Financial Statement Errors

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Financial Statement Errors Irregularities

• Uncovering Earnings Manipulation and
  Misappropriation of Assets

Presented by Jeffrey Harfenist, CPA, MBA
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Who is Responsible for This Mess?
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Greed Is Good Gordon Gecko from Wall Street
Greed Causes Fraud
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Restatements Resulting From Accounting Errors
Irregularities
133 Increase
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SAS 53 Errors vs. Irregularities

• Errors Involve
• Mistakes in gathering and processing data
• Incorrect use of estimates
• Certain mistakes in applying accounting principles

• Irregularities Involve
• Manipulating, altering or falsifying records
• Intentional omission of events, transactions or
  significant events
• Misapplication of accounting principles with
  intent to deceive

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Common Motives for Misstating Income

• Meet aggressive corporate targets
• Earn bonus and/or stock options
• Avoid reporting a loss
• Increase stock price

• Insure compliance with loan covenants
• Cover up past sins
• Meet or exceed analyst expectations
• Avoid de-listing

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Common Areas of Abuse
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Common Areas of Abuse

• Revenue Recognition
• Premature recognition of sales
• Phantom sales
• Improperly valued transactions
• Reserves
• Bad-faith estimates
• One-time charges

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Common Abuses - Continued

• Inventory
• Overvaluation
• Nonexistent inventory
• Expenses
• Delayed expense recognition
• Improper capitalization of expense
• Offsetting expenses

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Common Abuses - Continued

• Other
• Incentive compensation issues
• Related party transactions
• Acquisition issues

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Examples of Fraud
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Identify Unusual Relationships
Sunbeams Operational Performance
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Reserve Manipulation

• Assume reserve is initially established in
  conformity with EITF 94-3 and 95-3.
• Record restructuring charge associated with 40mm
  severance package stemming from pending layoff of
  4,000 employees
• Record one-time charge of 40,000,000 (Expense)
• Record obligation of 40,000,000 (Liability)

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Reserve Manipulation-Continued

• Six month later the layoffs are complete, yet
  only 3,200 of the 4,000 employees lost their
  jobs
• Remaining obligation of 8,000,000 (Liability)
• Eliminating this liability from the balance sheet
  reduces operating expense by 8,000,000 and
  correspondingly increases EBIT and operating cash
  flows by the same amount

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Purchase Price Allocation

• ABC Company purchases 500,000,000 of targets
  assets for 650,000,000
• Allocates the purchase as follows
• 490,000,000 to hard assets
• 10,000,000 to patents
• 150,000,000 to goodwill
• Sells patents 9 months later for 45,000,000
  generating income of 35,000,000

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Misappropriation of Assets

• Establishing dummy vendors
• Making payments to legitimate vendors for
  personal gain
• Payments to related parties
• Abuses of legitimate corporate policy

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Misappropriation of Assets

• Abuses of legitimate corporate policy
• Executive takes out 4mm loan to pay tax on
  exercise of 10mm in stock options
• Loan forgiven via bonus grant of 6.67mm
• Company looses both the initial 4mm the
  2.67mm tax paid by the company to cover the loan
  forgiveness

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Warning Signs of Financial Statement Fraud
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Warning Signs

• Balance Sheet
• Cash equivalents decline relative to total
  assets
• Potential liquidity concerns

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Warning Signs

• Balance Sheet
• Accounts receivable grows substantially faster
  than sales
• Aggressive revenue recognition

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Warning Signs

• Balance Sheet
• Bad debt reserves decline relative to accounts
  receivable
• Understating reserves leads to inflated operating
  income

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Warning Signs

• Balance Sheet
• Prepaid expenses grow relative to total assets
• Improperly capitalizing expenses

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Warning Signs

• Balance Sheet
• Growth in A/P substantially exceeds revenue
  growth
• Failing to pay current expenses will require
  larger cash outlays in future periods (Bonus may
  be tied to CFFO)

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Warning Signs

• Balance Sheet
• Gross PPE increase sharply relative to total
  assets
• Improperly capitalizing repairs and maintenance
  expenses

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Warning Signs

• Income Statement
• Majority of net income comes from one-time gains
• Core business may be deteriorating

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Warning Signs

• Income Statement
• Operating expenses decline sharply relative to
  sales
• Improperly capitalizing expenses or offsetting
  investment gains

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Warning Signs

• Income Statement
• Seller provides financing and/or extended payment
  terms
• Quality of earnings may be suspect

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Warning Signs

• Statement of Cash Flows
• Cash flow from operations materially lags net
  income
• Quality of earnings may be suspect

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Warning Signs

• Statement of Cash Flows
• Company fails to disclose details of cash flows
  from operations
• Attempt to hide source of cash flow problems

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Warning Signs

• Statement of Cash Flows
• Company cash flows come primarily from assets
  sales, borrowings or equity offerings
• Sign of material weakness in core business

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Warning Signs

• Footnotes, MDA, Proxy Auditors letter
• Change in accounting principles, estimates and
  classification
• Attempt to hide operating problems

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Warning Signs

• Footnotes, MDA, Proxy Auditors letter
• Change in auditor, CFO or outside counsel
• Questionable application of accounting principles

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Warning Signs

• Footnotes, MDA, Proxy Auditors letter
• Very acquisitive in recent past
• Potential for masking past poor performance and
  manipulating net income

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A Few Additional Thoughts

• Restating company financials will likely trigger
  an SEC investigation
• SEC investigation will trigger shareholder
  actions
• Act of restatement will give DO carriers several
  viable reasons to deny coverage
• Implications for Directors Officers is
  extremely serious

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In Conclusion

• Generous P/Es of 1990s are disappearing
• Projected earnings growth is moderate...
• Healthcare costs are soaring
• Companies lack pricing power
• Earnings pressure has not abated
• As A Result

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Stripes will still be in fashion in 2003 and
beyond!
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Thank You!
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Questions?
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• For Additional Information, please contact
• Jeffrey T. Harfenist, CPA, MBA
• Mann Frankfort Stein Lipp
• 12 Greenway Plaza, 8th Floor
• Houston, Texas 77046
• [phone]
• jeffha_at_mfslhou.com