Dipping into the cookie jar

I've always had a sweet tooth, so in this Cookbook, let's bake some cookies! Actually, I'll use two recent cases and one classic older recipe to illustrate the fraudulent financial reporting scheme known as "cookie jar" reserves. This fraud involves unnecessarily setting up liabilities by either accruing excess expenses or deferring revenue that should be recognized.

And once we've baked the cookies, let's eat them! An important characteristic of cookie-jar reserves is their impact on multiple years of financial statements. When a company establishes cookie-jar reserves, it falsely underreports net income for a period. In later years, when management dips into the reserves, it falsely inflates net income (or reduces a net loss).

Companies sometimes employ cookie-jar reserves during periods of strong financial performance as cushions for the inevitable future periods when performance will decline.

Accounting

The legitimacy of reserves like these is covered under the accounting rules for contingent liabilities: the U.S. Generally Accepted Accounting Principles at ASC (the Financial Auditing Standards Board's Accounting Standards Codification) 450 and the International Financial Reporting Standards at IAS 37. Generally, a liability should be recorded in the financial statements only if all three of the following conditions are present:

1. The underlying causal event occurred prior to the balance sheet date.
2. It's probable that a loss has been incurred (i.e. more likely than not, an outflow of resources will be required).
3. A reasonable basis for estimating the loss reliably exists.

The absence of any one of the three precludes recognition of a liability. And fraudsters can manipulate any of the three. However, the second criterion is the most subjective, which makes it the most likely candidate for fraud. Companies shouldn't record obligations that are merely possible or potential — not probable.

Bankrate Inc.

The first case of cookie-jar reserves comes from a September 2015 U.S. Securities and Exchange Commission (SEC) enforcement action against Internet-based consumer banking and personal-finance network company Bankrate Inc.

The company's CFO reviewed Bankrate's preliminary financial results for the second quarter of 2012 and saw that they fell short of investment analysts' expectations, so he directed two divisions to book $800,000 of additional revenue with no basis or support. Bankrate employees in these divisions reluctantly complied. One division recorded $476,000 of phony revenue, but the second division refused to record any additional revenue without justification. So the CFO directed the company's vice president of finance to make up the difference by recognizing revenue to Bankrate's core financial statement. The VP complied by doubling revenue recognition of two customers — to the tune of another $305,000.

It's clear they each knew that what they were doing was wrong. This excess accrual resulted in a cookie jar of about AUD $1 million.

He directed one of Bankrate's accountants to reduce a liability that had been accruing for "Search Engine Marketing" expenses by $400,000. The CFO had been unnecessarily accruing expenses to this account since at least early 2011, so he knew exactly where to go when he needed to increase company profits in 2012.

Computer Sciences Corporation

The second recent cookie jar example involves Computer Sciences Corporation (CSC). The SEC announced this case in June 2015. Much of this wide-ranging example involves accounting fraud in connection with a contract CSC had in the U.K. with the National Health Service. However, the company raided the cookie jar in Australia.

Two employees at CSC's Australian subsidiary stored huge stacks of cookies during a very successful year in FY 2008 because they knew that future budget shortfalls were inevitable. They targeted four areas for their cushion. First, they over-accrued expenses for gift cards that the company gave out for employee recognition purposes. According to the SEC, one said to the other in an email, "while it's likely we'll pay [AUD] $150 per employee, we have booked an accrual equivalent to [AUD] $350 per employee, largely as a mechanism to carry forward a provision into FY09." With statements like this, there's no room for attributing the excess accrual to a mistake in judgment or poor estimating. It's clear they each knew that what they were doing was wrong. This excess accrual resulted in a cookie jar of about AUD $1 million.

They also built up excess reserves in accounts related to employee bonuses (AUD $590,000) and a corporate restructuring (AUD $1.65 million). The company never paid the bonuses, and it didn't even document the supposed restructuring in the form of a plan, which is a requirement under ASC 420 as a condition for recording a termination reserve.

The fourth area in which excess accruals were built up in 2008 involved inflating labor-cost accruals associated with fictitious training costs. This category alone resulted in an AUD $5.4 million cookie-jar reserve for the company's use.

CSC tapped into each of these cookie jars when they needed to boost earnings in the first quarter of FY 2009. The company released AUD $5.4 million of excess labor accruals, AUD $1 million associated with the gift cards and most of the excess bonus and restructuring accruals. Without dipping into its cookie jar, CSC would've missed analysts' earnings targets for the quarter.

The CSC case involves a variety of additional interesting accounting and disclosure frauds. I'll cite the CSC case again in an upcoming column on a different type of financial statement fraud — just like my own cookie jar of fraud cases for future use! But for those of you who can't wait, read the SEC enforcement action.

Beazer Homes

No cookie recipe is complete without a nod to one of the best cookie bakers ever: Beazer Homes USA Inc. A 2009 SEC complaint outlines a lengthy and deliberate scheme to fraudulently "manage" the earnings of this builder of homes.

Like many homebuilders, Beazer enjoyed a period of strong financial performance during the years of the housing boom in the early 2000s, followed by a period of gradual and then steep decline. From 2000 through 2005, Beazer's chief accounting officer (who held the title of corporate controller during the earliest periods) fraudulently decreased Beazer's reported net income. Beginning in 2006, as the company's financial performance began declining, he began raiding the corporate cookie jar.

Beazer had two varieties of cookie jars. The first involved land inventory accounts. Costs of acquiring and developing land accumulate in these accounts as assets of the company. As the company sells homes in a development, it removes from the account an allocation of costs attributable to each home. In theory, after the company sells the final home in a development, the account balance should be zero.

However, Beazer significantly over-allocated costs removed from the account as it sold homes. This negative balance in the land inventory accounts effectively resulted in a reserve — a liability — for certain developments. It started small (about $900,000 in the first quarter of FY 2000) and gradually increased (to about $5 million per quarter in FY 2005).

Like the CSC case, Beazer officials left an email trail that clearly indicates that these excess allocations were intentional — not just some accident or erroneous estimate. In one email, the company's chief accounting officer instructed the Florida division to provide "more than adequate land allocations in communities closing out this year." In another message, which he sent to several divisions, he writes, "[s]et aside all the reserves you reasonably can … the quarter is too high." He then told each division what their individual net earnings should be lowered to.

When things turned bad for Beazer in 2006, it raided the cookie jar. It started slowly, just $100,000 and $301,000 in the first two quarters of FY 2006. But by the third quarter, Beazer reduced these phony reserves by more than $14 million, followed by another $10.8 million in the fourth quarter. Once again, a string of email messages document the chief accounting officer's directions to reduce these reserves.

The second type of cookie jar Beazer established involved reserves for the cost to complete homes. As is customary in the industry, Beazer typically would reserve a portion of the profit earned on the sale of a home in a "house cost-to-complete" liability account, which would cover any unknown costs Beazer might incur after the sale closes, such as minor repairs and cosmetic touchups.

Beazer's transgressions weren't as egregious as the land inventory accounting fraud, but it did overestimate the cost-to-complete reserves in most of the quarters of FY 2000 through 2005. In FY 2006, the reversal of these reserves began with just $183,000 in the first quarter and nothing in the second. But in the third quarter, reversals of inflated reserves amounted to $2.1 million, and in the fourth quarter it was $209,000. The company reversed a final $1.5 million in the first quarter of 2007.

Understating profits is also fraud

Whether it's just human nature, auditors' supposedly conservative nature or some other attribute, it seems somehow like less of an offense — and in some cases even acceptable — to underreport earnings using inflated reserves. Who would argue with a company's defense that it wants to establish reserves to be on the safe side and just wants to assure the company is adequately protected?

However, intentionally understating profits is no less of a fraud than inflating them. It's just that it becomes much clearer that the former took place when the latter becomes apparent.

I'm always looking for recent cases and news involving alleged financial reporting fraud around the globe. Please email me your links, news or information on public reports of alleged fraud.

Regent Emeritus 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 an ACFE faculty member and was the 2015 chair of the ACFE Board of Regents. His email address is: gzack@bdo.com.