The many recipes for financial statement fraud

This will be my final edition of the ACFE Cookbook. I'll be working on developing periodic feature articles on hot topics. Since it's the last one, rather than profile specific cases — my usual practice — I'd like to focus on some trends in financial statement fraud I've observed from recent enforcement actions.

In the ACFE's two-day seminar, Financial Statement Fraud, we explain that we can classify the numerous methods of cooking the books into five broad categories:

• Fictitious revenues.
• Timing schemes, involving either revenue or expenses.
• Asset valuation schemes.
• Underreporting of liabilities or expenses.
• Disclosure schemes.

As I've pointed out before, studies — such as the COSO report I've previously cited, Fraudulent Financial Reporting 1998 – 2007: An Analysis of U.S. Public Companies — have indicated that the majority of financial statement frauds have traditionally involved revenue recognition, usually in the form of either fictitious revenue or early revenue recognition. And many of the cases I've written about in this column have involved manipulation of amounts reported for revenue in the financial statements.

However, times are changing, and the face of financial reporting fraud is also changing. Fraudsters are using more diverse methods (and reasons) to manipulate financial statements.

Trends in enforcement actions

From Jan. 1, 2016, through Sept. 30, 2016, the U.S. Securities and Exchange Commission (SEC) issued 82 Accounting and Audit Enforcement Releases (AAERs), according to a Floyd Advisory analysis of these AAERs.

Forty-one of these AAERs involve Rule 102(e), which authorizes the SEC to discipline professionals if it finds that they've engaged in "improper professional conduct," among other grounds.

Those violators of Rule 102(e) in AAERs are often former chief financial officers or other senior officials of companies, but they might also be company auditors. Accordingly, many of these so-called Rule 102(e) AAERs involve financial reporting fraud or other misstatements in financial statements. [For an excellent and more detailed explanation of Rule 102(e), see Law and Practice Under Rule 102(E), by Gregory G. Ballard, Kevin A. Burke and Neil D. Corcoran, The Review of Securities & Commodities Regulation, Aug. 19, 2015.]

Another 16 of the SEC's AAERs involve the Foreign Corrupt Practices Act (FCPA). As I explained here in the September/October 2015 issue, the U.S. Department of Justice (DOJ) investigates charges of illegally paying bribes in violation of FCPA, but the SEC enforces the books and records provisions of FCPA. So, AAERs dealing with FCPA focus on companies' failures to properly account for — or failing to maintain internal controls in connection with — bribes attributable to a company.

What's notable about the 16 FCPA-related AAERs issued in the first nine months of 2016 is that this number already easily surpasses the four total AAERs involving FCPA for all of 2015. Clearly, the DOJ and the SEC have been strongly focusing on FCPA matters.

Floyd Advisory's quarterly and annual analyses of SEC AAERs also classify the financial reporting issues addressed in relevant AAERs. This provides a high-level overview of where financial reporting manipulation is taking place in the financial statements. I'll use this analysis as my starting point for further discussion of emerging trends.

Of the AAERs involving financial reporting issues, 48 of them pertained to manipulation of — or errors in — companies' balance sheets. However, since most accounting manipulations affect both income statements and balance sheets, the focus of many cases might have begun on income statements with companies' desires to improve reported profits.

Indeed, 53 AAERs involved misstatements or fraud involving income statements. And this is where things get interesting. Thirty-four of these 53 AAERs involved misstatements of expenses while just 19 pertained to revenue recognition — a shift from the traditional assumption that most schemes involve revenue recognition. And this shift isn't unique to 2016; AAERs issued in 2015 with expense misstatements also outnumbered those involving revenue.

Types of SEC Accounting and Audit Enforcement Releases (Floyd Advisory. These AAERs aren't accumulative; because of overlap within the categories, the total is 82 AAERs for the nine-month period.)

Whether the expense misstatement AAERs were primarily motivated more by an attempt to manipulate income statements or balance sheets (or both) is irrelevant to the broader issue — that financial reporting schemes (and errors) are quite diverse. Assuming that revenue recognition is the only area of risk would be a major mistake.

Regardless of whether balance sheet accounts were the focus of the misstatements or the effect, certain areas of the balance sheet have been cited in numerous AAERs over the last few years:

• Fair value measurements of certain assets.
• Failures to impair carrying amounts of loans and other assets.
• Underreporting of liabilities.
• Inventory inflation schemes.

In looking back at two years of cases I've profiled in this column, as well as many additional cases I reviewed but didn't use, I've easily found numerous examples in each of these four preceding categories and others.

Fair value measurements

Certain assets and liabilities are carried in the financial statements at fair value on a recurring basis, which means that as the value goes up or down, the basis of the asset or liability also is adjusted.

Many other assets are subject to downward adjustments (impairments) when fair value declines below cost but not upward adjustment if fair value exceeds cost. In either case, the measurement itself of fair value can be subject to manipulation. In these cases, the erroneous fair value often stems from one or more of the following:

• Using a measurement model that isn't appropriate for the asset being measured.
• Including incorrect assumptions when applying the valuation model (e.g. using a longer period of assumed future cash flows).
• Omitting important information from consideration (e.g. condition or value of collateral supporting a loan value).
• Clerical errors or intentional manual overrides of calculations.
• Hiding information from independent appraisers or using appraisers that have conflicts of interest.

Asset impairments

Many asset impairment schemes also involve one or more of the fair value measurement issues listed in the preceding section. For example, a company might recognize that an impairment loss has been incurred, but it understates the amount of the impairment because it manipulated the fair value calculation.

However, additional schemes might involve situations in which a company is aware of the signs that it has incurred an impairment, but it willfully ignores these signs and therefore doesn't perform a calculation of fair value.

This category of scheme is associated with assets that don't require an impairment assessment (and the resulting calculation of fair value) unless specific triggering conditions are present. For example, accounting standards require that companies treat many intangible assets this way. So, if a company ignores the existence of these triggering conditions, it then avoids performing a calculation of fair value and doesn't record any impairment losses.

Liability issues

The fraudulent financial reporting issues associated with liabilities fall simply into two broad categories:

• Omitting a liability from the balance sheet.
• Understating a liability that's recognized in the balance sheet.

Liability omissions are most commonly associated with contingent liabilities (obligations that are created when specified events occur), guarantees, conditional asset retirement obligations (liabilities a company will incur when certain triggering events occur in connection with an asset it owns, such as asbestos abatement when selling or demolishing a building) and a few others. Improper measurement of liabilities, which result in an understatement, is most commonly associated with deferred revenue (with the corresponding effect of revenue inflation), but might also be found with certain pension liabilities (such as those that are estimated based on actuarial studies) and other accruals.

Inventory inflation

As I reported in the November/December 2016 column, inventory inflation schemes come in many sizes and shapes.

Most of these schemes fall into one or more of these categories:

• Failing to write off obsolete inventory or items whose values are below cost.
• Cut-off schemes, in which dates of incoming or outbound shipments of inventory are manipulated to make it appear that more inventory is on hand at year-end.
• Physical inventory schemes, such as padding of boxes and containers to make them appear to be full in order to count and include them in year-end inventory balances.
• Improper costing of inventory.
• Manipulation of work-in-progress calculations and documentation by manufacturers.

Disclosure risks

Disclosure fraud is a category of financial reporting fraud that has emerged as an important risk but which research studies rarely track separately. Companies provide disclosures in the footnotes to their financial statements and other reports, press releases and documents.

Companies can commit disclosure frauds in two ways:

• Providing inaccurate or otherwise misleading information.
• Omitting important information.

Inaccurate disclosures can range from statements that are simply wrong to those specifically designed to confuse readers by describing transactions or activities using overly complex sentence structure or lots of technical jargon.

Common examples of omitted disclosures include:

• Transactions with related parties (e.g. sales to — or purchases from — unconsolidated affiliates, loans, etc.).
• Important subsequent events (those events that occur after the close of the financial reporting period but before the issuance of the financial statements, such as the termination of an agreement with an important customer).
• Covenants that must be complied with for loans and other financing arrangements — violations of which would put the debt in default.
• Material commitments, obligations and certain contingencies.
• Areas in which material estimating was required in the measurement of amounts reported in the financial statements.

The list of possible disclosure frauds is a long one. Investment analysts, lenders, bankers, regulators and many others rely heavily on these disclosures in evaluating companies. As a result, this is another area that's ripe for manipulation.

Motives behind financial statement fraud

Traditionally, the reasons that companies commit financial statement fraud have most commonly involved a desire to achieve certain targets for:

• Gross revenue.
• Net income.
• Earnings per share.
• Current ratio or other measures of liquidity.

However, in recent years, more complicated reasons behind financial reporting schemes have emerged. In an article I wrote for the September/October 2016 issue of Fraud Magazine ("When do non-GAAP metrics become fraudulent publicity?"), I explained one of the most important of these new reasons: non-GAAP performance measures.

If you look at the quarterly or annual earnings releases, guidance on future periods, explanations of key results and press releases, you're more likely than ever to see an emphasis on metrics that don't appear in companies' financial statements.

These non-GAAP measures — designed to provide additional insight into companies' operations — might or might not be derived from GAAP figures. But a company gets to decide which of these measures to disclose and even how to name and calculate it.

The SEC and other regulators around the world have taken notice of this trend. But the use of these measures is likely to continue to increase as will the corresponding risk of fraud. This is an important one to watch.

Signing off

I've thoroughly enjoyed writing this column for you. I hope it was useful. Fraudsters have more ways than ever to cook the books, and CFEs need to be diligent in monitoring and investigating the financial and nonfinancial reporting of companies.

At one time, we thought financial reporting fraud didn't have a lot of variety. But now this couldn't be further from the truth.

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 also was the 2015 chair of the ACFE Board of Regents. His email address is: gzack@bdo.com.