Hog fraud, negligent audit committee, disclosure omissions and more

Welcome to the first chapter of "The ACFE Cookbook," in which we'll examine recent cases and news involving alleged financial reporting fraud. Our focus will be global, so no matter where you are, if you see news of financial reporting fraud, we'd like to hear about it for possible coverage. Send your links, news or information on public reports of alleged fraud to gzack@bdo.com.  — ed.

In this issue, we cover a recent case and the latest chapter in an older case. But first: a case with a twist.

AUDIT COMMITTEE CHAIR CHARGED IN ACCOUNTING FRAUD

It's very unusual for members of a company's audit committee to be charged in connection with a financial statement fraud. The company itself is normally charged and — if any individuals are named — it's usually the CFO, the CEO or some other member of management. However, as audit committees globally continue to take on greater importance and are the targets of increased regulation, we shouldn't be surprised that legal ramifications of fraud are beginning to affect the individuals who serve on these important committees. [See the U.S. Securities and Exchange Commission (SEC) release.]

In March, the SEC alleged that the former audit committee chair of AgFeed Industries Inc. failed to perform his gatekeeper function. AgFeed, which filed for bankruptcy in July 2013, was a publicly traded hog and feed production company with operations in China and the U.S.

The SEC charged four former members of the company's Chinese management team with a $239 million revenue inflation scheme carried out between 2008 and 2010. The scheme involved the use of fake invoices for the sale of feed, the sale of fake hogs, inflating the weights of hogs sold and, as a result, inflating the sales revenues for those hogs — because fatter hogs bring higher market prices.

As AgFeed would record inflated revenues, the company would sometimes also record phony corresponding cost of goods sold to maintain a proper gross margin relationship. However, in some cases, the company apparently made the offsetting entries to construction in progress or fixed assets, falsely inflating those accounts. To keep track of the fraud, AgFeed maintained two completely separate sets of accounting records. The company withheld the accurate set of books (reflecting the lower amounts) from the auditors and U.S. management.

When AgFeed began closing underperforming farms in China, it became necessary to unwind some of the fraudulent transactions in an attempt to avoid detection. To accomplish this unwinding (which was referred to as "digestion," and somehow seems appropriate with a fraud involving hogs), the company made journal entries to reduce the effects of the fraud, which brought the two sets of books closer together. In many cases, the company explained write-offs of the fake hogs as hog deaths because of illness or floods.

But things got even more interesting when AgFeed's then-chair of the audit committee first became aware of the massive fraud in May 2011, according to the complaint. In June 2011, an internal investigation had concluded that fraud took place, which was documented in the form of a memo from in-house legal counsel in China. Yet, according to the SEC, the audit committee chair failed to:

• Disclose the fraud to the external auditors.
• Hire outside investigators to investigate further.
• Take any follow-up actions.

It wasn't until September 2011 that, upon the urging of a new COO, AgFeed announced the formation of a special board committee to investigate the fraud. In December 2011, the company formally announced discovery of the fraud to the public.

In announcing the charges, an SEC official stated that the action is "a cautionary tale about what happens when an audit committee chair fails to perform his gatekeeper function in the face of massive red flags."

Where this case goes from here remains to be seen. Lawyers for the former audit committee chair claim their client was instrumental in having the fraud investigated.

What is becoming clear, however, is that regulators are seemingly beginning to hold audit committees to a higher standard through enforcement actions such as this.

CVS SETTLES DISCLOSURE OMISSIONS AND IMPROPER ACCOUNTING CHARGES FOR $20 MILLION

In April, CVS Caremark agreed to pay $20 million to settle fraud charges stemming from two separate financial reporting issues. (See the SEC litigation release.)

The first arose in connection with a $1.5 billion bond offering in 2009. The SEC claims that in offering documents for the bonds, CVS "fraudulently omitted that it had recently lost significant Medicare Part D and contract revenues in the pharmacy benefits segment. Investors were therefore misled about the expected future financial results for that line of business." When the company ultimately made the disclosure in November 2009, the price of CVS stock fell by 20 percent in a single day.

This is an excellent illustration of the concept that fraudulent reporting can extend well beyond the numbers reported in the financial statements. Disclosures are every bit as important as the financial statements themselves. Key disclosure areas include:

• Descriptions of key accounting principles used in the preparation of the financial statements.
• Additional details about amounts reported as single line items in the financial statements.
• Important information unrelated to any specific line item in the financial statements. 
• Subsequent events: key events that take place after the end of the reporting period.

Each one of these areas has the potential for manipulation. Failure to disclose information that could adversely affect stock price is one of the most common techniques.

The second charge incorporated into the CVS settlement agreement involves improper accounting for the company's October 2008 acquisition of another chain of 525 drug stores called Longs. As the relevant accounting standards require, CVS allocated its purchase price associated with the Longs acquisition among the various assets acquired and liabilities assumed, using the fair values associated with each at the time of acquisition.

The initial allocation was reflected in CVS' 2008 year-end financial statements, as well as those issued for the first two quarters of 2009. However, for the third quarter 2009 financial statements, CVS made an adjustment to the purchase price allocation, reducing the amount allocated to tangible personal property by $189 million and increasing the amount recorded as goodwill by the same amount. In addition, it made a one-time catch-up adjustment to reverse $49 million of depreciation expense that had previously been recorded in connection with the personal property.

The potential incentive here is clear — personal property is subject to regular depreciation charges, which lower profits, while goodwill isn't. Several other financial reporting frauds have involved a similar strategy of over-allocating a purchase price to longer-lived or non-amortizable, non-depreciable assets to preserve the value on a company balance sheet for a longer period of time.

Without going into the details of the accounting standards and CVS' underlying steps, the SEC alleges the adjustments weren't supported and the original allocation should have remained. The SEC has filed a separate complaint against the former retail controller at CVS who orchestrated the scheme. He has settled that case and paid a $75,000 penalty.

ROYAL AHOLD TO PAY $297 MILLION

Amsterdam-based retailer Royal Ahold settled a class-action suit in May for $297 million, which hopefully closes a financial statement fraud saga that has plagued the company for more than 10 years. (See The Wall Street Journal article, Ahold to Pay $297 Million to Settle Class Action Lawsuit, by Maarten Van Tartwijk, May 21.)

Royal Ahold is the name used in the U.S. by Koninklijke Ahold N.V., which operates supermarket chains in several parts of the world.

In 2003, the fraud was discovered in U.S. Foodservice (USF), now known as U.S. Foods, but at the time a wholly owned subsidiary of Royal Ahold. In 2001 and 2002, senior executives of USF engaged in a fraud scheme involving manipulation of promotional allowances received from vendors.

A typical vendor promotional allowance would involve USF committing to purchase a certain minimum quantity of goods from a vendor at agreed-upon prices. In exchange for this commitment, a vendor would agree to pay a per unit rebate of a portion of the original purchase price back to USF, based on an agreed payment schedule. Some allowances were paid as they were earned. However, in connection with multi-year contracts, it was common for vendors to prepay some portion of the projected rebate based on purchase targets.

Well, USF had another target in mind: profitability. And, to meet profitability targets, the company recorded completely fictitious promotional allowances. Company officials fed a series of lies to their external auditors to conceal their scheme. In addition to falsely claiming that promotional allowance arrangements weren't documented in the form of agreements, USF officials rigged the audit confirmation process. Because audit confirmations sent to vendors contained the inflated allowance amounts, USF officials would contact vendors to tell them that the amounts were internal estimates only. In some cases, they even sent side letters to vendors assuring them that they would not be held to the allowance figures included in the audit confirmations.

The Royal Ahold case is one of many we've seen in which perpetrators of financial reporting frauds go to great lengths to conceal their actions from the auditors and fraud examiners. We face immense challenges in designing effective anti-fraud and audit strategies when crooked companies consistently work this hard to break the law.

Gerry Zack, CFE, CPA, CIA, is a managing director in the Global Forensics practice of BDO Consulting, at which he provides fraud risk advisory and investigation services. He's a member of the ACFE Board of Regents and is an ACFE faculty member.