© January/February 2006
Association of Certified Fraud Examiners

Financial statement fraud in the Katrina aftermath

A Whirlwind of Opportunities

By Tracy L. Coenen, CFE, CPA

From the January/February issue of
Fraud Magazine

Hurricane Katrina has caused more than 1,300 deaths, destroyed thousands of homes, and scattered the populace of half of New Orleans throughout the country. And some have estimated that up to 50 percent affected by the storm will experience varying degrees of post-traumatic stress. Lives have been altered permanently.

The hurricane also has devastated thousands of companies and eliminated jobs. But for other firms it has created opportunities to enhance their financial statements. All too often, management feels a certain sort of market pressure that pulls them into financial statement fraud. What sometimes starts as aggressive accounting treatment to "fix" a quarter that fell short of expectations can quickly snowball into long-term, large-scale fraud.

Consider the situation of Waste Management Inc. The U.S. Securities and Exchange Commission (SEC) determined that from 1992 through 1997, management officials participated in a systematic scheme to falsify the company's financial results.

Their actions caused expenses to be underreported, which increased net income by $1.7 billion. Quarterly financial statements were adjusted to align Waste Management's results with predetermined earnings targets. By meeting earnings targets, management received performance-based bonuses and valuable stock options.

Financial statement frauds following the devastation created by Hurricane Katrina will be no different. While the underlying motive may be a bit different, the results will still be the same. Earnings will be "enhanced" or "managed" to temper the negative financial effects of the natural disaster.

The risk of fraud may be greatest in the industries that were hardest hit by Katrina: shipping, tourism, gambling, and fishing. The more obvious frauds will include those committed by contractors and insurance policyholders who overstate cleanup and repair costs. The less obvious situations, however, relate to financial statement manipulation following the hurricane.

The opportunities abound for financial statement fraud yet no obvious cases of this type of fraud have been publicized. Is this because it hasn't happened? Or could it be that auditors are more sympathetic to their clients as victims of natural disasters? Has the hardship of it all caused the financial watchdogs to take a softer approach to the business of auditing?

Magnitude of the damage
The human toll may be incalculable but since Hurricane Katrina hit there have been many estimates of the total monetary damage caused by the natural disaster. Damage to the Louisiana ports alone exceeds an estimated $1.7 billion, according to the American Association of Port Authorities. The United States Census Bureau estimates that 9.7 million residents of the Gulf Coast were affected by Hurricane Katrina. Thousands of businesses have been affected as well.

Risk Management Solutions estimates insured losses to be between $40 billion and $60 billion. Uninsured and underinsured losses will add billions to those figures. The total economic loss from this natural disaster is expected to exceed $125 billion.

In comparison, Hurricane Andrew caused an estimated $30 billion to $45 billion in property damage, which was the costliest natural disaster in U.S. history up to that point. The 1992 natural disaster hit the southern part of Florida, continued across the Gulf of Mexico, and then struck the Louisiana coastline. It left an estimated 250,000 people homeless, and destroyed or damaged 82,000 businesses.

A hurricane obviously makes an impact in the short term by flooding businesses, forcing closures, and damaging buildings. Unfortunately there will be a long-term impact as well. Even with proper insurance coverage and an opportunity to rebuild quickly, a business is still in the position of ramping-up business particularly when there may be a decrease in population.

Accounting standards
Accounting Principles Board (APB) Opinion No. 30 directs reporting of expenses related to "Extraordinary, Unusual and Infrequently Occurring Events and Transactions." If a hurricane is considered unusual in nature and nonrecurring, then losses are to be shown as a line-item separate from continuing operations.

However, due to the geography of the Gulf Coast, most agree that a hurricane wouldn't be considered nonrecurring. That is, it's more likely than not that a hurricane will hit the area in the future. So even though the extensive damage from Hurricane Katrina might be considered unusual, the losses from the hurricane must be included in income or loss from continuing operations because a similar event will occur again.

Some companies still may be inclined to report their hurricane losses as extraordinary and separate them from income from continuing operations. This accounting treatment is attractive because the company would be highlighting the company's normal performance separate from the unusual losses. However, this isn't the proper treatment.

An unsophisticated user of financial statements likely won't make the distinction between this treatment of the losses and the proper treatment under Generally Accepted Accounting Principles (GAAP). In fact, many may agree that it may be seem fairer to present the financial statements with the Hurricane Katrina losses separated from normal operations.

The fraud risk
The U.S. Department of Justice is interested in fraud schemes related to Hurricane Katrina, so a task force has been organized to focus on government benefit fraud, government contract fraud, fraudulent charities, insurance fraud, and identity theft.

No attention has been given to the risk of financial statement fraud although arguably it could cost more than the frauds being eyed by the task force. Financial statement fraud will occur in both private and public companies but it's unlikely that the financial statement fraud perpetrated by private companies will be publicized.

It should be noted that financial statement fraud risks aren't limited to companies directly in the path of Hurricane Katrina. Companies that do business with hurricane victims have opportunities to manipulate their financial statements as well.

Risk: revenue overstatement
The risk of generally overstating revenues applies to both companies in the path of Hurricane Katrina, as well as companies that do business with Katrina victims. In both situations, pressure for financial results may encourage the deliberate recognition of fictitious revenues.

For at least three quarters in 1995 and 1996, Photran Corp. executives recorded fictitious revenues to avoid showing financial losses in the company's filings with the SEC. The company had inadequate internal controls, which allowed the recording of false revenues. Executives themselves even assisted in backdating documents to support Photran's premature revenue recognition. The result of this scheme was a net profit shown in the initial registration statement and subsequent quarterly filings, when the company actually had substantial losses.

Companies affected directly or indirectly by Hurricane Katrina also may be inclined to record fictitious revenue to bolster their financial statements. Auditors should be skeptical of the revenue of companies in the path of Katrina or companies doing business with Katrina victims.

It's recommended that auditors pay special attention to the revenues recorded after the disaster and ask themselves whether those financial results are reasonable. These companies probably should show decreased revenues in the months following the disaster. If revenues show no noticeable change, further examination is warranted.

Risk: revenue recognition
Companies may be tempted to improperly recognize sales when, in fact, the sales weren't completed due to circumstances surrounding the hurricane. Consider a manufacturer of heavy equipment. Orders for machinery may be made months or years in advance of the expected delivery date. What happens if the manufacturer has nearly completed the machinery, but the customer was hit by Hurricane Katrina and is unable to accept delivery?

While the manufacturer may have legal remedies available to enforce the contract, revenue recognition rules will likely prohibit the company from recording a sale. FastComm Communications Corp. found itself in hot water with the SEC when it was alleged that on at least two occasions the company recorded sales for products that weren't even completed at the end of the quarter. This improper recording of revenue overstated the company's revenues by 33 percent in one quarter.

Similarly, machinery or products that aren't able to be completed or shipped to Hurricane Katrina victims shouldn't be recognized as completed sales. It's easy to see why management may be inclined to record certain incomplete sales particularly when the items are of significant value.

Auditors should be on the lookout for sales recorded toward the close of the accounting period. Supporting documentation should be examined, and the company's premises should be inspected, if possible.

On one audit, I asked management the name of a customer for a large piece of equipment that appeared to be collecting dust. An examination of the financial records showed a sale to that same customer just prior to the close of the fiscal year. In fact, that was an improperly recorded sale for the piece of equipment in the plant, which couldn't be shipped until some other difficulties were resolved. The reversal of the sale changed the company's bottom line from a profit to a loss.

Risk: accounts receivable reserves
Consider the potential losses from accounts receivable due from hurricane victims. Companies decimated by Hurricane Katrina have a high likelihood of slow payment or non-payment of receivables.

Upon discovering that accounts receivable aren't likely to be collected, GAAP requires that the company establish a reserve for the uncollectible accounts. This records a corresponding expense, thereby lowering the company's profits.

It's apparent why an executive may be reluctant to book these expenses, particularly if large dollars are in play. Not only will the company's financial statements suffer in the current year, the following year's sales may also suffer if a significant number of customers are now out of business.

The SEC is on the lookout for companies that don't properly account for uncollectible and delinquent accounts. First Merchants Acceptance Corp. experienced rising delinquent accounts in 1996. To avoid charging off the uncollectible accounts, the company manipulated the accounts receivable to make more than 7,000 delinquent accounts appear current. The effect of this was an overstatement of net income by $76.7 million in 1996, for which the SEC took action.

Overstatement of accounts receivable may not be easily discovered, but auditors can engage in specific procedures to help uncover delinquent accounts related to Katrina. Significant customers should be examined, and the auditor should attempt to determine the location of those customers' operations. If the operations are located in the "Katrina zone," then further investigation of the collectibility of accounts receivable is warranted. Additional procedures might include confirmations and review of cash receipts subsequent to the close of the accounting period.

Risk: inventory fraud
An annual concern shared by many companies is the problem of obsolete inventory. Companies identify old inventory that has little value, and then they are left to decide whether they will recognize an expense in the current year as required by the accounting rules.

From 1997 through 2000, Del Global Technologies materially overstated its inventory by maintaining obsolete inventory on its balance sheet at the full value, rather than properly writing it down. This, in conjunction with the improper capitalization of ordinary expenses, overstated Del's pre-tax income in each year by $3.7 million to $7.9 million. The overstatement of net income was 110 percent to 466 percent of the actual net income.

The fraud went undetected by the auditors because the company maintained two sets of books - one for its auditors and one for internal purposes. Fictitious documentation was created by management to further conceal the fraud.

Hurricane Katrina may give companies an opportunity to reduce their inventory write-offs this year. To the extent that obsolete inventory really was damaged by the hurricane, insurance coverage may apply. However, the valuation of the inventory may be called into question, and companies may attempt to over-value the inventory for insurance purposes.

Companies also may be tempted to write off obsolete inventory as damaged by the hurricane even if this isn't the case. Investors and users of the financial statements may likely judge that type of write-off less harshly than a straight inventory write-off due to obsolescence.

Auditors should critically examine the write-offs due to the hurricane and compare details to the prior year's obsolete inventory reserves. If auditors are observing the company's annual physical inventory they should be on the lookout for damaged inventory and perform additional procedures to verify the correct accounting treatment.

Risk: underreporting expenses
A simple way to beef up a company's financial statements is by not reporting expenses. Hurricane Katrina cleanup and rebuilding is expensive and to the extent that a company doesn't report these items on the financial statements net income is increased.

Consider the example of Aurora Foods Inc. In 1998 and 1999, upper management underreported trade marketing expenses by more than $43 million, and actively concealed the underreporting from the independent auditors. This resulted in the material misstatement of Aurora's financial statements, which inflated the company's net income by $43 million.

When management is actively concealing the company's expenses, it may be very difficult to determine that a fraud has occurred. Auditors should be looking for expenses related to cleanup. The absence of such expenses should raise serious questions, and the auditor should conduct a skeptical inquiry into the whereabouts of cleanup and rebuilding costs.

Risk: improper capitalization of expenses
It's often tempting for companies to capitalize expenses and deduct them over several accounting periods rather than expensing the entire cost immediately. Costs related to Katrina clean-up and rebuilding are no different. These costs may be substantial, and executives may be inclined to spread the costs out over a few years rather than expensing them when they are incurred.

The most notable fraud related to capitalized expenses was committed by executives at WorldCom Inc. Billions of dollars in operating expenses were capitalized during 2001 and early 2002. This reduced the expenses shown on the income statement thereby overstating the company's net income.

Many hurricane clean-up costs won't benefit future accounting periods, and therefore shouldn't be capitalized. Capitalization may be appropriate for some repair and replacement of significant equipment and buildings, but these situations should be easy to spot.

In theory, improper capitalization of expenses shouldn't regularly occur in companies with independent auditors. The rules about capitalization are fairly straightforward, and improperly recorded transactions should surface if the auditors carefully examine capitalized items. However, the devil is in the details if management creates fictitious documentation to support its accounting treatment of items that they prefer to capitalize.

Risk: overstatement of insurance receivables
In addition to the rules on the technical treatment of the losses under today's accounting rules, management must also consider the proper treatment of insurance reimbursements. Properly insured companies will be reimbursed for the majority of their property losses and loss of business. However, insurance settlements and payments may not be made for some time.

It's expected, therefore, that financials of hurricane victims will show decreased revenue from Gulf Coast locations for at least the third and fourth quarters of this year. Recoveries from insurance policies shouldn't be recorded by the companies until contingencies are resolved and the amount of insurance payments can be reasonably estimated.

If a company includes an insurance receivable in the current year's financial statements, auditors should critically examine the source documentation and inquire with management. They should determine whether the insurance company has agreed to such payments, and this might be accomplished with confirmations.

Risk: disguising losses as related to Katrina
Although losses related to Hurricane Katrina should be combined with regular business expenses, the management's discussion and analysis will likely highlight the magnitude of these items. Therefore, it might be advantageous for companies to try to disguise ordinary losses as related to Katrina.

The easiest types of expenses to roll into hurricane-related accounts would be related to repairs and cleaning because those sound like Katrina items. Auditors should be examining supporting documentation and determine whether items are related to the hurricane. Questionable items should be investigated more thoroughly, and auditors may consider contacting vendors to inquire about the true nature of products and services provided.

Be sympathetic but skeptical
Will Katrina-related frauds really be any different from the garden-variety financial statement frauds? I don't think so. Instead, I think that Hurricane Katrina has just created an additional avenue for fraud.

I believe most of the general population has sympathy for the individuals and businesses affected by this tremendous natural disaster, and this may cause them to be less skeptical about financial results. Auditors should make sure that the true facts are not lost in management's "spin" on the hurricane's effect on the financials.

It's important as fraud examiners that we find the latent fraud and avoid adding to the woes of the people of the region.

Tracy L. Coenen, CFE, CPA, is president of Sequence Inc., a forensic accounting firm with offices in Milwaukee and Chicago. Her e-mail address is: tracy@sequence-inc.com.