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Uncovering Financial Statement
Fraud: A Case Study
An Acquisition in Wonderland?Presented by Carolyn Newman,
Audimation Services, Inc.
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The Acquisition
• Purchaser
– privately held company
– sophisticated management
– national and international presence
• Seller
– small business in the transportation industry
– owned principally by an investor group
– managed by minority owners
The Situation• Company was fully advanced on $3 million line of credit;
-Technically in default on covenants
- Default on interest payments
• CFO
- Lied to National Bank about true amount of collateral
- Misled National Bank to extend line of credit to $5 million
- Was a minority owner (along with other executives)
- Made personal guarantees to National Bank and investor group
• Investor Group
- Loaned $7 million
- Advanced an additional $1.8 million through December;
• Courtship of Purchaser began in January, closed in May
• Arbitration proceedings began less than a year later
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Defendant’s “Expert’s” Findings
• Detected method of manipulation for the
pre-acquisition accounts receivable
• Provided exhibits documenting the method
• Dismissed the apparent fraud as
correcting the detail for “system problems”
and “human error”
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Passage from Plaintiff’s Expert Witness Report
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…
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How Did It Get To This Point?
Purchaser
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Mad Hatter and March Hare’s
Tea Party
CFOController
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Games at the Tea Party:
Fraud Schemes to Overstate Income
1.Use of formulas to artificially inflate accounts receivable
2.Manipulation of customer accounts receivable balances
3.“Rebucketing” of accounts receivable
4.Use of “credit to clear” process to secretly write off uncollectible accounts receivable
5.Use of unsupported topside entries to manipulate the general ledger and financial statements
6.Understatement of liabilities
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Effects of the Tea Party
Pre-
Acquisition
September
At Acquisition
May
(8 Months Later)
At Fiscal
year-end
(10 Months
Later)
Methods of Overstating Financial
Statements:
Understated liabilities 1,500,000 2,750,000 4,750,000
"Credit to clear" 300,000 1,200,000 -
Uncollectible accounts receivable - - 3,000,000
Fictitious accounts receivable 1,200,000 1,550,000 2,400,000
3,000,000 5,500,000 10,150,000
Increase in fraud as of the acquisition 2,500,000
Increase in fraud from acquisition until discovery 4,650,000
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The Game:
Using Formulas
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The Game:
Manipulating Accounts Receivable
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Accounts Receivable: Manipulation
Through Use of Formulas
• Downloaded actual accounts receivable
detail to MS Excel
• Individual accounts inflated through
application of percentage increases
• Manipulated until detail AR total supported
AR balance derived from the financial
statement formulas
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Arbitration
Alice vs. Cheshire Cat, et al
Discrepancies in Reported Accounts Receivable as of November 30 (Post-Acquisition)
0 to 30 Days 31 to 60 Days 61 to 90 Days Over 90 Days Total
Amounts reported to
Alice $ 11,212,388 $ 1,596,347 $ 80,457 $ - $ 12,889,192
Compared to
amounts reported in
subledgers:
- Division A 772,574 85,754 93,493 911,680 1,863,501
- Division B
Component 1 5,043,961 573,159 161,066 191,834 5,970,020
Component 2 739,143 739,143
6,555,678 658,913 254,559 1,103,514 8,572,664
Difference $ 4,656,710 $ 937,434 $ (174,102) $ (1,103,514) $ 4,316,528
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-
500,000
1,000,000
1,500,000
2,000,000
2,500,000
3,000,000
3,500,000
4,000,000
4,500,000
5,000,000
p-aug p-sep p-oct p-nov p-dec p-jan p-feb p-mar p-apr a-may a-jun a-jul a-aug a-sep a-oct a-nov
Effects over Time of AR Manipulation Game
Post-acquisition period
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The “Rebucketing” Game
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The “Credit to Clear” Game
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Arbitration
Alice v. Cheshire Cat, et al
Monthly Reporting for Credit-to-Clear Customers
Customer Name
Peachtre
e Sub-
Ledger
p-Mar
Per "the
List“p-Mar
Reported
to Alice
and
National
Bank
p-Apr
Reported
to Alice
and
National
Acct'g
Firm
a-May 11
Reported
to Alice
a-May
Reported
to Alice
a-Jun
Reported
to Alice
a-Jul
%
Increase
from
a-Jun
to a-Jul
Credit-
to-Clear
through
a-Aug
Reported
to Alice
a-Aug
Age (in
Days) of
Last
Invoice
Credited
Absolute Transport 17,635 20,677 0 17,635 17,635 17,635 22,573 128% 17,635 0 204
CSD Transport.
Inc. 10,330 13,929 0 10,330 10,330 10,330 13,222 128% 10,330 0 903
Freight Express
Inc. 23,720 31,983 0 23,720 23,720 23,720 30,362 128% 23,720 0 459
Gregory Trucking
Inc. 61,311 0 0 0 0 61,311 0 61,311 0 911
Judah Enterprises 14,399 19,415 0 14,399 14,399 14,399 18,431 128% 14,399 0 483
Rex Transportation 22,462 30,287 0 22,462 22,462 22,462 28,752 128% 22,462 2,049 518
Sureway Transport 72,383 0 0 0 0 72,383 0 72,383 0 937
Westerfield
Transport 28,689 37,627 5,212 31,753 31,753 36,096 46,202 128% 36,096 0 135
TOTALS: 898,528 1,059,028 64,529 783,935 788,250 934,288 989,284 909,899 13,364
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The Game of Understating
Liabilities
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The Topside Entries Game
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Mr. Expert’s Admission
He is unable to find supporting documentation:
Debit Entries = 45%
Credit Entries = 38%
Equates to:
Debit Entries = $400 million unsupported
Credit Entries = $350 million unsupported
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King of Hearts Got It Right
“Topside entries are neither immoral or
illegal if properly supported. If they’re
not properly supported, they’re bad.”
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Things Got
“Curioser and Curiouser”
Uncovering the Fraud
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Autonomy Agreement
• Alice agreed to minimize oversight of Acquired Company as long as certain financial targets (EBITDA based) were met
• Monthly reporting packages indicated all targets were being met
• First indication that targets would not be met came 10 months after acquisition
• Explained to be a result of slumping economy and industry… everyone in the industry was having a difficult time
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Events Leading to Discovery
• Alice has a lot of questions about A/R
• Mad Hatter & March Hare are terminated
• Accounting staff inform Alice that certain accounts can not be reconciled
• $10 million “suspense” account is created
• White Rabbit is engaged to take a look
• National Accounting Firm called in to re-audit financial statements for several periods
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Fraud Investigation Tools
Uncovering the Mechanics of the Fraud
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Accounting Staff Interviews
• Topside entries
• Falsification of supporting documentation
• Altering bank reconciliations to achieve
pre-determined cash balances
• 3rd Re-Bucketing
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Data Mining
• From transactional/accounting databases
• Used to extract evidence of claims made during staff interviews:
– Existence and magnitude of topside entries
– 1st, 2nd and 3rd Re-bucketings made within the accounting systems
– “Credit-to-clear” transactions
– Age of actual invoices written off through “credit-to-clear”
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Application of the Fraud Triangle
Pressure, Opportunity and
Rationalization of Defrauding Alice
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PressurePre-acquisition: Cash crisis, staying out of trouble
with the bank
Post-acquisition: Maintaining the Lie:
i. To cover tracks of the pre-acquisition fraud
(including bank fraud)
ii. To meet financial targets required by Alice
in order to preserve the autonomy
agreement
- Keep Alice from meddling in the
books
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Opportunity
Ease of Manipulation
i. Mad Hatter was an owner of Acquired Company
i. Personal guarantees on debt
ii.Full access to books and records
iii.Responsibility for reporting to National Bank, National Accounting Firm and Alice
ii. March Hare did what he was asked, and didn’t ask questions
iii. Employees of March Hare did as asked, without asking questions
Autonomy Agreement
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Rationalization
It Will All Be OK:
• Fraud in one month perpetuated fraud in next month
• Mad Hatter had a business idea that needed Alice’s money to get up and going
• Once up and going it would generate positive earnings enough to slowly “bleed off” the fraud
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Lessons Learned – Internal
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Lessons Learned – Internal
• Don’t put all the “eggs in one basket”
• Don’t allow personal guarantees to minimize due diligence work
• If it sounds like an excuse, it probably is
• Don’t minimize oversight based on financial performance
• An internal audit function is crucial; don’t expect external audit to replace the need for good governance and internal controls
• Use computer assisted audit techniques
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Lessons Learned – External
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Lessons Learned – External
• If it looks like an Excel document, it probably is
• Don’t let immateriality override fraud indicators
• Understand how numbers end up in the financial statements
• Talk to the accounting staff, not just the CFO and Controller
• Perform basic audit procedures effectively
• Use computer assisted audit techniques
• Do not rely on management representations… test them
Top-Side Entry Analytical Test
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POST_MONTH NO_OF_RECS AMOUNT_SUM DEBIT_SUM CREDIT_SUM
1 410 0.00 882159.96 882159.96
2 339 0.00 618704.63 618704.63
3 324 0.00 994848.60 994848.60
4 323 0.00 338068.58 338068.58
5 315 0.00 268598.01 268598.01
6 345 0.00 427479.03 427479.03
7 284 0.00 348951.38 348951.38
8 288 0.00 381291.56 381291.56
9 433 0.00 873683.75 873683.75
10 245 0.00 582472.84 582472.84
11 321 0.00 1312782.71 1312782.71
12 374 0.00 1207927.32 1207927.32
Great Analytics for Detecting Financial
Statement Fraud
• Summarizing Transactions to Find
Anomalies
• Transactions on Weekends
• Benford’s Law Analysis
• Round Numbers
• Searching for Odd Descriptions
• Comparing Files
Summarizing Transactions
to Find Anomalies
Transactions on Weekends
Benford’s Law Analysis
Round Numbers
Search for Odd
Descriptions/Comments
File Compare
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Questions
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Summary
• “Fraud is not an
acceptable accounting
practice.”
– C. R. Vance, Jr.
• “Internal Audit…the
coolest profession in
the world.”
– Tom Peters at 2013
IIA Conference.
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The End
The King of Hearts
Says….
“Begin at the beginning
and go on till you come
to the end…..then stop.”
So I will.
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