auditor has responsibility to plan and
  perform the audit to obtain reasonable assurance
  about whether the financial statements are free
  of material misstatement, whether caused by error
  or fraud.
• AICPA, Statement on Auditing Standards (SAS) No.
  1, Codification of Auditing Standards and
  Procedures

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Fraudulent Financial Reporting

• Managements Role
• Management is responsible for adopting sound
  accounting policies and for establishing and
  maintaining internal control that will, among
  other things, initiate, record, process and
  report transactions (as well as events and
  conditions) consistent with managements
  assertions embodied in the financial statements.
• SAS No. 1

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Fraudulent Financial Reporting

• Managements Role Against Fraud
• Management, along with those who have
  responsibility for oversight of the financial
  reporting process (such as the audit committee
  or board of directors), should set the proper
  tone, create and maintain a culture of honesty
  and high ethical standards, and establish
  appropriate controls to prevent, deter, and
  detect fraud.
• SAS No. 1

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What is Fraudulent Financial Reporting?

• Fraudulent Financial Reporting may be
  accomplished by the following
• Manipulation, falsification, or alteration of
  accounting records or supporting documents from
  which financial statements are prepared
• Misrepresentation in or intentional omission from
  the financial statements of events, transactions,
  or other significant information
• Intentional misapplication of accounting
  principles relating to amounts, classification,
  manner of presentation, or disclosure
• AICPA, Statement on Auditing Standards (SAS) No.
  99, Consideration of Fraud in a Financial
  Statement.

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Why is it done?

• To report a smooth, regular, and increasing
  pattern of earnings
• To enrich corporate insiders / management
• To give investors / bankers / Wall Street what it
  wants

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Fraud Risk Conditions Present when Fraud Occurs

• Incentives / Pressures
• Opportunities
• Attitudes / Rationalizations

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Conditions Present when Fraud Occurs

• Three conditions are generally present when fraud
  occurs.
• First, employees have an incentive or are under
  pressure, which provides a reason.
• Second, circumstances exist for example, when
  controls are ineffective or can be overridden
  that provide an opportunity.
• Third, those involved are able to rationalize
  committing fraud.

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But . . .

• Even honest individuals can commit fraud if under
  enough pressure.
• The greater the pressure, the more likely an
  individual will rationalize committing fraud.

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Fraud Risk Incentives/Pressures

• Profitability threatened by economic, industry,
  or entity operating conditions.
• Management pressured to meet third-party
  expectations.
• Management or board members personal finances
  threatened by the entitys financial performance.
• Employees pressured by management to meet
  financial targets.

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Fraud Risk Opportunities

• Complex or unstable organizational structure.
• Deficient internal controls
• Poor accounting system
• Management override

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What is a Typical Pattern of Fraud?

• It does not start with dishonesty.
• It starts with pressure.
• It starts small.
• Opportunities allow it to happen.
• It is rationalized as appropriate.
• The fraud grows over time.
• There is no way out.
• Adapted from Michael R. Young, Accounting
  Regularities and Financial Fraud, 2d, Aspen Law
  Business, p. 11-13.

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Where Can Fraud Occur?

• Revenues
• Premature recognition of revenue
• Right of return, right of refund, or ability for
  customer to resell
• Large, nonrecurring revenue sources
• Concurrent transactions
• Expenses
• Capitalizing vs. expensing
• Delaying expense recognition (deferral)
• Acquisition and restructuring reserves used to
  generate income or cover period expenses

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Where Can Fraud Occur?

• Assets
• Fixed Assets (impairment or write-downs)
• Change in method of capitalization or
  depreciation
• Inventories
• Liabilities
• Cookie Jar, Acquisition, or Restructuring
  Reserves
• Off-balance sheet financing
• Contingent liabilities
• Allowance for doubtful accounts
• Miscellaneous Accruals

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Where Can Fraud Occur?

• Disclosures
• Non-transparent
• Inadequate / Misleading
• Not GAAP Compliant

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Case Study X-Tech Corporation

• A True Story
• The names have changed to protect the innocent
  (and the guilty)

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X-Tech Corp

• Overview
• X-Tech manufacturers and sells computer hardware
  used to track sales, inventory, shipments, etc.
• Over 1 billion in sales
• Traded on NYSE

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X-Tech Corp

• Background
• Anonymous letter sent to SEC alleging X-Tech
  prematurely invoiced and shipped product to two
  large customers
• X-Tech retains ABC law firm to conduct
  investigation
• SEC expresses dissatisfaction with scope of ABCs
  investigation
• X-Tech hires second law firm (XYZ) and forensic
  accountants to conduct investigation

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X-Tech Corp

• XYZ law firm and Forensic Accountants
• Reviewed over 500,000 pages of documents
• Reviewed over 400,000 restored e-mail and
  voice-mail messages
• Reconciled SAP invoices to reported financial
  results
• Conducted revenue testing of invoices covering
  28 of reported revenue and 70 of total credit
  memos

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X-Tech Corp - Interference with Investigation

• Senior VP - Finance directed employees to
• Hide the existence of an important field in the
  SAP program
• Alter documents related to quarter-end
  adjustments
• Deliberately omit transactions in response to
  data request for largest transactions
• Destroy documents related to side deals and
  manipulating quarterly numbers

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X-Tech Corp -Summary of Forensic Findings

• Revenue figures in SEC filings inaccurate for
  1998, 1999, 2000, 2001, and 2002
• Revenue accelerated from future quarters to
  current quarters
• Revenue inflated because of round-trip
  transactions
• Manual accounting entries booked improperly at
  cycle end to improve numbers

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Examples of X-Tech Behavior Swing Sheets

• Senior management used Swing Sheets comparing
  quarterly raw results, management forecasts, and
  proposed adjustments to raw results
• Swing Sheets discussed in meetings separate from
  normal closing and staff meetings
• Adjustments to hit numbers had no basis in GAAP
• In Q1 2000, Swing Sheet adjustments increased EPS
  from 0.16 to 0.20
• Earlier 0.18 projection provided to the Board

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Examples of X-Tech Behavior Intimidation and
Bullying

• Senior management employed a harsh and
  dictatorial management style with unrealistic
  revenue goals
• Practice of intimidating and pressuring workforce
  to make sales targets by any means
• Employees publicly humiliated or lost jobs (or
  both) after failing to achieve sales goals set by
  CEO

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Examples of X-Tech Behavior Round-Trip
Transactions

• X-Tech paid reseller to purchase X-Tech product
  from a distributor.
• X-Tech booked sale at quarter-end.
• X-Tech paid reseller purchase price plus one
  percent.
• Reseller returns product to X-Tech after quarter
  end.
• Employees called these Candy deals
• Example 5 Transactions -gt 18.7M in Sales

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Examples of X-Tech Behavior Revenue
Acceleration

• X-Tech took income in one quarter that should
  have been recorded in subsequent quarters using
  practices such as
• Channel Stuffing
• Bill and Hold
• Cut-off

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Examples of X-Tech Behavior Channel Stuffing

• Examples of channel stuffing include
• Premature or excessive shipments
• Shipment of products not ordered, or in excess of
  customer needs
• Lifting credit holds and temporary increases in
  credit limits
• Side agreements, including special out-of-policy
  return agreements
• Conversion of accounts receivable to notes
  receivable

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Examples of X-Tech Behavior Bowling for Dollars

• Sales Team had practice called Bowling for
  Dollars
• X-Tech asked channel partners and end-users to
  accept product earlier or in greater quantity
• X-Tech did not always get customer consent before
  modifying order
• Example X-Tech shipped product to customer for
  new-store rollout but store was not ready to
  accept product

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Examples of X-Tech Behavior Premature or
Excessive Shipments

• X-Tech customers complained that they were
  invoiced for products they never received.
• At least once X-Tech invoiced customer for
  product that had not yet been assembled
• X-Tech shipped more product than customer
  requested
• X-Tech shipped at quarter end on a slow boat or
  slow truck to arrive after the quarter

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Examples of X-Tech Behavior Manipulating
Shipments

• X-Tech hired local shipper to pick up product
  from X-Tech and hold it before delivering to
  second carrier for customer delivery
• On one occasion, X-Tech received call from
  customer asking why there was a tractor trailer
  unloading X-Tech product at customer site.
• Before X-Tech responded, customer called again,
  inquiring about arrival of a second tractor
  trailer from X-Tech.

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Examples of X-Tech Behavior Swapping Products

• X-Tech often would have difficulty finding
  appropriate product configuration needed to fill
  late-quarter orders
• Sometime, product needed for order unavailable
  until next quarter
• Under direction of senior management, X-Tech
  substituted product it had in stock for the
  product customer ordered without knowledge or
  permission from the customer

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Examples of X-Tech Behavior Lifting Credit
Holds

• X-Tech lifted credit limits to allow sales to be
  processed at quarter- and year-end
• Practice contrary to X-Techs stated policies and
  without regard to customers ability to pay
• Example Credit limit for customer was raised
  from 750,000 to 35 million for two weeks then
  returned to original level
• In interim period, more than 28 million shipped
  to customer and revenue recognized

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Examples of X-Tech Behavior Side Agreements

• X-Tech had side deals and extended payment terms
  to consummate sales at quarter-end
• Typically side deals done orally
• Allowed for abnormally long time to pay or
  excessive right to return

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Examples of X-Tech Behavior Blackout Period
for Credit Processing

• X-Tech restricted processing credits and returns
  at quarter- and year-end
• A blackout period for the processing of credits
  and returns was employed for two weeks before and
  after close
• No credits or returns could be processed without
  VP-Sales or Sales Director approval
• Credits owed customers were not processed for
  months

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Examples of X-Tech Behavior Bill and Hold

• X-Tech made a practice of Bill and Hold / Ship
  In Place transactions
• Customer billed, but goods held at X-Tech until
  buyer requested delivery.
• Many transactions were not authorized by the
  customer and occurred at the end of quarters
• Authorization letters examined by forensic
  accountants were signed by senior executives at
  X-Tech or were on X-Tech letterhead

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Examples of X-Tech Behavior Cut-off Problems

• X-Tech shipments to international customers
  typically governed by FOB Destination shipment
  terms
• Under FOB terms, title and risk of loss did not
  pass to customer under order reached customers
  delivery location
• X-Tech shipped international orders up until the
  last day of the quarter and recognized revenue
  even though customer would not receive product
  until next quarter

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Examples of X-Tech Behavior Concurrent
Transactions

• X-Tech enters into transaction with Z-Tech
• X-Tech purchases Z-Tech software for 10.5M
  (overpaying by 5.25M)
• X-Tech sells 5.25M of product to Z-Tech on bill
  and hold transaction
• Z-Tech had no customers for X-Tech product and
  had never bought from X-Tech before
• Z-Tech software still sitting unused in a box at
  X-Tech
• CEO exerted tremendous pressure on his staff to
  consummate this deal

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Examples of X-Tech Behavior Manipulating
Ratios and Disclosures

• X-Tech publicly announces improvement in its Days
  Sales Outstanding (DSO) in analyst calls
• Did not disclose that it changed methodology for
  calculating DSO
• Actual collection performance deteriorating.
• CFO instructs staff to exclude certain factors
  from accounts receivable sales tax, freight,
  charges, VAT, etc.
• Reported DSO artificially lowered actual DSO
  climbs as high as 119 days

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Examples of X-Tech Behavior Manipulating
Journal Entries

• X-Tech manually recorded approximately 10,000
  journal entries
• Many questionable in terms of substance or
  documentation
• No pre-review or approval necessary before entry
• No systematic post-entry review

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Consideration of Fraud in a Financial Statement
Audit
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Consideration of Fraud in a Financial Statement
Audit

• The Importance of Exercising Professional
  Skepticism
• Discussion among Engagement Personnel
• Obtain Information to Identify Risks
• Identify Risks
• Assess Risks in light of Company Anti-Fraud
  Programs and Internal Controls

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Consideration of Fraud in a Financial Statement
Audit

• Responding to the Results of the Assessment
• Evaluate the Audit Evidence
• Communication of Possible Fraud to Management,
  Audit Committee, and Others
• Documenting the Auditors Consideration of Fraud

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Asking Questions and Analyzing Data
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Asking Questions Analyzing Data -Key Points

• Financial Statements Understanding What is
  Going On Behind the Line Items
• Budgets and Targets Aggressive vs. Realistic
• Earnings Estimates Meet or Miss
• Performance Relative to Competitors and Industry
• External Data What are Others Saying?

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Asking Questions

• What are the companys financial targets?
• How aggressive are the targets?
• Does senior management state that the targets are
  reasonably achievable on analyst calls?
• What is the tone at the top with regard to
  meeting targets?

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Asking Questions

• Are budgets/forecasts an integral tool to running
  the business?
• How often are budgets and forecasts updated?
• Do current budgets/forecasts reflect current
  business conditions?
• At what point during the quarter does management
  know whether the company will meet or miss
  targeted financial performance and third party
  earnings expectations?

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Asking Questions

• What is the companys history in meeting
  consensus earnings estimates?
• Why are earnings estimates met or missed?
• Is the possibility for surprises and variability
  in the achievement of key assumptions understood
  and communicated within the company?

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Asking Questions Outside or Third Parties

• Inquiries of Outside or Third Parties allow you
  to
• Obtain perspectives from those not directly
  related to the company,
• Corroborate responses received from company /
  management, or
• Assess the possibility of collusion.

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Analyzing Data

• Consider Comparisons between
• Data from comparable prior periods
• Budgeted data
• Industry data or peer/competitor companies
• Analyst expectations

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Analyzing Data

• Consider Comparisons between Revenue Data and
• Accounts Receivable (e.g. DSO)
• Inventory levels on hand
• Inventory in distribution channels
• Deferred revenue
• Unbilled receivables
• Customer returns
• Customer allowances

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Analyzing Data

• Consider Comparisons between Revenue Data and
• Cost of Goods Sold
• Selling expenses, such as commissions
• Key performance indicators related to revenue
  (e.g. per sq. ft / per employee)
• Percentage change from prior periods or from
  budget
• Sales volume, as determined from recorded revenue
  amounts, compared to production capacity.

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Analyzing Data

• Consider Disaggregating the revenue data by
• Relevant time period quarter, month
• Product line
• Revenue time
• Customer or customer group
• Business segment or geographic location

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Analyzing Data

• Examine three years of quarterly analysis to
  track
• Actual EPS
• Consensus EPS
• Dollar amount to move EPS one cent
• Reserve or allowance account balances
• Consider significant or unusual moves
• Consider any insider activity in any quarter with
  unexplained changes

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Analyzing Data

• Examine External Documents
• Analyst reports
• Short-sellers reports
• Media reports
• Industry reports
• Credit rating reports
• Investor chat rooms / bulletin boards

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Analyzing Data

• Items which may need further investigation
• Large transactions
• Transactions with specific customers or groups of
  customers
• Transactions near the end of a reporting period
• Transactions with related parties
• Revenue transactions with vendors

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Be Careful What You Say E-mails Recovered by
Forensic Accountants

• Examinations of employee e-mail

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Last Point Examples of Bad E-mails

• Separate contracts into two pieces so I can get
  accounting
• OK to cover from rainy day fund
• You have to agree to tie to future sales so I
  can get accounting
• Clean excess accrual to account XXXXX (a.k.a.
  Rainy Day Fund)
• Can you justify using this excess accrual
  somewhere else?
• Dont pay until they pay us. (concurrent
  transaction)

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Last Point Examples of Bad E-mails

• Need two cents to meet consensus earnings
• Can you work some magic to increase reserves
• Clean excess reserves to liability account XYZ
  future needs
• Call vendors for additional promotional funds
• Shift item to retail inventory pool (50 v. 20
  margin)
• Hide field before giving to auditors.
• Dont show to auditors

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Questions and Answers

• Disclaimer
• The information contained herein is of a general
  nature and is not intended to address the
  circumstances of any particular individual or
  entity. Although we endeavor to provide accurate
  and timely information, there can be no guarantee
  that such information is accurate as of the date
  it is received or that it will continue to be
  accurate in the future. No one should act on
  such information without appropriate professional
  advice after a thorough examination of the
  particular situation.
• The views and opinions expressed herein are those
  of the authors and do not necessarily represent
  the views and opinions of KPMG LLP.