Fraud Midterm
Arthur Levitt's "Renewing the Covenant with Investors"
(2000) - Discusses culture of gamesmanship where managers feel pressure to meet analyst expectations, auditors are testing the limits of appropriate conduct in providing services to clients (auditing and consulting) - For investors to have confidence in the quality of the audit, the public must perceive the accountant as independent - CPA firms position themselves globally as "multidisciplinary professional service organizations" rather than accounting firms - "A public accountant acknowledges no master but the public." But, when auditors engage in extensive services for an audit client truly unrelated to the audit, they must now also serve another master - management. In this dual role, the auditor, who guards the integrity of the numbers, now both oversees and answers to management. - 3 ways to address conflict: 1. develop broad principles of independence, 2. require greater public disclosure of types and amounts of services offered, 3. certain services considered inconsistent with an independent public audit could be prohibited
Accountants as Gatekeepers
(2001) - Investors rely on accountants for financial information and the SEC granted public accountants an important public trust - Managed Earnings: managers manipulate earnings to make financial statements look better and in turn enhance their stock prices; but resulting restatements of earnings have caused investors to lose money and confidence in the markets - Pro-Forma Information: un-audited and not in conformity with GAAP, pro forma earnings may be "materially misleading" to reasonable investors, violating the federal securities laws - Valuation: there is an increasing need to improve the quality and comparability of fair value measures and the auditing of those measurements; investors need to become more educated on fair value estimates - how they are calculated, what they mean and when they are used
(POTENTIAL ESSAY) Why the increase in accounting fraud in the past 30 years?
(underauditing) - Relaxation in 1990 of AICPA rules of conduct on contingent fees, advertising and solicitation, and commissions and referral fees, all of which increased competition. - Transformation of large accounting firms to consulting entities, confusion of roles among employees, tensions between partners and front-line auditors, and loss of fundamental responsibilities to the public. - Litigation reform of the mid-1990s has made it more difficult for plaintiffs to file class action lawsuits against businesses, managers, and their auditors. - Management succumbs to analyst pressures and plays the "earnings game." - Companies pay their auditors, hire and fire their auditors, and award consulting contracts. - Large accounting firms take aggressive positions on independence to develop new business. - Audit methodologies are questionable: o Cheap and inexperienced labor. o Judgmental vs. statistical sampling. o Analytical reviews vs. detailed substantive testing. o Increased use of technology vis-à-vis humans.
What is transparency?
- A Spirit of Transparency means that companies willingly provide information needed by shareholders and other stakeholders to make decisions. - Information is transparent when it provides the reader with a clear understanding of the company's financial condition, results of operations, cash flows, and other aspects of the business.
How should you interpret Altman Z score?
- A Z-score equal to or less than 1.81 indicates a very high probability of financial distress (bankruptcy) - A Z-score between 1.81 and 2.99 indicates a gray area - A Z-score greater than or equal to 3.00 indicates that the company is financially healthy (known as the "safe zone") and is not likely to go into financial distress
What are the main ideas of "Collectivization of Judgement" by Herb Miller, Arthur Andersen retired partner, 1974?
- Accounting is subjective...thus accountants must hone their individual professional judgment to carry out the tasks they take on. - Judgment develops from the interaction of education and experience. - The profession's activities (e.g., self-regulation) cannot enhance the quality of personal judgment nearly as much as partners and managers in the accounting firm. - The profession has attempted to improve judgment by increasing the uniformity of standards (i.e., a rules based approach). The idea is to replace judgment with uniformity. - Personal judgment is enhanced more from partners and managers than via professional activities. - Litigation provides firms incentives to develop judgment in their personnel.
What are some common management and control red flags?
- CEO is founder of the company, or firm dominated by one or a few without adequate oversight - Related party transactions - High management and board turnover - Low board independence and lack of audit committee - Complex ownership and financial structure or weak internal controls - Few analysts follow the company
What are some common performance red flags?
- Contractual incentives: debt contracts, stock-based compensation, performance-bonus - Pressure to obtain capital and stay competitive - Inability to obtain capital and stay competitive - High growth entering low growth phase - Declining trend in profitability - Unusually rapid growth or profitability - History of operating losses - Operating results highly sensitive to external economic factors - High visibility company
What are other items that one can check out for potential manipulation?
- Financial analysis results including negative working capital, high leverage, unusual receivable and inventory patterns, large SG&A, negative OCF, unusual ETRs. - Complex accounting issues such as accounting and transactions not consistent with business strategy, misuse of derivatives, or excessive contingencies. - Corporate governance such as board dominated by insiders, CEO exerting too much influence, Excessive CEO compensation and overuse of stock options, or related party transactions and insider trading. - Auditing such as auditor report date close to 10K required filing date, high non-audit fees, or opinion or internal control exceptions. - Restated earnings and regulatory investigations. - Stock prices such as price drops related to a specific known event. - Any other bad news.
What are some common industry and market structure red flags?
- Significant competition accompanied by declining margins - Declining industry with increasing business failures and declines in customer demand - Rapid industry changes such as new technologies, new industries, new financing techniques, or new accounting - Economic conditions
What is earnings management?
- active manipulation of accounting results for the purpose of creating an altered impression of business performance - management choosing policies to maximize their own utility and/or the market value of the firm - involves the use of various forms or gimmickry to distort a company's true financial performance in order to achieve a desired result
What are examples of Fraudulent Reporting?
-Inflating Assets (over stating assets or revenues causes the most damage to markets) -Inflating Revenues -Understating Liabilities -Understating Expenses -Creating Timing Differences -Misclassifying Balance Sheet Items -Committing Disclosure Fraud
Three important factors affecting information and decision making
1. Information Asymmetry 2. Adverse Selection 3. Moral Hazard
(POTENTIAL ESSAY) What are eight major areas of potential reported manipulation?
1. Pensions: Pensions and OPEB expenses greater than 10% of net income can be concerns. Additionally, these are off-balance sheet obligations. Although disclosures exist, they can be particularly confusing and leave room for manipulation. 2. Stock Options: Options greater than 10% of outstanding shares and option expense greater than 10% of income can be concerns. Stock options are a signal of executive incentives to meet earnings targets, increasing the potential for earnings magic. Options dilute equity and, if not expensed, are a real compensation cost that should be recognized. 3. Stock and Dividends: Treasury stock greater than 10% of equity can be a concern. Treasury stock is anti-dilutive, uses cash, and reduces equity. It can also be used to prop up a company's stock price. A dividend payout ratio greater than one can also be a concern. 4. Off-Balance Sheet Items: Operating leases and special purpose entities are used specifically to keep liabilities unrecorded. When these amounts are large, manipulation is suspected. For example, operating leases greater than 10% of assets is a concern. 5. Revenue: Manipulation of revenue is a common method of earnings management because there are multiple ways of doing so. Although manipulation is very difficult to detect, it is helpful to look at changes in revenue from period to period. For example, if revenues are usually brisk but receivables are rising even faster, it is likely that credit terms are being relaxed. This is a bad strategy because of increased bad debts. Magic is more likely if revenues are rising, receivables are rising much faster, and the allowance for doubtful accounts is actually falling. 6. Earnings, Expenses, and Expectations: Earnings and expense categories should be reasonably consistent from year to year. Unusual changes could be a sign of earnings management. 7. Strange Special Items: Special items can be problematic if they are a large percentage of earnings. These unusual items, such as gains on discontinued operations, need to be investigated for reasonableness. 8. Acquisitions: Earnings management can occur in this area specifically through the manipulation of goodwill. If goodwill is greater than 10% of assets or a large percentage of an acquisition price, there could be cause for concern.
What can signal management incentives to misreport?
1. Performance factors 2. Management and control issues 3. Industry and market structure
When was Arthur Andersen's "Postulate of Accounting" written?
1960
When was the SEC's former chairman Arthur Levitt's Numbers Game speech?
1998
What is the Sloan Accrual Measure?
= (Net Income - Free Cash Flows) / Average Total Assets where average total assets in year t = (total assets(t) + total assets(t-1))/2 and free cash flows = operating cash flows - capital expenditures and capital expenditures should be included as a positive number This is a measure of accrual quality. The red flag benchmark is a ratio greater than 0.1
What is the conservatism ratio?
= Reported Income Before Taxes / Taxable Income where taxable income = total current tax payable during the year / effective tax rate The conservatism ratio is an excellent measure of a company's aggressiveness in its income recognition. The lower the ratio, the more conservative the company. The higher conservatism ratio indicates that management is more aggressive with its income recognition compared with taxable income. The red flag benchmark is a ratio more than 1.
What is the quality or revenue ratio?
= cash collected from customers/net sales where cash collected from customers in year t = net sales - (AR(t) - AR(t-1)) This is a measure of the revenue quality. The red flag benchmark is a ratio less than one (cash collected is slower than revenue).
What is the quality of earnings ratio?
= operating cash flow/net income This is a measure of the earnings quality. The red flag benchmark is a ratio of less than 1 (not generating enough cash from NI), but a high ratio also can be problematic suggesting unusual cash inflows.
What is a stealth restatement?
A stealth restatement is a restatement revealed in a periodic report (10-K or 10-Q) without a prior disclosure in Not Timely (NT) 10-K or 8-K. (considered a stealth restatement if they did not tell investors ahead of time, indicator that company is trying to hide something until the last minute, can be a shock for investors)
What are SEC's rules to report pro-forma earnings?
According to the SEC's Compliance & Disclosure Interpretations, EBITA is defined under Regulation G as net income before interest, taxes, depreciation, and amortization. SEC Section 103. EBIT and EBITDA Question 103.01 - "Earnings" means net income as presented in the statement of operations under GAAP. Measures that are calculated differently than those described as EBIT and EBITDA in Exchange Act Release No. 47226 should not be characterized as "EBIT" or "EBITDA" and their titles should be distinguished from "EBIT" or "EBITDA," such as "Adjusted EBITDA." - In other words, the only way to properly compute EBITDA under regulation G is by starting the calculation with net income and adding back only interest, taxes, depreciation and amortization. A public company cannot add back other items such as stock-based compensation costs, impairments of fixed assets, or anything else to compute EBITDA. Such errors can materially overstate EBITDA and lead to potential regulatory sanctions. Any different calculation cannot be called EBITDA, but can be called "Adjusted EBITDA" or some other appropriate name.
What is adverse selection?
Adverse selection is information asymmetry where one party is at a disadvantage and where one party to a transaction knows things pertaining to the transaction that are relevant to but unknown by the second party.
How should you interpret the Beneish M score?
An M score that is greater than -1.78 indicates that there is a high probability of earnings manipulation
What is Benford's Law and how is it used to detect financial statement fraud?
Benford's Law is a frequency distribution of leading digits in lists of numbers which is used in the accounting practice to detect instances of fraud. It was discovered that lower numbers have higher probabilities of occurrence, whereas larger numbers have a lower frequency. In the distribution, the number one is the most significant and has a frequency of 30%. As the numbers increase the frequencies decrease, with 9 being the least occurring number which has a frequency of less than 5%.
What are the differences between earnings management and the financial numbers game?
Earnings Management: generally viewed as an interperiod concept, where earnings are moved from one period to the next (example - earnings in a future year much be reduced or increased in an effort to raise or lower earnings in the current year) Financial Numbers Game: includes steps taken to manage earnings, and thus it encompasses these interperiod activities. Also includes intraperiod activities, where earnings or cash flows are moved around within a single period's financial statements
What type assets and liabilities are measured with fair value accounting?
Fair value is mostly used to measure "financial" assets and liabilities, as opposed to "non-financial" assets and liabilities, such as property or intangible assets. Financial assets and liabilities include, but are not limited to, investment securities, derivative instruments, loans and other receivables, notes and other payables, and debt instruments issued. Not all of these financial assets and liabilities are required to be measured at fair value; some are permitted to be measured at fair value because of provisions that generally permit an entity to elect fair value accounting for financial assets and liabilities.
Which one word best summarizes Arthur Andersen's "Postulate of Accounting" in 1960?
Fairness - Each party to the accounting is entitled to a fair statement of his economic rights and interests. - Financial statements cannot be so prepared as to favor the interests of any one segment without doing injustice to others; and such statements could not meet the test of fairness which the public demands always be present in public financial reporting.
HW2: Earnings management is the active manipulation of accounting results for the purpose of creating an altered impression of business performance. Earnings management can be interperiod and intraperiod. True or False
False
What are key elements of FV under this definition?
Four key elements of FV under US GAAP: - FV assumed based on an orderly transaction (not forced due to liquidation or distress) - Hypothetical transactions assumed to occur in the principal or most advantageous market (market with the greatest volume of activity for the asset or liability; if no such market exists, market that maximizes the amount) - FV should be determined without regard to transaction costs (transportation costs are considered) - Highest and best use of assets should be used in assessing FV (physically possible, legally permissible, financially feasible)
What are two potential fraud risks stemming from the FV definition?
Fraud Risk No. 2.1 Basing fair value determinations on other known transactions, when the transactions cited are not "orderly." Fraud Risk No. 2.2 Misrepresenting the highest or best use of an asset in order to inflate its estimated fair value.
How can Benford's Law detect financial statement fraud?
Fraud numbers are generated by specifically assigned numbers by humans, instead of occurring naturally in the course of business, thus manipulating the overall population in most cases. This skews the frequencies of the digits so that certain numbers stick out. A specific example is disbursement fraud. In most organizations, a dollar limit threshold is set for employees that requires supervisory approval to approve the payment. This means as a fraudster builds confidence and starts increasing the dollar value in each fraudulent payment, eventually the dollar value will level off and stay right below the supervisory threshold, in order to prevent detection. From an overall analysis of the frequency of digits, this will lead to an increase in a specific range causing it to rise above the typical Benford's law trend.
What is fraud?
Fraud occurs when financial statements violate accounting standards due to willful misreporting by the financial statement preparers
According to the Association of Certified Fraud Examiners (ACFE), what are three categories of fraud?
Fraudulent reporting, Asset Misappropriation, and Corruption. Fraudulent reporting is the least common category, but has the highest dollar impact.
What is the main idea of the Numbers Game speech?
He discussed problems with Big Bath charges, creative acquisition accounting, miscellaneous "cookie jar reserves", materiality, and revenue recognition. Then he called out the auditors for their responsibilities.
Arthur Levitt's suggestions in Numbers Game speech
He suggested improvements for the Accounting Framework, better training and supervision for auditors, strengthening the audit committee process with more/longer meetings, and a cultural change in which corporate managers realize that honest financial reporting is directly related to the long term interest of the firm
What is the lifeblood of the capital markets?
Information
What is information asymmetry?
Information asymmetry occurs when one party to a potential transaction has more information than another. Information is not symmetric or balanced. Therefore, there is information asymmetry.
(POTENTIAL ESSAY) What are three common approaches to determine fair value and what are associated fraud risks for each approach?
Market approach: uses prices and other information generated by market transactions involving identical or comparable assets or liabilities. Fraud Risk No. 3.1 Drawing inappropriate conclusions about an asset's FV based on consideration of a range of prices or inputs available from market transactions. Income approach: uses valuation techniques to convert future amounts (e.g., cash flows or earnings) to a single present amount (discounted). Fraud Risk No. 3.2 Misapplication of the income approach by using improper amounts for cash flows, manipulating the timing of future cash flows, or using an inappropriate discount rate. Cost approach: assesses what it would cost to replace an asset, or its service capacity, then making adjustment to that cost figure (e.g., obsolescence). Fraud Risk No. 3.3 Using inappropriate replacement cost estimates or making inaccurate adjustments for obsolescence in determining FV under the cost approach.
What is moral hazard?
Moral hazard occurs when one party to a transaction may undertake certain actions that affect the other party's valuation of the transaction, but that, the second party cannot monitor / enforce perfectly.
What are pro-forma earnings?
Non-GAAP earnings They usually leave out "special", "one-time", "exeptional", or "non-cash expenses". They are not audited.
What is the trend for privately held companies with regard to fair value accounting?
Privately held companies in the United States—which are less oriented toward capital markets than their publicly traded counterparts are—have recently set up their own accounting standards board, the Private Company Council, to get away from fair value accounting.
What is the fair value option under SFAS No. 159?
SFAS 159 provides an "option" for firms to elect fair value measurement for most financial assets and liabilities, with unrealized changes in fair value reported in earnings and thereby impacting net income. A reporting entity's decision about whether to elect the FVO: - Is applied on an instrument-by-instrument basis, with certain limited exceptions, - Is irrevocable (once selected for an individual instrument) and therefore cannot be changed subsequent to election, and - Is applied only to an entire instrument and not to only specified risks, specific cash flows, or a portion of that instrument.
What is the definition of fair value under SFAS No. 157?
SFAS No. 157 defines "fair value" as follows: - Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.
3. What is the SEC regulation on fraudulent financial reporting?
Securities and Exchange Act of 1934 Rule 13b2-1 -- Falsification of Accounting Records: No person shall directly or indirectly, falsify or cause to be falsified, any book, record or account subject to section 13(b)(2)(A) of the Securities Exchange Act. Section 13(b)(2)(A): Every issuer that has a class of securities registered pursuant to section 12 must make and keep books, records, and accounts, which, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the issuer.
How should you interpret changes in Total Accruals to Total Assets (TATA)?
TATA is a ratio of income before extraordinary items less cash from operations to total assets which assesses the extent to which managers make discretionary accounting to alter earnings TATA is a proxy for non-cash earnings
What is the Altman Z score?
The Altman Z score is a formula that assesses the probability of a company going bankrupt within the next 2 years using five specific ratios
What is the Beneish M Score?
The Beneish M score assesses the probability of earnings manipulation activity using eight financial ratios.
How should you interpret changes in the Sales, General, and Administration Expenses index (SGAI)?
The index is a ratio of current SG&A expenses to the prior year which, if disproportionately increasing relative to sales, may suggest an incentive to manipulate earnings upward
How should you interpret changes in the Daily sales in receivables index (DSRI)?
The index is a ratio of current days' sales in receivables to prior year. - An increase from year to year might suggest accelerated revenue recognition to inflate earnings (earnings manipulation)
How should you interpret changes in the Leverage Index(LVGI)?
The index is a ratio of current total debt to total assets versus prior year which is intended to capture debt covenant incentives for earnings manipulation
How should you interpret changes in the Gross Margin index (GMI)?
The index is a ratio of prior year gross margin to that of the current year which, if greater than one, suggest a declining gross margin and could indicate an incentive to inflate earnings
How should you interpret changes in the Depreciation index (DEPI)?
The index is a ratio of the prior year's depreciation rate to current year's which, if greater than 1, may suggest that the firm has increased the estimated useful lives of assets or has implemented "income friendly" methods of depreciation
What is the role of accounting earnings?
The role of accounting earnings is to alter beliefs about the firm's ability to pay future dividends and is consistent with the belief that earnings are an indicator of future dividend-paying ability.
Creative Acquisition Accounting
They classify an ever-growing portion of the acquisition price as "in-process" Research and Development, so -- you guessed it -- the amount can be written off in a "one-time" charge -- removing any future earnings drag. Equally troubling is the creation of large liabilities for future operating expenses to protect future earnings -- all under the mask of an acquisition.
HW3: The SEC question 103.1 regulates on how companies should report EBITDA. True or False
True
Big Bath Restructuring Charges
When earnings take a major hit, the theory goes Wall Street will look beyond a one-time loss and focus only on future earnings. (already having a bad year? just make it really bad)
How should you interpret the results of Benford's Law?
While no set of financial statement data will conform perfectly with the standard distribution, the analysis is helpful in identifying patterns that may be cause for concern. These patterns should prompt further inquiry into why the numbers may not conform
How do you compute the Beneish M score?
You compute the Beneish M Score by inputing the 8 financial ratios into the following formula M score = -4.84 + 0.920*DSRI + 0.528*GMI + 0.404*AQI + 0.892*SGI + 0.115*DEPI -0.172*SGAI -0.327*LVGI + 4.679*TATA The constant = -4.84 8 Ratios: 1. Daily sales in receivables index (DSRI)= Days Receivable (CY) /Days Receivable (PY) 2. Gross margin index (GMI) = Gross Margin (PY) / Gross Margin (CY) 3. Asset quality index (AQI) = Asset Quality (CY)/ Asset Quality (PY) 4. Sales growth index (SGI) = Sales (CY)/ Sales(PY) 5. Depreciation index (DEPI) = Depreciation Rate (PY)/Depreciation Rate (CY) 6. Selling, general, and administrative index (SGAI) = SG&A ratio (CY) / SG&A ratio (PY) 7. Leverage index (LVGI) = Leverage (CY)/ leverage (PY) 8. Total accruals to total assets (TATA) = Accruals / Total Assets *these will be given on the formula sheet
How do you compute Altman Z score?
You compute the Z score using the 5 ratios below: 1. EBIT/Total Assets 2. Net Sales/ Total Assets 3. Market Value of Equity/ Total Liabilities 4. Working Capital/ Total Assets 5. Retained Earnings/ Total Assets Then, plug the ratios into the following formula: Z-score = 3.3*(1)+0.99*(2)+0.6*(3)+1.2*(4)+1.4*(5) *this formula (including ratios) will be given on the formula sheet*
How should you interpret changes in the Sales Growth index (SGI)?
a ratio of current sales to prior year sales which, while the index itself does not imply manipulation, is important as high growth companies are likely under pressure to achieve earnings targets
How should you interpret changes in the Asset Quality index (AQI)?
an increase in long term assets other than property, plant, and equipment relative to total assets from the current year compared to the prior year indicates that a firm might have increased its propensity to capitalize, and thus defer, costs
HW3: Which of the following items should NOT be adjusted to compute GAAP EBITDA from net income? a. depreciation expense b. amoritzation expense c. impairment expense d. interest expense
impairment expense
Materiality
some companies misuse the concept of materiality. They intentionally record errors within a defined percentage ceiling. They then try to excuse that fib by arguing that the effect on the bottom line is too small to matter.
Revenue Recognition
some companies recognize revenue before a sale is complete, before the product is delivered to a customer, or at a time when the customer still has options to terminate, void or delay the sale. (happens often at FYE)
HW3: Which of the following incentive factors is associated with performance incentive factors? a. CEO is founder of the company. b. Few analysts follow the company. c. Unusually rapid growth or profitability. d. Overall economic conditions. e. Related party transactions.
unusually rapid growth or profitability
Cookie Jar Reserve
using unrealistic assumptions to estimate liabilities for such items as sales returns, loan losses or warranty costs. In doing so, they stash accruals in cookie jars during the good times and reach into them when needed in the bad times (make reserve up front so later on if you need it you can release it from the balance sheet)
(POTENTIAL ESSAY) What are the three levels of fair value hierarchy?
• Level 1 in the hierarchy includes inputs that are based on quoted prices in active markets for the identical asset or liability. • Level 2 includes quoted prices of similar instruments in active markets, quoted prices for identical or similar instruments in inactive markets, and observable market information on valuation parameters or market-corroborated information. • Level 3 represents measurements that incorporate significant unobservable inputs that reflect the reporting entity's own assumptions regarding valuation parameters that market participants would use.