An acquisition in wonderland?

Just like Alice in her Wonderland, the acquiring company didn't anticipate the tricks of the Mad Hatter and March Hare. But eventually the purchasers discovered the nightmare of an $18-million fraud in the company they had bought. 

(Mr. Expert's) report evokes memories of a passage from "Alice's Adventures in Wonderland," in which Alice and the Queen of Hearts have the following exchange:
"There's no use trying," (Alice) said; "one can't believe impossible things."

"I daresay you haven't had much practice," said the Queen. "When I was your age, I always did it for half-an-hour a day. Why, sometimes I've believed as many as six impossible things before breakfast."

(Mr. Expert) obviously adopted the Queen's advice in connection with this engagement. Close analysis of his recent report reveals that (Mr. Expert) is asking Your Honor to believe scores of impossible things...

Follow me into an Acquisition in Wonderland.

Setting the stage
This litigation arises from an acquisition under a stock purchase agreement (SPA) occurring in May of 2000. The plaintiff is the acquirer, a privately held company with national and international presence, managed and operated by highly astute and sophisticated individuals. By any measure, this was a group of people who knew what they were doing in the world of corporate acquisitions. The defendants included the acquired company and its owners and investors. The acquired company was a small business in the transportation industry owned principally by the investor group, but managed and operated by the minority owners. The acquired company had been audited by an international accounting firm, and had undergone several collateral audits by a national bank.

To "protect the innocent" and add a little color to this sad tale, each key party is assigned a character's name from "Alice's Adventures in Wonderland" that best fits their role. The purchaser is Alice who finds herself in a bewildering series of events from which she eventually emerges. The seller's CFO is the Mad Hatter and the seller's controller is the March Hare, fitting assignments, as you will see. The forensic accountant who led the fraud examination is the White Rabbit, always seeking the truth. And while the unreasonable Queen of Hearts has no counterpart in the case, you might find that her "off with their heads" declaration is fitting, figuratively speaking, of course. Keep her in mind.

Perpetration of the fraud: the tea party
The Mad Hatter's chaotic tea party in "Alice's Adventures in Wonderland" is a good illustration of the events that led to the dispute in this case. Alice acquired a company where the Mad Hatter was having his own tea party on a monthly basis (pre- and post-acquisition), at which he and the March Hare played an assortment of games with the components of the financial statements. They manipulated the financial statements to overstate revenue, and thus Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA), which was a key financial measure during the acquisition and post-acquisition. The games included:

• the use of formulas;
• a practice of re-aging accounts receivable, coined "re-bucketing;"
• understating liabilities;
• the use of unsupported topside journal entries; and
• telling lies to everyone who inquired about the financial condition of the company.

Mad Hatter and March Hare's games resulted in an overstatement of revenue by at least $3 million before Alice ever entered the scene. At the acquisition date, the overstatement was at least $5.5 million, and at Alice's fiscal year-end ten months after the acquisition, the fraud had grown to at least $10 million. Twenty-two months after the acquisition, the international accounting firm quantified the fraud at $18 million. Here is how the tea party games were played:

The use of formulas was two-fold: formula-driven financial statements and the inflation of customer accounts receivables by the application of a formula. The formula-driven financial statement is where the fraud began every month. Mad Hatter (the CFO), who was a CPA and an ex-bank auditor, knew exactly what the financial statements needed to look like so that financial ratios would indicate the company was profitable and growing month over month. So each month he would sit down with a blank canvass (Microsoft Excel), and he would use a series of formulas to create financial statements based on pre-determined ratios. The Mad Hatter's financial statements weren't based on the actual books and records of the company and certainly had nothing to do with the company's economic reality.

After the creation of the monthly financial statement, it was necessary to make the supporting documentation match the amounts contained therein. Accounts receivable was by far the company's largest asset, so Mad Hatter would spend a lot of time fabricating supporting documentation. Each month he would have the actual accounts receivable sub-ledgers downloaded to Microsoft Excel and would then apply formulas (and other methods discussed later) to artificially inflate individual customer balances until the total of the detail matched the pre-determined accounts receivable number derived from the financial statement formulas.

The March 31, 2000 accounts receivable detail document was attached to the SPA and was separately represented and warranted by the sellers. Because of the massive manipulations the plaintiffs believed were contained in this document (referred to in the litigation as "The List") it was a source of great debate throughout the lawsuit proceedings. Later in this article, I'll explain how we found the source of the creation but first here's an example of how Mad Hatter used formulas in his manipulation games, taken directly from The List.

Customer ABC was downloaded from the actual sub-ledger to "Sheet 1" in a Microsoft Excel workbook with a balance of $22,462.26 in the "over 21" column. A separate sheet in the same workbook shows Customer ABC with a balance of $25,831 in the "0-7" column. Review of the cell contents for the $25,831 reveals a formula: "=22462k1.15." Presto! The result is a 15 percent inflation of the customer's balance. For purposes of The List, however, 15 percent wasn't enough to support Mad Hatter's pre-determined accounts receivable number. On another sheet in the same workbook, the contents of which exactly matches "the List" detail, Customer ABC has a balance of $30,287, still in the "0-7" column. The corresponding cell contains another formula referencing back to the cell with the $25,831 multiplied by 1.1725, another 17.25 percent inflation for a total inflation of almost 35 percent.

During this case we used new terms and phrases to describe what was going on; one was re-bucketing, the practice of moving an individual customer's balance in one aging category to a more current aging category to make the receivable appear healthier than it really is. Mad Hatter used re-bucketing to re-age the accounts receivable to a more current state. In most cases he played this game in the Microsoft Excel-created schedules. The practice became apparent when we compared the actual sub-ledgers for any given month with the detail of accounts receivable given to various third parties including the national bank, the international accounting firm, and Alice (the purchaser). As an example: when comparing the actual sub-ledger as of a certain date with detail provided to the national bank in connection with the company's borrowing base certificate, balances in the "0-30," "31-60" and "61-90" day categories were added together and re-bucketed to the "0-30" category; balances in the "91-120" and "121-150 columns were added together and re-bucketed to the "31-60" column; and balances in the ">150" category were re-bucketed to "61-90."

Re-bucketing within the accounting systems also occurred, initially with two separate system conversions. Customer balances, without regard to the number of invoices or the aging category, were entered into the new system as one invoice dated as of the time of the system conversion. The result was that receivables more than a year old were suddenly shown as current. The other re-bucketing within the accounting systems was done by issuing credit memos to zero old invoices and re-issuing new invoices for the same amount but dated with the date the new invoices were created.

Though accounts receivable was the company's largest asset with the greatest amount and most varied methods of manipulation, other assets and liabilities were also manipulated. Mad Hatter's game of understating liabilities created support for two line items on his financial statement: cash and current liabilities, specifically held checks. Through discovery two very different bank reconciliations for a pre-acquisition period were produced. The actual bank reconciliation produced by the acquired company begins with a negative bank balance of approximately $150,000 that reconciles to negative $3.8 million after the consideration of outstanding checks. (No deposits-in-transit were noted.) The falsified bank reconciliation produced by the national accounting firm from their audit workpapers begins with the same negative bank balance (that's a little more difficult to manipulate), and includes made up deposits-in-transit, only $2 million of outstanding checks, and an add-back for $1.8 million in held checks for a reconciled balance of approximately $58,000. Not only was the cash balance manipulated and the outstanding check amount grossly misstated but the liability side of the $1.8 million in held checks wasn't added to the financial statements. With a few clicks of the mouse, Mad Hatter erased more than $3.7 million of liabilities and negative cash position.

Until now, I've discussed manipulations occurring outside of the company's accounting systems (but for a few occurrences). However, at some point, someone might want to look at the general ledger or a trial balance. So how would one make the general ledger match the fabricated amounts in the financial statements and supporting documentation? The answer lies in a practice that businesses caught up in the large accounting scandals have used: topside journal entries. This company had annual gross revenue of $50 million to $60 million and annual net revenue of about $7 million. Monthly topside journal entries posted to the general ledger in pre- and post-acquisition months range from a low of $26.6 million to a high of $348 million! Astonishing when considering annual gross revenue was at best 17 percent of the high! And by the admission of the defendants' own expert no supporting documentation could be found for more than 38 percent of the topside entries.

Lastly, was the game of telling lies. Throughout my involvement in this case one thing was abundantly clear: Mad Hatter would stop at no form of deceit when portraying the acquired company's financial condition to a third party. Month after month, he combined various games to create financial statements that were a complete sham. And he lied to anyone who inquired about the financial condition. (Remember the Queen of Hearts and her declaration?)

Uncovering the fraud: Alice's discovery of the tea party
The Mad Hatter's ultimate objective was to deceive everyone about the acquired company's true financial condition. Once Alice (the purchaser) became involved, the probable instrument used by the fraudsters to conceal the fraud was an autonomy agreement signed at the closing of the acquisition. This agreement minimized Alice's oversight of the daily operations of the company as long as certain financial targets (EBITDA-based) were met. So month after month the reporting packages submitted to Alice indicated the company was meeting the financial targets. Ten months after the acquisition came the first indication that the targets wouldn't be met. Mad Hatter and other members of management blamed the negative results reported by the acquired company as of Alice's fiscal year end on a slumping economy that had badly beaten the transportation industry. That slump couldn't have come at a better time for Mad Hatter; it played right into his games.

During this same time, Alice was reviewing its credit insurance policies to determine any necessary changes and had a lot of questions for Mad Hatter and March Hare about the company's accounts receivable, all of which were unsatisfactorily answered. Shortly thereafter, Alice terminated March Hare for telling a lie to one of Alice's executives. Given the questions surrounding accounts receivable and the termination of March Hare, Alice's personnel closed the company's accounting records for the previous month and in the process learned from the acquired company's accounting staff that certain accounts couldn't be reconciled. As a result, Alice created a $10 million "suspense" account with a debit balance on the balance sheet and began the investigation. In the end, the international accounting firm declared a "massive financial statement fraud," and required Alice to record an $18 million loss including the write-off of its $10 million goodwill investment in the company.

To determine the mechanics of how the fraud was perpetrated, White Rabbit and members of his team (of which I was a member) used a combination of tools and techniques, including interviews with the company's accounting staff, comparison of documents, data mining and a little luck.

Interviews with the acquired company's accounting staff revealed a host of information. Mad Hatter and March Hare had instructed some of these people to enter false information to the accounting systems and to falsify supporting documentation. Although they questioned these actions, the employees told the investigation team they believed at the time that they were simply obeying their bosses. But they divulged plenty of information during the interviews. They told about the topside journal entries, falsifying supporting documentation, altering bank reconciliations to reach pre-determined cash balances, and re-bucketing within the accounting systems. In many cases, the information gathered in the interviews was the entrance to the maze of determining how the fraud had been perpetrated.

The process of comparing documents didn't require much skill or time, and the information gleaned was invaluable. Simply looking at the differences between an actual bank reconciliation and the corresponding falsified reconciliation revealed exactly what Mad Hatter and March Hare had done to deceive the national accounting firm. We also compared documents to determine how accounts receivable had been manipulated month after month. By comparing the detail given to third parties with the actual sub-ledgers in the accounting systems, we clearly saw the artificial inflation of the numbers and re-bucketing of the agings.

Data mining requires training and experience, but an individual with both forensic and technology skills can provide fruitful results. I was that individual in this case, and my tool of choice was IDEA Data Analysis Software. I mined the accounting databases of the acquired company to extract evidence of claims made during the accounting staff interviews. This included the existence and magnitude of the topside journal entries and the three re-bucketings within the accounting systems. Data mining produced hard evidence of what otherwise may have been considered hearsay or stories concocted by disgruntled or uneducated employees of the acquired company.

My guess is luck plays a role in more fraud examinations than not when examiners stumble upon a critical piece of evidence. In this case, luck definitely played a role with the discovery of the "garage tapes." Earlier I gave an example of how formulas were used to manipulate customer balances in The List attached to the SPA taken directly from the actual Microsoft Excel workbook used to create the document. The author of this document was always in question because of The List's importance and the massive manipulations it contained. Months into the proceeding, the defendants' expert and/or counsel proposed that perhaps someone representing Alice during the acquisition created this document. Of course, that was preposterous, and infuriated many of the people working for Alice. One employee became so angry that he vowed to find the source file for the document. One day he told a friend, who was an ex-employee of the acquired company, about his mission to locate the source file. The ex-employee remembered that when he left the acquired company he had network back-up tapes in his desk drawer that he thought might now be in a box in his garage. Sure enough, he did have the tapes in his garage; and they contained, among other things, the source file that produced The List, which included metadata showing Mad Hatter as the last person to save that file!

The accounting staff interviews were the entrances to the maze of uncovering the fraud. The processes of comparing documents and data mining based on the information we learned in those interviews provided most of the evidence needed to prove the mechanics of the games played by Mad Hatter and March Hare. But I can't say enough for what luck did in this case. Finding the garage tapes may have been the single most fruitful discovery in this case; it provided close to physical evidence that Mad Hatter was the perpetrator of the fraud.

Lessons learned
As students of fraud, we're all aware of the Fraud Triangle, which tells us that in each fraud case we should find three points: 1) pressure 2) opportunity and 3) rationalization. Pressure in this case came at two different times: pre- and post-acquisition. Pre-acquisition, the pressure was a cash crisis the acquired company had been experiencing long before Alice ever came into the picture. The company was in technical default on its loan covenants (loans that Mad Hatter and others had personally guaranteed), had misled the national bank into extending its line-of-credit, and was in default on interest payments due to its non-bank debt holders. The pressure was mounting heavily by the end of 1999, and the courtship of Alice began in early 2000. Post-acquisition, the pressure came from a need to maintain the charade to cover the pre-acquisition fraud and to meet the financial targets required by Alice to preserve the autonomy agreement.

I believe Mad Hatter was the author of the rules of the games played at the tea party. The opportunity for Mad Hatter to play his games came from his responsibility for reporting, both internally and externally, full access to the books and records of the company, and internal controls that he circumvented. Mad Hatter also supervised March Hare and the accounting staff.

Understanding the month-to-month rationalization of the fraud is easy: the fraud in one month was necessary to cover up the fraud in the previous month. Figuring out the rationalization long-term, however, has been a bit of a challenge. With everyone denying a fraud occurred we'll probably never find someone to explain how this mess was to be cleaned up. But, here's what I believe happened. Prior to Alice coming into the picture, Mad Hatter and other executives of the acquired company had been discussing an Internet application that would allow significant expansion of, and improvement to, their service offerings via the Web. They projected the application to make a significant amount of money in comparison to the company's historical record. I believe the executives hoped Alice would spend the money on the new application and the revenue and earnings generation would be significant enough to slowly hide and erase the fraud.

There are other lessons I learned from this case. Each is fairly simple, and had Alice, the international accounting firm, or the national bank been more skeptical in any one of these areas the fraud may have been discovered earlier. These lessons can be divided into two categories: those gained from viewing the circumstances from inside the organization and those from outside the organization.

Here are lessons from inside, say from the perspective of management or an internal auditor:

• Don't put all of your eggs in one basket. The international accounting firm did everything. They audited the acquired company out of one office, and audited Alice and performed the due diligence work out of another office.
• Don't minimize oversight based on financial performance. This is the autonomy agreement, which provided the foundation for Mad Hatter's depiction of the acquired company's monthly financial performance, which was a complete sham, and kept Alice from meddling in the books and records.
• An internal audit function is crucial; don't expect external audit to replace the need for good governance and controls. Alice's involvement from an internal control perspective was almost non-existent so she had very little chance of catching Mad Hatter's circumvention of the controls. The national accounting firm didn't detect the circumvention either, perhaps because the acquired company was immaterial to Alice as a whole.
• Use computer-assisted audit tools. Data mining was used to provide evidence to support the information learned during the accounting staff interviews.
  Here are the lessons from the outside, say from the perspective of a financial statement auditor or bank examiner:
• If it looks like a Microsoft Excel document, it probably is. We were truly amazed at the number of Excel-created documents handed off to the international accounting firm, the national bank, and Alice without anyone questioning the source.
• Understand how numbers end up in financial statements. This coincides with the previous statement; know the source of documents under review especially financial statements.
• Use computer-assisted audit tools. Performing an audit or bank examination includes gaining an understanding of the normal transactions for the company under scrutiny. Using computer-assisted audit tools, tests for data anomalies or non-normal transactions can be designed so the auditor/fraud examiner is testing by exception, rather than by rule. Using this approach can mitigate the risk of not finding the anomalies when using other testing methods.
• Don't rely on management's representations... test them. In this case, there were many false representations made to the national accounting firm, the national bank, and Alice that were never tested for validity. During an audit or examination, management makes a lot of representations, both verbally and in written form. Be sure to see the proof of management's representations.

Awakening to a nightmare
At the end of "Alice's Adventure in Wonderland," Alice awakens and realizes her adventure was just a dream; the craziness wasn't real. In this case, our Alice awakened to the fraud, but the chaos created by Mad Hatter and March Hare hasn't faded with a dream. While drawing inferences from "Alice's Adventures in Wonderland" has been fun, this is still a serious matter. Our Alice has had a costly mess to clean up, followed by the costly pursuit of justice through litigation. Despite our Alice's plight, the story does have somewhat of a happy ending. The arbitrator in the case found in favor of Alice because of the fraud and awarded her damages; however, the arbitrator penalized Alice for not being more involved with the acquired company and for not being aware that something was very wrong at a much earlier point in time by only awarding a portion of Alice's damages. The fate of Mad Hatter and March Hare is yet to be determined.

1. Topside journal entries are high-level entries coded directly into an account but not made either at the module level (i.e., through accounts receivable, accounts payable, inventory, etc.) or at the division or subsidiary level. For example, if payroll is handled by an outside vendor then a topside journal would be required to record payroll for each day period. However, if payroll is handled internally through an integrated system, the entries would automatically post to the general ledger through the payroll module. 

Elizabeth M. Junnell, CFE, CPA, is manager, forensic and litigation consulting for FTI Consulting in Dallas, Texas.