Post on 04-Oct-2020
How the fraudsters fool the auditors
6 November 2012
Financial statement fraud
Sarbanes Oxley
perpetuates change
• higher standards for corporate governance
• independent regulatory framework
• quality and transparency of financial reports
• severe civil and criminal penalties
• protections for corporate whistleblowers
CLERP 9 impact
Establish ‘auditor obligations’ to guide financial
reporting. Requirements:
• auditor registration
• ASIC reporting requirements
• transaction specific disclosure relating to
securities, financial services and markets
• disclosure for the on-sale of securities and
other financial products
PCAOB established by
Sarbane’s Oxley
• registered public accounting firms
• establishing or adopting auditing, quality
control, ethics and independence
• investigating registered public accounting
firms
• enforcing compliance with the Sarbanes-
Oxley Act
PCAOB Model: Asia Pacific
Fraud still happens….
0% 10% 20% 30% 40% 50%
Deloitte & Touche
PricewaterhouseCoopers
KPMG
Ernst & Young
Big Four Total
19%
12%
22%
9%
15%
45%
39%
23%
21%
33%
2010
2009
Deficient audits
\Source: New York Times, The percentage of audits reviewed by the Public Company Accounting Oversight Board that were found to be
deficient by inspectors rose sharply in 2010 from 2009.
2007
2008
2009
2010
2011
163
209
157
174
191
Law suits filed per year
Shareholder class actions not declining
Source: Figure 1, Page 5, The ever-changing landscape of litigation comes full circle: 2011 Securities Litigation study , April
2012
Internal Controls
Revenue Recognition
Other
Overstatement of assets
Understatement of liabilities & expenses
Estimates
Purchase accounting
62%
32%
27%
26%
16%
14%
8%
Financial statement fraud has many hats
Source: Figure 5, Page 13, Percentage of accoutning cases citing specific issues, 2010-2011, April 2012
The auditor’s responsibility
“An auditor is responsible for
obtaining reasonable assurance
that the financial report taken as
a whole is free from material
misstatement, whether caused
by fraud or error.”
Source: Auditing Standard ASA 240 The Auditor's Responsibilities Relating to Fraud in an Audit of a Financial Report
What % of frauds do
auditors detect?
What % of fraud do
auditors prevent?
ACFE Report to the Nations on Occupational Fraud and Abuse, 2012
Tip
Management Review
Internal Audit
By Accident
Account Reconciliation
Document Examination
External Audit
Notified by Police
Surveillance/Monitoring
Confession
IT Controls
Other
43.3
14.6
14.4
7
4.8
4.1
3.3
3
1.9
1.5
1.1
1.1
Percent of Cases
What is a quality audit?
audit staff collects sufficient, competent, and
reliable evidence
auditor raises issues with the audit team
issues reported to management, board, and/or
audit committee
But, too often fraud slips through the cracks…
Causes of audit failures
overly complex structure
management bullying
restricted contact with staff
change in operations (acquisition)
artificial time pressure/deadline
reliance on junior staff
lack of sufficient fees v
Causes of audit failures
incompetence / poor judgment
greed
mis-aligned incentives
dependence on fees
Auditors have the best intentions
Stuff rolls downhill
Client
Stuff
Partner
Senior
Manager
Manager
Senior
Crest of Ignorance
Junior auditor
Senior
Cave of Unreported Exceptions
Junior
auditor
Fermented stuff
Analysts
Fermented stuff
Analysts
Actions have consequences…
Why commit financial
statement fraud?
conceal embezzlement
conceal true business wealth
preserve personal status and control
maintain personal income/wealth
achieve incentives
Bank reconciliation
manipulation…
Bank balance 12,000,000
Cheque 230,000
Cheque 6,000
Cheque 4,000
EFT 1,500,000
EFT 750,000
Cheque 510,000
General ledger bank balance 15,000,000
Auditors checked balance
to bank confirmation
Auditors agreed
subsequent cheque
and EFT deposits to an
online bank statement
printed from online by
employee
Auditors agreed balance
to general ledger
Employee produced a forged bank statement
Employee stole $2,250,000
Lessons learned
internal control audit identified cash controls
HIGH risk
auditors failed to consider HIGH risk
audit standards require more stringent
substantive procedures
Judgement & manipulation
Setting the scene…
AUDITORS
AUDIT COMMITTEE
BOARD OF DIRECTORS
CEO
CFO
GM GM GM GM GM
ACCOUNTING
TEAM
Aggressive accounting or fraud?
inventory provision
impairment of intangibles
accounts receivable provision
Judging management’s intention…
Judging management’s intention…
Lessons learned
Auditors detailed concerns but severity of the
issues was not properly communicated to the
Board of Directors.
Board relied on management to explain and
justify any issues raised by the auditors.
Loan fraud and a
questionable audit
Timeline of events
Bank discovered
red flag transaction
Missing computer equipment: offices
appeared closed down. Forensic
technologists recovered data
External auditor refused
access: power failure
Bank appointed receivers
and managers
Identified and documented
$20m fraud
Related-party transactions and
complex organisational structures
ADMINISTRATORS OWNERS
LOAN BOOK
Lessons learned
Auditors failed to understand complex
structure of entities and transactions resulting
in improper disclosure.
Requesting documents prior to arriving does
not represent good investigative skills.
Improper acquisition
accounting and co-opting
of auditors
Yellow Star Industries
2005
2006 2008
2009
2010
2007
Yellow Star IPO
Hope Electronics
Jenkins Manufacturing
Other Acquisitions
Key perpetrators
What was their strategy?
aggressive number of acquisitions
cut costs wherever possible
manipulated the financial statements of the
acquired companies pre consolidation
Financial statement fraud
defer revenue
overbook reserves
pre-pay expenses
write down inventory
REVERSE all entries on consolidation of
Yellow Star
Then, the “stuff” hit the fan
Former CEO turns Whistleblower
What % of frauds are detected by
whistleblowers/tips?
ACFE Report to the Nations on Occupational Fraud and Abuse, 2012
Tip
Management Review
Internal Audit
By Accident
Account Reconciliation
Document Examination
External Audit
Notified by Police
Surveillance/Monitoring
Confession
IT Controls
Other
43.3
14.6
14.4
7
4.8
4.1
3.3
3
1.9
1.5
1.1
1.1
Percent of Cases
Investigation commenced
financial statement analysis
document reviews
witness interviews - key to understanding
intent and circumstances behind the suspect
entries (intent to defraud?)
targeted former employees of the acquired
companies, including…
Bill “Papa” Thomas
nonsense inventory
adjustments!
deferred to judgment of
Yellowstar and outside
accountants
entries reversed after
consolidation
“they weren’t stupid, they
were crooks!!”
signed declaration and
assisted litigation
Karen Jillwater
experienced
accountant/former auditor
revenue deferrals and
expense pre-payments
“were crazy”
Cruz: “shut up and do as
you’re told!”
spreadsheets with evidence
(stoplight)
signed statement and
assisted litigation
Auditors Conspired with Cruz
Cruz was a former Partner at
the audit firm
Huge fees for the auditors
colluded with management
Cruz bullied and convinced
employees and auditors to
come along for the ride
audit teams led
consolidation and created
red, yellow, and green
coding system for entries
Financial statement fraud
Pre-
acquisition
Post-
acquisition
Impact for Yellowstar
Delayed revenue
recognition
Recognise
revenue Increase profits
Reserve/inventory
manipulation Write up inventory
Increase profits
Premature
recognition of
expenses
Expenses are
artificially low
Increase profits
Recap after stuff hits the fan
v
v
stock price plummeted
investors lost billions
indictments
litigation, investigation, and recovery
investors recovered billions from company
and auditors
Lessons learned
co-opted auditors (internal and external)
management and employees driven by stock options
internal auditors rewarded by increase in stock price
acquisitions increased work for external auditors
Cruz cherry picked his audit team
Overstated capital assets
Detection – data analytics
Allocated to COGS
NOT
a cash payment or creditors
Increase PP&E $926,361
Increase net assets $962,361
Decrease COGS ($926,361)
Increase net profit $962,361
BOTTLE
BOTTLE
BOTTLE
BOTTLE
Documentation to verify
the bottle mould purchase
Additional evidence provided
Lessons learned
auditors failed to understand severity of
debt
no review of bank covenants
audit fee too low
Recap Case How the financial statement fraud was
concealed from the auditors?
Employee
embezzlement
Forged documents
Reliance on junior staff
Molly’s Makeup Used complex models
Relied on management representation
Aussie Auto Loans Auditor requested documents in advance of visit –
forged documents
Complex related party transactions and low fees
resulted in missed disclosure requirements
Yellow Star Auditors colluded with management – high audit
fees and stock incentives
Bottle Corp Late journal entries
Management bullying
Audit Partner relied on junior staff
v
v
v
What’s the solution?
Mandatory auditor rotation?
Government intervention?
Insurers hire auditors?
ACFE’s involvement?
Angela Clancy
Senior Manager, Forensics
Melbourne, Australia
t: +61 3 9269 4123
e: aclancy@ppbadvisory.com
w: www.ppbadvisory.com