A CFO, bullied by the CEO, used creative accounting and fraudulent schemes to falsely improve a company's bottom line. Here's how he did it and what to keep an eye out for in your organization.
The chief financial officer's accounting fraud was intended to improve the company's financial statements and inflate its stock price. Mission accomplished on both accounts. The fraud led to increased market capitalization for the company and millions of dollars in losses for stockholders who bought the stock at inflated prices.
The CFO succeeded in his scheme for almost two years. An astute member of the financial press ultimately exposed the fraud, which led to criminal charges. The CFO eventually served five years in prison for securities fraud.
This article highlights the mechanics of how he accomplished his fraud using creative schemes to boost revenue, lower cost of goods sold and inflate net income.
In writing this article, I hope to raise awareness of his schemes and help fraud examiners prevent and catch these kinds of accounting gimmicks.
I was involved as an attorney and CFE in civil litigation that overlapped with the criminal case. I analyzed accounting records and audit work papers, assisted in a deposition of the CFO in prison and attempted to piece together the puzzle of the CFO's fraud, among other things. The identities of the CFO and the company will remain anonymous because certain information in the case was non-public in nature.
THE PRESSURING CEO
The chief executive officer of the company heavily pressured the CFO (I'll call him Jack) to report growing earnings. The CEO gave aggressive financial projections to the media, and then he pushed Jack to meet the market's expectations. The CEO had a domineering, threatening personality. Jack was relatively new to the company and was hesitant to say no to his strong-willed boss.
Jack owned shares of the company's stock. Although that was an incentive to inflate the stock price, his main motivation was to please the CEO. Jack had no stock options or incentive-based bonuses.
The expectations of Wall Street and the CEO proved tough to meet. Jack needed a crutch to creatively meet the push for strong financial results. Initially, he used a few minor accounting tricks to improve the short-term bottom line; he didn't intend for them to evolve into a long-term solution or full-fledged fraud. He planned on reversing most of the fraudulent transactions in later accounting periods. Jack hoped that future sales growth — triggered by a new product in the pipeline — would significantly and discreetly absorb the effects of reversing the fraudulent transactions. However, the sales growth never materialized, and Jack wasn't able to cover his tracks.
The pattern should sound familiar to fraud examiners. It's a classic example of the motives and snowball effect that often lead to large-scale fraud.
FICTITIOUS SALES INVOICES
A key component of Jack's fraud was fictitious sales transactions. His starting point in booking these transactions was to create false invoices in the company's accounting system. There were no underlying customer orders, shipping documents or payments. Jack simply entered information into the invoice system such as a real or fake customer name, item description, unit price, quantity and sale date. When the system created the invoices, the system automatically recorded a debit to the accounts receivable (AR) general ledger account and credit to the sales account. Creating the invoice was easy. The tougher part was dealing with the fraudulent AR that remained on the company's books from these transactions.
Jack subsequently cleared some of the AR off the books with cash received from unrelated transactions to make it appear that the fraudulent account receivable was paid off. For example, in one instance the company received cash from a large investor for the payoff of a receivable from the investor's prior purchase of stock. When the incoming cash was received, Jack correctly booked it as a debit to cash. However, he booked the credit portion of the entry to AR from the fictitious sale rather than the receivable from the investor. Thus, the fraudulent AR balance was no longer on the company's books at year-end.
In other instances, he left the AR from fictitious sales on the company's books through year-end. This was risky because Jack knew the auditors would review and test at least some of the company's year-end AR balances. In fact, for one of the fake receivables, the auditors sent an audit confirmation to the listed customer. The customer was a real entity that conducted prior business with the company, but it was run by an accomplice, who aided in the company's fraud. The accomplice signed the confirmation, falsely agreeing that the sale took place and that the receivable was legitimate.
Jack, a former auditor, knew most of the audit procedures that the company's auditors would perform at year-end. More importantly, he knew ways to evade them. For example, he often recorded the fictitious sales in small amounts to avoid creating an unusually large transaction or significant accounts AR balance that might attract the auditor's attention. He was also careful to record the sales at least five days before year-end to avoid any cutoff tests.
SALES WITH NO CORRESPONDING COST OF GOODS SOLD
Some of the fictitious sales were booked with corresponding cost of goods sold (COGS) entries; however, some weren't. COGS is an expense account that reflects the cost basis of sold inventory. The absence of COGS entries meant that the sales were booked with a 100 percent profit margin. In other words, the entire amount of the sale directly increased net income because no corresponding COGS entry was booked to an expense account to record the cost basis of the sold inventory.
To illustrate, sales entries in legitimate accounting systems are generally booked as a debit to AR and credit to sales for the total amount of the sale. A corresponding entry is booked as a debit to COGS and credit to inventory for the company's cost basis of the inventory. The latter entry removes the sold inventory from the company's books. The cost basis of the inventory is usually less than the sales price, with the difference representing the company's profit from the sale.
In cases where no COGS entry was booked (i.e., no debit to COGS, and no credit to inventory), no expense was recorded to net down the company's revenue from the sale. So, the entire sale amount represented profit flowing through to net income.
The company's accounting system automatically booked a debit to COGS and credit to inventory when an inventory item number was listed on the sales invoice. In instances where the CFO wanted to avoid the COGS entry, he simply excluded an inventory item number on the invoice. Alternatively, if an inventory item number was listed on the invoice, he sometimes recorded a manual journal entry to reverse the COGS entry booked by the system. The end result was a sale transaction booked with a 100 percent profit margin.
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