1

Uncovering Financial Statement

Fraud: A Case Study

An Acquisition in Wonderland?Presented by Carolyn Newman,

Audimation Services, Inc.

2

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

3

4

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”

5

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…

6

How Did It Get To This Point?

Purchaser

7

Mad Hatter and March Hare’s

Tea Party

CFOController

8

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

9

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

10

The Game:

Using Formulas

11

The Game:

Manipulating Accounts Receivable

12

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

13

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

14

-

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

15

The “Rebucketing” Game

16

17

The “Credit to Clear” Game

18

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

19

The Game of Understating

Liabilities

20

The Topside Entries Game

21

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

22

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.”

23

Things Got

“Curioser and Curiouser”

Uncovering the Fraud

24

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

25

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

26

Fraud Investigation Tools

Uncovering the Mechanics of the Fraud

27

Accounting Staff Interviews

• Topside entries

• Falsification of supporting documentation

• Altering bank reconciliations to achieve

pre-determined cash balances

• 3rd Re-Bucketing

28

29

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”

30

Application of the Fraud Triangle

Pressure, Opportunity and

Rationalization of Defrauding Alice

31

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

32

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

33

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

34

Lessons Learned – Internal

35

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

36

Lessons Learned – External

37

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

38

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

45

Questions

46

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.

47

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.

48