Chapter 11

Financial statement fraud

The problem of financial statement fraud

The stock and bond markets are critical components of a capitalist economy. The
efficiency, liquidity, and resiliency of these markets depend on the ability of investors,
lenders, and regulators to assess the financial performance of businesses that raise capital.
Financial statements prepared by such organizations play a very important role in keeping
capital markets efficient. They provide meaningful disclosures of where a company has
been, where it is currently, and where it is going. Most financial statements are prepared
with integrity and present a fair representation of the financial position of the
organization issuing them. These financial statements are based on generally accepted
accounting principles (GAAP), which guide the accounting for transactions.

Financial statement fraud in recent year

During the years 2000–2002, numerous revelations of corporate wrongdoing, including

financial statement fraud, in the United States created a crisis of confidence in the capital
markets. The crisis led to a $15 trillion decline in the market value of all public company
stock. Before focusing on financial statement fraud, we include an overview of several
abuses that occurred during this time period to paint a more complete picture of why
corporate America experienced such a severe crisis. Some of the most notable abuses
include the following:
• Misstated financial statements or “cooking the books”: Examples include Qwest, Enron,
Global Crossing, WorldCom, and Xerox. Some of these frauds involved 20 or more
people helping to create fictitious financial results.
• Inappropriate executive loans and corporate looting: Examples include John Rigas
(Adelphia), Dennis Kozlowski (Tyco), and Bernie Ebbers (WorldCom).
• Insider trading scandals: The most notable examples are Martha Stewart and Sam
Waksal, both of whom were convicted for using insider information to profit from trading
ImClone stock.
• Initial public offering (IPO) favoritism, including spinning and laddering (spinning
involves giving IPO opportunities tothose who arrange quidpro quo opportunities, and
laddering involves giving IPO opportunities to those who promise to buy additional
shares as prices increase): Examples include Bernie Ebbers of WorldCom and Jeff
Skilling of Enron.
• Excessive CEO retirement perks: Delta, PepsiCo, AOL Time Warner, Ford, GE, and
IBM were highly criticized for endowing huge, costly perks and benefits, such as
expensive consulting contracts, use of corporate planes, executive apartments, and maids
to retiring executives.
• Exorbitant compensation (both cash and stock) for executives: Many executives,
including Bernie Ebbers of WorldCom and Richard Grasso of the NYSE, received huge
cashandequity-based compensationthat has since been determined to have been
excessive. • Loans for trading fees and other quid pro quo transactions: Financial
institutions such as Citibank and JPMorgan Chase provided favorable loans to companies
and executives at companies such as Enron and WorldCom in return for the opportunity
to make hundreds of millions of dollars in derivative transactions and other fees.
• Bankruptcies and excessive debt: Because of the abuses described here and similar
problems, seven of the ten largest corporate bankruptcies in U.S. history up to 2002
occurred in 2001 and 2002. These seven bankruptcies were WorldCom (largest, at $101.9
billion), Enron (second, at $63.4 billion), Global Crossing (fifth, at $25.5 billion),
Adelphia (sixth, at $24.4 billion), United Airlines (seventh, at $22.7 billion), PG&E
(eighth, at $21.5 billion), and Kmart (tenth, at $17 billion). Four of these seven involved
financial statement fraud.
• Massive fraud by employees: While not in the news nearly as much as financial
statement frauds, there has been a large increase in fraud against organizations, with some
of these frauds being as high as $2 to $3 billion.

Why these problems occured

Each of the problems discussed earlier represents an ethical compromise. The

explanations covered previously about why people commit other frauds apply to financial
statement fraud as well. Recall that three elements come
together to motivate all frauds:
(1) a perceived pressure,
(2) a perceived opportunity, and
(3) the ability to rationalize the fraud as acceptable.

Whether the dishonest act involves fraud against a company, such as employee
embezzlement, as we have already discussed, or fraud on behalf of a company, such as
financial statement fraud that we will now discuss, these three elements are always
present.

Element 1 : booming economy

The first element of the perfect storm was the masking of many existing problems and
unethical actions by the booming economy of the 1990s and early 2000s. During this
time, most businesses appeared to be highly profitable, including many new “dot-com”
companies, which were testing new (and many times unprofitable) business models.
These booming economic conditions allowed fraud perpetrators to conceal their actions
for longer time periods. Additionally, the advent of “investing over the Internet” for a few
dollars per trade brought many new inexperienced people to the stock market, and many
investors made nonsensical investment decisions. History has now shown that several of
the frauds that came to light around the turn of the millennium were being committed
during the boom years while the economy hid the fraudulent behavior.
Element 2 : decay of moral value

The second element of the perfect fraud storm was the moral decay that has been
occurring in recent years. Whatever measure of integrity one uses, dishonesty appears to
be increasing. For example, numerous researchers have found that cheating in school, one
measure of dishonesty, has increased substantially in recent years. Whether it is letting
someone copy work, using a cheat sheet on an exam, or lying to obtain a job, studies
show that these numbers have drastically increased over the years. While cheating in
school is not necessarily directly tied to management fraud, it does reflect the general
decay of moral values in society at large.

Element 3 : misplaced incentives

The third element of the perfect fraud storm was misplaced executive incentives.
Executives of most fraudulent companies were endowed with hundreds of millions of
dollars in stock options and/or restricted stock that put tremendous pressure on
management to keep the stock price rising, even at the expense of reporting accurate
financial results. In many cases, this stock-based compensation far exceeded executives’
salary-based compensation.

Element 4 : high analysts expectations

The fourth element of the perfect storm, and one closely related to the last,was the often
unachievable expectations of Wall Street analysts that targeted short-term behavior.
Company boards and management, generally lacking alternative performance
metrics,used comparisons with the stock price of “similar” firms and attainment of
analysts’ expectationsasimportantdefactoperformancemeasures. These stock-based
incentives compounded the pressure induced by the analysts’ expectations.

Element 5 : high debt levels

The fifth element in the perfect storm was the large amounts of debt each of these
fraudulent companies
had. This debt placed tremendous pressure on executives to have high earnings to offset
high interest costs and to meet debt covenants and other lender requirements.

Element 6 : focus an accounting rules rather than principles

Some believe that another element of the perfect storm was the nature of U.S. accounting
rules. In contrast to accounting practices in many countries such as the United Kingdom
and Australia, generally accepted accounting principles (GAAP) in the United States are
more rule based than principles based.3 One potential result of having rule-based
standards is that if a client can find a loophole in the rules and account for a transaction in
a way that is not specifically prohibited by GAAP, then auditors may find it hard to
prohibit the client from using that method of accounting. Unfortunately, in some cases,
the auditors helped their clients find the loopholes or gave them permission to account for
transactions in ways that violated the principle of an accounting method but was within
the rules. The result was that specific rules (or the lack of specific rules) were exploited
for new, often complex financial arrangements, as justification to decide what was or was
not an acceptable accounting practice.

Element 7 : lack of auditor independence

A seventh element of the perfect fraud storm was the opportunistic behavior of some CPA
firms. In some cases, accounting firms used audits as loss leaders to establish
relationships with companies so they could sell more lucrative consulting services. In
many cases, audit fees were much smaller than consulting fees for the same clients, and
accounting firms felt little conflict between independence and opportunities for increased
profits. In particular, these alternative services allowed some auditors to lose their focus
and become business advisors rather than auditors. This is especially true of Arthur
Andersen, which had spent considerable energy building its consulting practice, only to
see that practice split off into a separate firm. Privately, several Andersen partners have
admitted that the surviving Andersen firm and some of its partners had vowed to “out
consult” the firm that separated from it and they became preoccupied with that goal.

Element 8 : greed

The eighth element of the perfect storm was greed by executives, investment banks,
commercial banks, and investors. Each of these groups benefited from the strong
economy, the many lucrative transactions, and the apparently high profits of companies.
None of them wanted to accept bad news. As a result, they sometimes ignored negative
news and entered into bad transactions.

Element 9 : educator failures

Finally, the ninth element of the perfect storm involved several educator failures. First,
educators had not provided sufficient ethics training to students. By not forcing students
to face realistic ethical dilemmas in the classroom, graduates were ill equipped to deal
with the real ethical dilemmas they faced in the business
world. In one allegedly fraudulent scheme, for example, participants included virtually
the entire senior management of the company, including but not limited to its former
chairman and chief executive officer, its former president, two former chief financial
officers, and various other senior accounting and business personnel. In total, it is likely
that more than 20 individuals were involved in the schemes. Such a large number of
participants points to a generally failed ethical compass for this group.

Nature of financial statement fraud

Financial statement fraud, like other frauds, involves intentional deceit and attempted
concealment. Financial statement fraud may be concealed through falsified
documentation, including forgery. Financial statement fraud may also be concealed
through collusion among management, employees, or third parties. Unfortunately, like
other fraud, financial statement fraud is rarely seen. Rather, fraud symptoms, indicators,
or red flags are usually observed. Because what appear to be symptoms can be caused by
other legitimate factors, the presence of fraud symptoms does not always indicate the
existence of fraud. For example, a document may be missing, a general ledger may be out
of balance, or an analytical relationship may not make sense. However, these conditions
may be the result of circumstances other than fraud. Documents may have been
legitimately lost, the general ledger may be out of balance because of an unintentional
accounting error, and unexpected analytical relationships may be the result of
unrecognized changes in underlying economic factors. Caution should be used even when
reports of alleged fraud are received, because the person providing the tip or complaint
may be mistaken or may be motivated to make false allegations.

Motivations for financial statement fraud

Motivations to issue fraudulent financial statements vary. As indicated previously in the

perfect storm analysis, sometimes the motivation is to support a high
stock price or a bond or stock offering. At other times, the motivation is to increase the
company’s stock price or for management to maximize a bonus. In some companies that
issued fraudulent financial statements, top executives owned large amounts of company
stock or stock options, and a change in the stock price would have enormous effects on
their personal net worth.

A framework for detecting financial statement fraud

Identifying fraud exposures is one of the most difficult steps in detecting financial
statement fraud. Correctly identifying exposures means that you must clearly understand
the operations and nature of the organization you are studying as well as the nature of the
industry and its competitors. Investigators must have a good understanding of the
organization’s management and what motivates them. Investigators must understand how
the company is organized and be aware of relationships the company has with other
parties and the influence that each of those parties has on management. In addition,
investigators and auditors should use strategic reasoning when attempting to detect fraud.

Management and the board of directors

As shown in the statistics presented previously, top management is almost always

involved when financial statement fraud occurs. Unlike embezzlement and
misappropriation, financial statement fraud is usually committed by the highest
individuals in an organization, and often on behalf of the organization as opposed to
against the organization. Because management is usually involved, management and the
directors must be investigated to determine their involvement in and motivation for
committing fraud. In detecting financial statement fraud, gaining an understanding of
management and what motivates them is at least as important as understanding the
financial statements. In particular, three aspects of management should be investigated:
1. Managements’ backgrounds.
2. Managements’ motivations.
3. Managements’ influence in making decisions for the organization.

Management backgrounds

With respect to backgrounds, fraud investigators should understand what kinds of

organizations and activities management and directors have been associated with in the
past. With the Internet today, it is very easy to conduct simple searches on
individuals.One very easy way is to type the individual’s name in Google or another
search engine. The search engine will quickly list all the references to the person’s name,
including past proxy statements and any 10-Ks (the corporate reports
filed with the SEC) of companies the person has been affiliated with, newspaper articles
about the person, and so forth. Also, if this simple search is not sufficient, it doesn’t cost
very much to hire a private investigator or to use investigative services on the Web to do
a search.

Managemenents motivations

What motivates directors and management is also important to know. Is their personal
worth tied up in the organization? Are they under pressure to deliver unrealistic results? Is
their compensation primarily performance-based? Do they have a history of guiding Wall
Street to higher and higher expectations? Have they grown through acquisitions or
through internal means?Does the company have debt covenants or other financial
measures that must be met?Is management’s job at risk? These questions are examples of
what must be answered in order to properly understand management’s motivations. Many
financial statement frauds have been
perpetratedbecausemanagementneededtoreportpositiveorhighincometosupportstockprices,
show positive earnings for a public stock or debt offering, or report profits to meet
regulatory or loan restrictions.

Managements’ Influence in Making Decisions for the Organization

Finally, management’s ability to influence decisions for the organization is important to

understand because perpetrating fraud is much easier when one or two individuals have
primary decision-making power than when an organization has a more democratic
leadership. Most people who commit management fraud are firsttime offenders, and
being dishonest the first time is difficult for them. For two individuals to simultaneously
be dishonest is more difficult, and for three people to simultaneously be dishonest is even
more difficult. When decision-making ability is spread among several individuals, or
when the board of directors takes an active role in the organization, fraud is much more
difficult to perpetrate. Most financial statement frauds do not occur in large, historically
profitable organizations. Rather, they occur in smaller organizations where one or two
individuals have almost total decision-making ability, in companies that experience
unbelievably rapid growth, or where the board of directors and audit committee do not
take an active role (something that is much harder to do now with the new corporate
governance standards
described in Appendix A of this chapter). An active board of directors and/or audit
committee that gets involved in the major decisions of the organization can do much to
deter management fraud. In fact, it is for this reason that NASDAQ and NYSE corporate
governance standards require that the majority of board members be independent and that
some of the key committees, such as audit and compensation, be comprised entirely of
independent directors. Once management decides that it will commit fraud, the particular
schemes used are often determined by the nature of the business’s operations. While we
usually focus on the schemes and the financial results of those schemes, remember that
the decision to commit fraud in the first place was made by management or other officers

Relationships whith others

Financial statement fraud is often perpetrated with the help of other real or fictitious
organizations. Enron’s fraud was primarily conducted through what are known as special
purpose entities (SPEs), which are
business interests formed solely in order to accomplish some specific task or tasks. SPEs
were not illegal, but were subject to accounting standards that designated which SPEs
were to be reported as part of the larger, parent, company instead of being reported as
independent entities and not consolidated with the parent. At the time of the Enron fraud,
an SPE was considered independent if it met the following two criteria: (1) independent
third-party investors made a substantive capital investment, generally at least 3 percent of
the SPE’s assets and (2) the third-party investment is genuinely at risk. Enron was
obligated to consolidate the assets and liabilities of entities not meeting these
requirements. The SEC’s complaint alleges that certain SPEs of Enron should have been
consolidated onto Enron’s balance sheet. Further, Fastow, Kopper, and others used their
simultaneous influence over Enron’s business operations and the SPEs as a means to
secretly and unlawfully generate millions of dollars for themselves and others. In
particular, Fastow profited immensely by making tens of millions of dollars designing
Enron’s SPEs in his favor.

Relationships with financial institutions

The real estate partnership referred to earlier involved a Wisconsin company taking out
unauthorized loans from a bank located in another state, where it had no business
purpose. The bank was used because the CEO of the client company had a relationship
with the bank president, who later falsified an audit confirmation sent by the bank to the
auditors. The loans were discovered when the auditors performed a lien search on
properties owned. Because the bank president denied the existence of the loans, liabilities
were significantly understated on the balance sheet.

Relationships whith related oganizations and individuals

Related parties, which include related organizations and individuals such as family
members,should be examined because structuring“non–arm’slength”and often unrealistic
transactions with related parties is one of the easiest ways to perpetrate financial
statement fraud.These kinds of relationships are usually identified by examining large
and/or unusual transactions, often occurring at strategic times(such as at the end of a
period)to make the financial statements look better. The kinds of relationships and events
that should be examined include the following:
• Large transactions that result in revenues or income for the organization.
• Sales or purchases of assets between related entities.
• Transactions that result in goodwill or other intangible assets being recognized in the
financial statements.
• Transactions that generate non operating, rather than operating, income.
• Loans or other financing transactions between related entities.
• Any transaction that appears to be unusual or questionable for the organization,
especially transactions that are unrealistically large.

Relationships whtih auditors

The relationship between a company and its auditors is important to analyze for several
reasons.If the re has been an auditor change,there is probably agood reason for the
change. Auditing firms do not easily give up clients, and the termination of an auditor–
auditee relationship is most often caused by failure of the client to pay, an auditor–
auditee disagreement, suspected fraud or other problems by the auditor, or the auditee
believing the auditor’s fees are too high. While some of these reasons, such as high fees,
may not signal a potential fraud problem, auditor– auditee disagreements, failure to pay
an audit fee,andsuspectedproblemscanallbereasonsthatsuggestafinancial statement fraud
problem. The fact that an auditor was dismissed or resigned, together with the difficulty
of a first-year auditor to discover financial statement fraud,
createsadoublecauseforconcernwhenthereisanauditor change.

Relationships with lawyers

Relationships with lawyers pose even greater risks than relationships with auditors.While
auditors are supposed to be independent and must resign if they suspect that financial
results may not be appropriate,lawyers are usually advocates for their clients and will
often follow and support their clients until it is obvious that fraud has occurred. In
addition, lawyers usually have information about a client’s legal difficulties, regulatory
problems, and other significant occurrences.Like auditors,lawyers
rarelygiveupaprofitableclientunlessthereissomething seriously wrong.Thus,a change in
legal firms without an obvious reason is often a cause for concern. Unfortunately, unlike
changing auditors, where an 8-K must be filed for public companies, there is no such
reporting requirement for changing lawyers.

Relationships with investors

Relationships with investors are important because financial statement fraud is often
motivated by a debt or an equity offering to investors.In addition,knowledge
of the number and kinds of investors (public vs. private, major exchange vs. small
exchange, institutional vs. individual, etc.) can often provide an indication of the degree
of pressure and public scrutiny upon management of the company and its financial
performance.

Relationship with regulatory bodies

Finally,understandingtheclient’srelationshipwithregulatorsisimportant.If the company you

are examining is a publicly held client, you need to know whether the SEC has ever
issued an enforcement release against it. For example, in its report pursuant to Section
704 of the Sarbanes-Oxley Act, the SEC stated that during the
fiveyearperiodfromJuly31,1997toJuly30,2002ithadfiled 515 enforcement actions
involving 869 named parties, 164 entities, and 705 individuals. You also need to know if
all annual, quarterly, and other reports have been filed on a timely basis.If the company is
in a regulated industry, such as banking,you need to know what its relationship is with
appropriate regulatory bodies such as the Federal Deposit Insurance Corporation,the
Federal Reserve,and the Office of the Comptroller of the Currency. Are there any
problematic issues related to those bodies? Whether
theorganizationowesanybacktaxestothefederalorstate government or to other taxing
districts is also important to know. Because of the recourse and sanctions available to
taxing
authorities,organizationsusuallydonotfallbehindontheirpaymentsunlesssomethingiswrong
orthe organization is having serious cash flow problems. The following questions should
be asked about a company’s relationships with others.

Organizations and industry

Financial statement fraud is sometimes masked by creating an organizational structure

that makes it easy to hide fraud. This was certainly the case with Enron and all of its non
consolidated SPEs (now called variable interest entities by the FASB).

Financial results and operating characteristics

Much can be learned about exposure to financial statement fraud by closely examining
management and the board of directors, relationships with others, and the
nature of the organization. Looking at those three elements usually involves the same
procedures for all kinds of financial statement frauds, whether the accounts manipulated
are revenues, assets, liabilities, expenses, or equities. The kinds of exposures identified by
the financial statements and operating characteristics of the organization differ from fraud
scheme to fraud scheme.