Anatomy of Financial Statement Fraud

GURUPRASAD V
B. Com, ACA, ACMA,ACS, CMA(USA), MIPA(Australia), ACSI (UK)
Associate Member-ACFE(USA)

September 03, 2014

The Institute of Chartered Accountants of India, Bangalore Branch

Anatomy of Financial Statement Fraud

Objectives
Introduce to the attendees what is Financial Statement Fraud
Types of Financial Statement Fraud
Why do CEOs CFOs commit Financial Statement Fraud
Three methods of committing Financial Statement Fraud
Anatomy of Financial Statement Fraud and their Red Flags

Cases on Financial Statement Fraud

Anatomy of Financial Statement Fraud

What do these entities share in Common?
ENRON CORPORATION U.S.A
XEROX U.S.A
ADELPHIA COMMUNICATION CORPORATION U.S.A
SINO FOREST CORPORATION - CHINA
SATYAM COMPUTER SERVICES -INDIA
REEBOK INDIA- INDIA
OLYMPUS CORPORATION -JAPAN
WORLDCOM INC U.S.A
HEALTHSOUTH CORPORATION U.S.A
TYCO INTERNATIONAL LTD - SWITZERLAND
HEATH INTERNATIONAL HOLDINGS INSURANCE LTD AUSTRALIA
BOND CORP - AUSTRALIA
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Anatomy of Financial Statement Fraud

Companies Act 2013
Sec 447
Any person who is found to be guilty of fraud shall be punishable with
imprisonment for a term which shall not be less than 6 months but
which may extend to 10 years and shall also be liable to fine which shall
not be less than the amount involved in the fraud but which may extend
to three times the amount involved in the fraud.
Sec 448
if in any return, report, certificate, financial statement, prospectus,
statement or other documents required by, or for, the purpose of any
provisions of this Act or the rules made there under, any person makes a
statement,- a) Which is false in any material particulars, knowing it to
be false, or b) Which omits any material fact, knowing it to be material,
he shall be liable under Sec 447.

Anatomy of Financial Statement Fraud

What is Financial Statement Fraud?
As per the Association of Certified Fraud Examiners, U.S.A

It is deliberate misrepresentation of the Financial

condition of an enterprise, accomplished through the
intentional misstatement or omission of amounts or
disclosures in the financial statements to deceive
financial statement users.

Anatomy of Financial Statement Fraud

Types of Financial Statement Fraud
It involves mainly
Fictitious Revenues being recorded
Improper Assets Valuation

Overstatement of revenues and gains

Overstatement of Assets

Concealing of Liabilities and Expenses

Understatement of Liabilities and

Expenses

Timing Differences

Cut- off fraud

Improper Disclosures
Overstatement of Operating Cash flows

Anatomy of Financial Statement Fraud

Why do CEOs, CFOs Commit Financial Statement Fraud

The Business Owners, CEOs, CFOs generally Cook the

Books and Bake the Ledgers for the key reasons like:
To Conceal true business performance either to
overstate or understate results of the Organisation.
To preserve personal status Senior people with
strong egos may not be willing to admit that their
strategy has failed.
To maintain personal wealth/income- To protect
the existing Salary, Stock options, Commission, Bonus
etc.
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Anatomy of Financial Statement Fraud

Three methods
1. Playing with the Accounting System as a tool

2. By-passing the Accounting System

3. Going beyond the Accounting System

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Overstating Revenues and Gains

Income Statement

Revenues

- Expenses

+ Gains

- Losses

= Earnings

Understating Expenses and Losses

Income Statement

Revenues

- Expenses

+ Gains

- Losses

= Earnings

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Balance Sheet Impact

Assets =

Liabilities

+
Owners Equity

Assets =

Liabilities

+
Owners Equity

Assets =

Liabilities

+
Owners Equity

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Anatomy of Financial Statement Fraud

Fictitious Revenue
Fabricated revenues involves recording of sale of goods and

services that did not happen.

It not only involve fake or phantom customers but also can

involve legitimate customer by preparing a fictitious invoice.

At the beginning of the accounting year, the year end sale is

reversed to help conceal the fraud, but this may lead to a revenue
shortfall in the new accounting year, creating a need to more
fictitious sales.

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Anatomy of Financial Statement Fraud

Red Flags of Fictitious Revenue
Recurring negative cash flows from operations or
inability to generate cash flow from operations while
reporting earnings and earnings growth.
Unusual increase in the number of days sales receivable.
A significant volume of sales to entities whose substance
and ownership is unknown.
Significant transactions with related parties or special
purpose entities or with those entities that are not audited.
Rapid growth or unusual profitability compared to other
entities in the same industry.
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Anatomy of Financial Statement Fraud

Improper Assets Valuation
Manipulation of Inventory valuation is done by:
failing to write down to its current value as per Accounting Stds
manipulating physical inventory count
inflating the unit costs used to value inventory
Creating fictitious inventory by creating fake documents like

Receiving reports, inventory count sheets.

Manipulation of Accounts Receivable balance is done by:

recording fictitious receivables
failure to write off bad debts deliberately
failure

to provide adequate provision

receivables.

for doubtful

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Anatomy of Financial Statement Fraud

Red Flags of Improper Assets Valuation
Recurring negative cash flows from operations or inability
to generate cash flow from operations while reporting
earnings and earnings growth
Significant decline in demand for products and increasing
business failures in either the industry or due to recession.
Unusual increase in gross margin or margin compared to
peers.
Unusual growth in the number of days purchases in
inventory and/ or in the number of days of sales in
receivables
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Anatomy of Financial Statement Fraud

Concealed Liabilities and Expenses

With relatively little effort, pre-tax income will increase by full amount of the
expense or liability which has not been recorded.
Easier to commit than falsifying many sales transactions.
Common methods for concealing Liabilities and Expenses are:
1. Liability/expense omissions
2. Capitalised expenses
3. Expensing Capital Expenditure
4. Either failure to record or understate the warranty costs and liabilities

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Anatomy of Financial Statement Fraud

Common Red Flags in Concealed Liabilities and
Expenses
Recurring negative cash flows from operations or inability

to generate cash flows from operations while reporting

earnings and earnings growth.
Unusual increase in gross margin or margin compared to
peers.
Unusual reduction in the number of days purchases remain
in Creditors account.
Allowance for Sales Returns, warranty claims etc are
shrinking in % terms or are otherwise out of line with peers.
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Anatomy of Financial Statement Fraud

Timing Differences
It involves recording of revenue/expenses in improper periods.
This is done by shifting revenues or expenses between one period
and the next, increasing or decreasing earnings as desired.
Premature recognizing of revenue in violation of Accounting
Standards.
Manipulating the percentage of completion and the estimated
costs to complete a construction contract to recognize revenue
prematurely and conceal contract overruns in the case of Long
Term Contracts.
Recording expenses in the wrong period due to pressures to meet
budget projections and goals or due to lack of accounting
controls.

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Anatomy of Financial Statement Fraud

Common Red Flags in Timing Difference
Recurring negative cash flows from operations or inability to
generate cash flows from operations while reporting earnings and
earnings growth.
Unusual increase in gross margin or margin compared to peers.
Significant, unusual or highly complex transactions especially
close to accounting period end that pose difficult substance over
form questions.
Unusual growth in the number of days sales in receivables.
Unusual reduction in the number of days purchases in accounts
payable.
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Anatomy of Financial Statement Fraud

Improper Disclosures
Management has an obligation to disclose all significant

information appropriately in the financial statement and in the

Management Discussion & Analysis. Further it should not be
misleading.
Improper Disclosures relating to financial statement usually

involve:
1. Liability omissions
2. Subsequent Events
3. Related Party transactions
4. Management Fraud
5. Accounting changes
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Anatomy of Financial Statement Fraud

Common Red Flags in Improper Disclosures
Domination of management by a single person or small group.
Ineffective Board of Directors or Audit Committee oversight over the

financial reporting process and internal control.

Ineffective communication, implementation or enforcement of the

entitys value or ethical standards by management. Absence of tone at

the top.
Significant, unusual or highly complex transactions especially close to

accounting period end that pose difficult substance over form questions.
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Anatomy of Financial Statement Fraud

Common Red Flags in Improper Disclosures
.. Continued

Overly complex organisational structure involving unusual legal

entities or management lines of authority.

Excluding certain company-owned units in consolidation so as to

improve reported earnings.

Significant related party transactions not in the ordinary course

or with related parties not subject to audit

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Anatomy of Financial Statement Fraud

OVERSTATEMENT OF OPERATING CASH FLOWS
A company may try to make itself better by classifying cash

receipts as operating activities instead of financing or

classifying cash payments as investing rather than
operating.
A company may borrow money using Debtors as a
Collateral and report this as Operating instead of
Financing.
It may also classify a normal operating expenditure as a
Capital Expenditure.
In this manner, operating cash flow is overstated and
investing cash flow is understated.
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Anatomy of Financial Statement Fraud

DISCUSSION ON REAL CASES OF FINANCIAL STATEMENT FRAUD

SATYAM COMPUTER SERVICES LIMITED India

OLYMPUS CORPORATION - Japan

WORLDCOM INC U.S.A

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Satyam Computer Services Limited

In Million US $

31, March
2008

31, March
2007

% Change

Revenue

2138.10

1461.40

46%

Trade ReceivableShort Term (a)

598.80

396.10

51%

Trade ReceivableLong Term (b)

38.20

21.20

80%

Unbilled Revenue (c )

81.50

38.60

111%

Bank Deposits (d)

894.80

782.70

14%

Total (a+b+c+d)

1613.30

1238.60

374.70%
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Satyam Computer Services Limited

According to the United States Securities Exchange

Commission law suit, SCS Ltd overstated revenue
by US$430.4 million in FYE March 31,2008.
90% of reported Cash and Bank Balance did not
exist.
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Anatomy of Financial Statement Fraud

Satyam Computer Services Ltd Ramalinga Raju on
January 7,2009 made shocking disclosure to the Board of
Directors of Satyam that the financial statement
contained:
o Inflated Cash and Bank Balance of Rs.50.4 Billion,
o Non-existent accrued interest of Rs.3.76 Billion,
o An understated liability of Rs.12.30 Billion on

account of funds arranged by Raju.

o An overstated Debtors position of Rs.4.90 Billion.

Ramalinga Raju
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Anatomy of Financial Statement Fraud

Olympus Corporation Japan
Olympus Corporation founded in 1919 is a Japanese manufacturer of
camera and medical imaging equipment.
Olympus incurred significant financial losses, which ballooned between
1997 and 1998.
It kept the loss off its own book by transferring financial assets that had
declined in value to special purpose entities that were not consolidated
in Olympuss Financial Statement.
Special purpose entities accounted these financial assets of Olympus at
book value instead of fair market value.
The funds used by these other entities came from bank borrowing
arranged by Olympus. Olympus therefore did not report any gain or
loss.
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Anatomy of Financial Statement Fraud

Olympus Corporation Japan
Olympus understated its liabilities and overstated owners
equity for many years.
when they repurchased the special purpose entities and were
forced to record the liability, they overstated the Goodwill
(assets). This Goodwill was then reported as being impaired
overtime to spread out the losses.
Large payments were made to financial advisors who
assisted in US$ 2.2 Billion acquisition of Gyrus with the
understanding that they would use these fees to settle the
account with the SG Bond of the Cayman Islands.

KIKUKAWA

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Anatomy of Financial Statement Fraud

WorldCom Inc. USA
WorldCom materially overstated the income it reported on its financial
statements by approximately $9 billion, mainly using two methods.
First, WorldCom reduced its operating expenses by improperly releasing as a
credit to operating expenses certain provisions previously established for line
costs and for taxes.
Second, the company improperly reduced its operating expenses by
recharacterising certain expenses as capital assets.
Much of the $9 billion related to improper accounting for
line costs, which were among WorldComs major operating
Expenses.

Bernard Ebbers
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Anatomy of Financial Statement Fraud

Deterrence of Financial Statement Fraud
Any Fraud has three components popularly called as Fraud
Triangle propounded by Dr. Donald Cressey comprising of
Perceived
Pressure,
Perceived
Opportunity
and
Rationalisation.

Dr. Donald Cressey

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Anatomy of Financial Statement Fraud

For Deterring Financial Statement Fraud, the
Management has to:
1. Reduce the Situational Pressures that Encourage
Financial Statement Fraud.
2. Reduce the Opportunity to Commit Financial
Statement Fraud.
3. Reduce the Rationalisation of Financial Statement
Fraud.

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Anatomy of Financial Statement Fraud

The Association of Certified Fraud Examiners, USA

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Anatomy of Financial Statement Fraud

Mr. Ramalinga Raju confessed in the Year to

the Board of Directors that the Company
Cooked the Books and hence the Financial
Statement are not reliable.

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Anatomy of Financial Statement Fraud

(Match the Following)

Sl
No

Entity

Nature of Financial
Statement Fraud
committed

Olympus
Corporation

Overstatement of Revenue and

Accounts Receivables

Satyam Computer
Services Ltd

Capitalized revenue expenses

WorldCom Inc

Understated its liabilities by

concealing it off the books.
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Anatomy of Financial Statement Fraud

Sl
Entity
No.

Nature of Financial
Statement Fraud
committed

Olympus
Corporation

Understated its liabilities by

concealing it off the books.

Satyam Computer
Services Ltd

Overstatement of Revenue and

Accounts Receivables

WorldCom Inc

Capitalized revenue Expenses

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Anatomy of Financial Statement Fraud

Satyam Computer Services overstated its Revenue as per SEC,

USA for the Financial Year ended March 31,2008 by

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Anatomy of Financial Statement Fraud

Satyam Computer Services overstated its Revenue as per SEC,

USA for the Financial Year ended March 31,2008 by

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Anatomy of Financial Statement Fraud

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Anatomy of Financial Statement Fraud

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