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Arresting Financial FraudThe Inside Story From
The FBI
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Course Objectives

• This program is designed to help you
• Understand the U.S. Department of Justices
  three-part definition of corporate fraud
• Understand the scope of the problem
• Identify common accounting schemes
• Work effectively with law enforcement and
• Better understand the impact of recently enacted
  legislation

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Todays Speakers

• Grant Ashley, CPA
• Assistant Director,
• Criminal Investigative Division
• Federal Bureau of Investigation
• --------
•  
•  Gary Dagan, CPA
• Chief,
• Economic Crimes Unit
• Federal Bureau of Investigation

• Keith Slotter, CPA
• Chief,
• Financial Crimes Section
• Federal Bureau of Investigation
• --------
• John F. Hudson, CPA
• Moderator
• Hudson Consulting Group, LLC

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Corporate Fraud - Background

• Following the corporate scandals of 2002, the
  Department of Justice issued a three-part formal
  definition which describes the illegal activities
  that encompass corporate fraud.
• These three parts are
• Accounting Fraud
• Self-Dealing by Corporate Insiders
• Obstructive Conduct

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Dept. of Justice Definition Corporate Fraud

• Part One Accounting Fraud (Cooking the Books)
• The falsification of financial information,
  including false accounting entries, bogus trades
  designed to inflate profits or hide losses, and
  false transactions designed to evade regulatory
  oversight.

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Restatements by Reason1997 - June 2002
Per GAO Report on Financial RestatementsFigure 3
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Why is Revenue Recognition So Important?

• In its October 2002 Report on Financial Statement
  Restatement, the GAO concluded that

• Almost 38 of the 919 announced restatements
  between 1997 and June 30, 2002 involved revenue
  recognition.
• Revenue recognition was the primary reason for
  restatements in each year.
• Over 50 of the immediate market losses following
  restatements were attributable to revenue
  recognition related restatements.
• Approximately 50 of the SECs enforcement cases
  have involved revenue recognition issues.

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Why is Revenue Recognition So Important?

• Restatements for improper revenue recognition
  also result in larger drops in market
  capitalization than any other type of
  restatement
• 8 out of the top 10 market value losses in 2000
  related to revenue problems.
• Of the 10 companies, the top 3 lost US20 billion
  in market value in just 3 days due to revenue
  recognition problems.

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Some Examples of Revenue Recognition Schemes

• Phantom Sales
• Parked Inventory Sales
• Swap (i.e., Round Trip) Transactions
• Channel Stuffing
• Accelerated Revenue
• Undisclosed Side Deals
• Undisclosed Contingencies
• Backdated Contracts

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Some Examples of Expense Liability Recognition
Schemes

• Capitalizing Expenses
• Deferring Expenses
• Unrecorded Expenses
• Big Bath Accounting
• Cookie Jar Reserves
• Creative Acquisition Accounting

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Cooking The Books Selected Recipes

• Parked Inventory Sales Recording sales for
  goods shipped to a site (warehouse, parking lot)
  controlled by the seller to provide the
  appearance a valid sale occurred.
• Swap Transactions A scheme in which two
  conspiring companies exchange payments and
  services solely for the purpose of inflating
  revenues.
• Channel Stuffing Overselling products to
  customers with a hidden understanding that the
  customer will receive deep discounts on the full
  invoice price at a future date.

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Cooking The Books Selected Recipes

• Side Deals An arrangement in which the buyer of
  goods is given the right to cancel the sales
  contract, return products or receive rebates in
  future periods. Although the sale is booked, the
  side deals are hidden from auditors.
• Accelerated Revenue Improperly recording
  revenues in the current fiscal period which are
  applicable to future periods. Examples are
  unshipped merchandise and percentage of
  completion contracts.

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Cooking The Books Selected Recipes

• Capitalizing Expenses The improper
  reclassification of an expense to an asset. This
  scheme is typically conducted through a series of
  journal entries at the end of a fiscal period in
  order to inflate the financial statements.
• Deferred Expenses Recording expenses applicable
  to the current fiscal period at some date in the
  future. Typically, this scheme continues to
  perpetuate itself in future periods.

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Dept. of Justice Definition Corporate Fraud

• Part Two Self-dealing by corporate insiders
  (Me First), including . . .
• Insider trading
• Kickbacks
• Misuse of corporate property for personal gain
• Individual tax violations related to self-dealing
  

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The Fundamentals of Corporate Governance

• Lessons often forgotten . . .
• A corporation is owned and controlled by the
  individual shareholders.
• The corporation is NOT the personal property of
  the individual executives of the company.
• Self-dealing places the greed of individual
  executives ahead of the shareholders.

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Examples of Self-Dealing

• Executive loans with no intentions to ever repay.
• Extraordinary personal expenses charged to the
  company.
• Failure to report forgiven loans or reimbursed
  personal expenses as taxable income.

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Examples of Self-Dealing

• Awarding business contracts in return for
  personal compensation.
• Receiving shares of stock in other companies in
  return for business transactions (shares are
  often placed in the name of another family member
  to avoid detection).

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Examples of Self-Dealing

• Insider Trading
• Buying or selling personally owned shares of
  stock prior to a major announcement that is
  expected to affect the stock price (i.e.,
  positive or negative earnings, new products,
  change in management, mergers acquisitions).

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Dept. of Justice Definition Corporate Fraud

• Part Three Obstruction of Justice (The
  Cover-up)
• Obstruction of justice designed to conceal the
  previously noted criminal conduct (accounting
  fraud self-dealing), particularly when that
  obstruction impedes the regulatory inquiries of
  the Securities and Exchange Commission or other
  agencies.

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Obstructive Conduct

• Shredding documents
• Erasing computer files
• Creating or altering documents to justify illegal
  conduct
• Purposely failing to provide all documents and
  files requested in a subpoena

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Obstructive Conduct

• Providing false testimony in SEC depositions
• Lying to criminal investigators
• Influencing another witness
• Threatening another witness
• Failing to maintain records for a prescribed
  period of time

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Record RetentionExpectations of the CPA

• In 2002, a new criminal law (title 18, section
  1520) was enacted which requires any accountant
  who conducts an audit of a public company to
  maintain all audit workpapers from this
  engagement for a period of five years.

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Corporate Fraud Victims

• Individual shareholders
• Employee pension plans
• Mutual funds
• Financial institutions (lenders)
• Market stability reliance

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Locations of Corporate Fraud Investigations

• New York, NY
• Chicago
• Los Angeles
• San Francisco
• San Diego

• Boston
• Detroit
• Houston
• And

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(Continued) Locations ofCorporate Fraud
Investigations

• Birmingham
• Charleston (SC)
• Anchorage
• Columbus (OH)
• Honolulu

• Omaha
• Erie (PA)
• Johnson City (TN)
• Oklahoma City

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Corporate Fraud
Is A National Problem
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Industry TrendsIn Current Investigations

• Energy
• Telecommunications
• Retail
• Medical
• Insurance

• Software
• Internet
• Banking
• Cable TV
• Charities

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Typical Scenario

• In far too many cases, accounting fraud began as
  a one time act to help meet the quarterly
  revenue targets.
• However, the just one time syndrome perpetuates
  itself into future quarters until the fraud
  becomes out of control.

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Case Study Example

• Corporate Fraud
• Walter Pavlos Insider Perspective . . .

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Case Study Example

• Lets look at an interview with Walter Pavlo . .
  .

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Perspective

• Some corporate executives have compared
  accounting fraud to a gambling or drug addiction.
  Although they believe it can be stopped at any
  time, their circumstances dictate otherwise.
• Phony accounting from prior periods combined with
  current losses has a snowball effect.

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Motives For Corporate Fraud

• Executive bonuses are tied to profits.
• Executives maintain their prominent positions
  within the corporation.
• Stock value remains artificially inflated based
  on phony financial performance indicators.
• Personal greed is the underlying factor.

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Impact

• Corporate fraud has negatively impacted the
  financial services sector. Its effect on the
  banking, insurance, and securities industries
  undermines the fundamental core of the United
  States economy.

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Overall Scope of Corporate Fraud

• Not limited to any geographic area or market
  segment.
• Despite media attention on several select
  companies, the FBI is currently pursuing 139
  cases of corporate fraud.
• Many companies are lesser known but effect on
  shareholders is the same.

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Corporate Fraud Investigations

• At least 16 cases with losses gt 1 Billion
• 50 cases with losses gt 100 Million
• Since January 2002 187 executives charged with
  corporate fraud violations.
• 3-6 new cases opened each month

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Participants In Corporate Fraud Vary But May
Include . . .

• Chief Executive Officer
• Chief Financial Officer
• Line Accountants
• Sales Personnel
• Shipping Personnel
• Corporate Attorneys
• Collusive Customers

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A Common Myth

• I work in a small local CPA firm. Corporate
  fraud is only a concern for the big, national
  accounting firms.
• I have very few (or no) publicly-traded audit
  clients. Therefore, the issue of corporate fraud
  has no effect on my practice.

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A Common Myth

• Should You Be Concerned About Corporate Fraud . .
  .
• Do you conduct audits?
• Do your clients have employees?
• Do you prepare tax returns?
• Do you conduct forensic examinations?
• Do outside parties rely on your clients
  financial statements?
• Do your clients transact business with other
  companies?

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A Common Myth

• If you answered Yes to any of these questions,
  you can be affected by corporate fraud.
• Because . . .

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Why You Should Be Concerned . . .

• As you certainly know, audited financial
  statements have end users, like investors and
  creditors, who rely on them.
• Employee theft and self-dealing is a corporate
  fraud violation.
• Individual tax violations from self-dealing is
  corporate fraud.
• One company may assist another company in
  committing accounting fraud if theres an
  incentive.

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Role of the CPA

• Independence remains a crucial element In
  conducting effective audits
• Objectivity and professional skepticism are also
  important
• CPAs must avoid placing themselves in the
  position of protecting a client under
  investigation.

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Role of the CPA

• A major public misperception of the CPA is that
  if a CPA performs a financial statement audit,
  he or she will detect any fraud that may exist.
• While an auditor does have responsibilities for
  detecting material fraud, audits are conducted to
  issue an opinion on the fairness of the financial
  statements.

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Statement on Auditing Standards No. 99
Consideration of Fraud in a Financial
Statement Audit
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Evolution of the Fraud Standard - Number of
Paragraphs
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Whats New in the Auditors Fraud Detection
Responsibilities?

• Evaluating how the entity responds to identified
  fraud risks
• More emphasis on professional skepticism
• Discussions among engagement personnel
• Expanded inquiries of management and others
  within the entity.
• Reorganized and modified fraud risk factor
  examples (the Fraud Triangle).
• Expanded fraud risk assessment approach

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Whats New in the Auditors Fraud Detection
Responsibilities?

• Expanded guidance on revenue recognition as a
  likely risk.
• Linkage between identified risks and the
  auditors response.
• Responses to address the risk of management
  override of controls.
• Documentation (expanded requirements).

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• The Governments Response To Corporate Fraud

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The Sarbanes-Oxley Act Why How

• Focused on restoring investor confidence by
• Placing greater accountability on corporate
  officers
• Forcing timely flow of information (both good new
  and bad news)
• Forcing greater separation of duties between
  auditors, consulting, and management and
• Limiting self-regulation of the accounting
  profession and standards-setting process.

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The Sarbanes-Oxley Act Why How

• Pursues these goals by amending existing laws, or
  creating new ones, which
• Requires officers, under possible civil and/or
  criminal penalty, to certify accuracy and
  representation of its financial conditions,
  disclosure controls and procedures, and assess
  its effectiveness on internal control structure
  and procedures over financial reporting
• Requires quarterly review of internal controls
• Places limitations on audit firms ability to
  provide some services and requires board approval
  of all non-audit services and
• Brings PCAOB into existence.

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The Sarbanes-Oxley Act Why How

• In essence, it endeavors to restore investor
  confidence by changing the corporate mind-set and
  actions towards controls and disclosures.

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The Sarbanes-Oxley Act of 2002

• Major Provisions
• Creates a new criminal violation (18 USC 1348)
  for securities fraud schemes.
• CEOs and CFOs must provide a Statement of
  Certification that the financial statements
  fairly present the financial condition of the
  company.
• Provides increased jail sentences for executives
  who engage in corporate fraud.

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The Sarbanes-Oxley Act of 2002

• Major Provisions
• CPAs must retain audit workpapers for 5 years.
  Failure to do so is a criminal violation (18 USC
  1520).
• Several new amendments added to obstructive
  conduct.

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The FBI Response

• Corporate Fraud Hotline
• Initiated February 2003 888-622-0117
• 2,000 calls logged to date
• Callers can be anonymous
• Several new cases opened based on caller
  information
• Several existing cases were enhanced
• Public cooperation is essential

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The FBI Response

• Reserve Team
• Consists of special agents and financial analysts
  with accounting skills.
• Temporarily assigned to corporate fraud cases
  across the country to efficiently conduct
  investigation.
• Emphasizes timely results through the use of
  seasoned investigators with strong interview
  interrogation skills.

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The FBI Response

• Accountants Are Essential
• Currently 1,334 FBI Special Agent Accountants
• 501 are Certified Public Accountants
• 336 are FBI Financial Analysts
• In the upcoming year, 15 of all new special
  agents hired will be accountants. Since its
  inception, the FBI has continuously hired
  accountants for diverse investigative roles.

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The FBI Response

• Corporate Fraud Investigative Partnerships
• Securities and Exchange Commission (SEC)
• National Association of Securities Dealers (NASD)
• U.S. Postal Inspection Service (USPIS)
• U.S. Department of Labor
• Internal Revenue Service
• Commodity Futures Trading Commission (CFTC)
• Federal Energy Regulatory Commission (FERC)
• Defense Criminal Investigative Service (DCIS)

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The FBI Response

• These investigative partnerships were formed to
  capitalize on agency expertise in areas like
• Securities
• Pensions
• Taxation
• Energy regulation and
• Government contracts

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My Client Is Under Investigation

• What you should know . . .
• CPA firms of all sizes are affected.
• FBI CPA roles are NOT adversarial.
• Expect subpoenas for workpapers.
• Expect interviews of audit personnel.

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(Continued) My Client Is Under Investigation

• What You Should Know . . .
• Client offices may be searched.
• These are normal investigative procedures.
• It is not the CPAs role to protect a client in a
  criminal investigation.
• Remember independence still applies.

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Criminal Justice and the CPA

• CPAs are hired by the government in accounting
  fraud cases. Their findings are important in
  identifying the extent of the fraud.
• CPAs are hired by the government as expert
  witnesses in criminal trials.

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Criminal Justice and the CPA

• When providing assistance to the Government
• How did you document answers from key personnel
  during the audit?
• Audit workpapers are valuable pieces of evidence.
  CPAs often document statements by corporate
  executives during an audit. These statements may
  later contradict the position of these executives
  in criminal cases.

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• Cooperatively . . .
• The FBI and the CPA Profession can tackle
  corporate fraud. Its in everyones best
  interest.

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Arresting Financial FraudThe Inside Story From
The FBI

• Summary Questions

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Arresting Financial FraudThe Inside Story From
The FBI

• Thank You
• For Participating!

65
Upcoming Webcasts
General Audit Risk Alert Update

• November 20, 2003 1pm Eastern Time
• Join your fellow CPAs for this live, interactive
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  changes that will impact your 2003-2004 audit
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•  
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66
Upcoming Webcasts
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Upcoming Webcasts
SEC Quarterly Update Webcast Series Sponsored by
the AICPA and CFO.com

• December 17, 2003
• March 16, 2004
• June 17, 2004
• September 21, 2004

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68
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• February 12, 2004
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