NDPPS Template Guide by rem12077

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									Fraudulent Financial Reporting – Identifying
Red Flags
                  Basic Understanding of Financial Disclosures Is
                  Important

                   Financial reporting encompasses more than balance sheet and income statement

                       -    Statement of cash flows can be enlightening as to potential problem areas

                       -    Footnotes provide details behind the numbers

                               • Debt compliance

                               • Contingent liabilities

                               • Commitments

                               • Accounting policies

                       -    Public companies are required to disclose impact of new accounting rules
                            that have not yet been implemented




F O R E N S I C                                            2
                  Basic Understanding of Financial Disclosures Is
                  Important (Continued)

                      Management’s discussion and analysis of financial condition and results of
                       operations supplements the financial statements

                               - Liquidity

                               - Critical accounting policies

                               - Off – balance sheet arrangements

                               - Quantitative and qualitative disclosures about market risk



                      Non – GAAP financial disclosures

                               - Excludes amounts, or is subject to adjustments that have the effect
                                 of excluding amounts, that are included in the most directly
                                 comparable measure calculated and presented i/a/w GAAP

                               - Includes amounts, or is subject to adjustments that have the effect of
                                 including amounts, that are excluded from the most directly
                                 comparable measure calculated and presented i/a/w GAAP



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                  Basic Understanding of Accounting Is Important

                   Certain elements of the financial statements result from accounting estimates,
                    which are not as precise as other reported amounts
                          - Valuation allowances and reserves against recorded assets
                          - Reserves for future obligations
                   Underlying certain elements of the financial statements are valuations that must
                    consider whether assets are impaired
                          - Goodwill
                          - Other intangible assets
                          - Investments
                          - Other long – term assets
                   Assessment of contractual terms is required for many transactions to determine
                    timing of revenue recognition, e.g. contracts that include multiple deliverables
                    over some period of time
                   Correlation between accounts




F O R E N S I C                                               4
                  Financial Reporting Is Difficult Even When Fraud Does
                  Not Occur

                   As evidenced by previous examples, accounting is not an exact science. These
                    areas provide greater opportunity for fraud

                   Critical accounting policies should be considered and used as a roadmap to when
                    potential issues may arise

                   Less robust and transparent financial disclosures may signal weaknesses and/or
                    “bad news”

                   Auditors are taught to use professional skepticism

                          - All users of financial statements should be professionally skeptical as they
                             study financial statements and disclosures

                          - Don’t make assumptions of honesty or lack thereof




F O R E N S I C                                              5
                  Fraudulent Financial Reporting

                  Definition

                   Intentional misrepresentation of financial information required for management
                    and/or external reporting.

                          - May or may not involve actual theft of cash or other assets

                          - Can materially affect the financial statements

                          - Could include omission of required or pertinent disclosures (amounts and
                            commentary)

                          - Not necessarily the result of a grand plan or conspiracy. Management may
                             rationalize the appropriateness of a material misstatement as an
                            aggressive rather than indefensible interpretation of complex accounting
                            rules, or as a temporary misstatement of financial statements, including
                            interim statements, expected to be corrected later when operational results
                            improve




F O R E N S I C                                              6
                  Fraudulent Financial Reporting (continued)

                  Fraudulent financial reporting may include:

                       Manipulation, falsification, or alteration of accounting records or supporting
                        documentation from which financial reports are prepared

                          – Revenue recognition

                          – Inventory

                       Misrepresentation in or intentional omission from financial reports of events,
                        transactions or other significant information

                       Intentional misapplication of accounting principles relating to amounts,
                        classification, manner of presentation or disclosure

                          – Reserve manipulation (“cookie jar”)

                          – Expense/capitalization and deferral

                          – Acquisition and restructuring charges




F O R E N S I C                                             7
                  Fraudulent Financial Reporting (continued)
                     Techniques that are used to mislead investors and other stakeholders
                      - Recording revenue too soon or of questionable quality
                      - Recording bogus revenue
                      - Boosting income with one-time gains
                      - Recording fictitious inventory or manipulating inventory counts
                      - Improperly capitalizing expense to inventory
                      - Shifting current expenses to a later period
                      - Failing to record or improperly reducing liabilities
                      - Shifting current revenue to a later period
                      - Shifting future expenses to the current period as a special charge
                      - Omitting required disclosures
                                    •   Debt covenants
                                    •   Commitments and contingent liabilities
                                    •   Related party transactions
                                    •   Accounting changes
                                    •   Significant events
                     Recent studies have indicated that of recent restatements, over one-third are the result of
                      revenue misstatements
F O R E N S I C                                                         8
                  Fraudulent Financial Reporting (continued)

                  Understanding fraudulent financial reporting

                   The key to understanding financial fraud perpetuated as a result of accounting
                     irregularities, and ultimately, the key to preventing it, is to understand the
                     corporate environment in which the fraud grows and the way that this
                     environment influences individual conduct.

                   Also areas of financial reporting that are most susceptible to fraud, inappropriate
                    manipulation, or inappropriate earnings management must be identified.




F O R E N S I C                                             9
                  Fraudulent Financial Reporting (continued)

                  Conditions generally present when fraud occurs

                   Incentives or excessive pressure to achieve targets,

                   Absent, ineffective, or weak internal controls that provide an opportunity for fraud to
                    be perpetrated, or

                   Attitudes or rationalizations that allow individuals to knowingly and intentionally
                    commit a dishonest act.




F O R E N S I C                                               10
                  Fraudulent Financial Reporting (continued)

                  Factors that can contribute to the risk of fraudulent financial reporting

                       Understaffed accounting and internal audit departments

                       Fear of losing one’s job or missing out on a promotion path

                       Low morale, lack of openness in the culture, or a culture of blame

                       Highly leveraged reward structures

                       Personal interest of management in the company’s share price

                       History of preparing over-optimistic forecasts

                       Cash flow problems, possibly breach of debt covenants

                       Aspects of the profit and loss account based on a significant degree of judgment

                       Significant, unusual, or highly complex transactions

                       History of sloppy balance sheet management




F O R E N S I C                                               11
                  Fraudulent Financial Reporting (continued)

                  Factors that can contribute to the risk of fraudulent financial reporting
                  (continued)

                       High degree of competition or market saturation, accompanied by declining
                        margins and customer demand

                       High vulnerability to rapid changes, such as technology, product obsolescence,
                        or interest rates

                       Recurring operating losses

                       Rapid growth and unusual profitability, especially compared to that of other
                        companies in the same industry

                       Profitability or trend level expectations of analysts and others

                       Significant related party transactions

                       High turnover of senior management, counsel, or board members




F O R E N S I C                                                  12
                  Fraudulent Financial Reporting (continued)

                  Case study – Overview

                  Hypothesize a company that goes public at a time of extraordinary economic
                  expansion and wonderful market performance…

                  Unfortunately, the company’s industry is beginning to slow down…




F O R E N S I C                                            13
                  Fraudulent Financial Reporting (continued)

                  Case study – What happens?

                  Hypothesize a company that goes public at a time of extraordinary economic
                  expansion and wonderful market performance…

                  Unfortunately, the company’s industry is beginning to slow down…

                  Senior management panics…




F O R E N S I C                                            14
                  Fraudulent Financial Reporting (continued)

                  Case study – What happens?

                  Hypothesize a company that goes public at a time of extraordinary economic
                  expansion and wonderful market performance…

                  Unfortunately, the company’s industry is beginning to slow down…

                  Senior management panics…

                  A division head feels the pressure of the unrealistically aggressive earnings target and
                  the potential consequence of failure…




F O R E N S I C                                               15
                  Fraudulent Financial Reporting (continued)

                  Case study – What happens?

                  Hypothesize a company that goes public at a time of extraordinary economic
                  expansion and wonderful market performance…

                  Unfortunately, the company’s industry is beginning to slow down…

                  Senior management panics…

                  A division head feels the pressure of the unrealistically aggressive earnings target and
                  the potential consequence of failure…

                  New quarter, new problem….




F O R E N S I C                                               16
                  Fraudulent Financial Reporting (continued)

                  Case study – What happens?

                  Hypothesize a company that goes public at a time of extraordinary economic
                  expansion and wonderful market performance…

                  Unfortunately, the company’s industry is beginning to slow down…

                  Senior management panics…

                  A division head feels the pressure of the unrealistically aggressive earnings target and
                  the potential consequence of failure…

                  New quarter, new problem….

                  Another quarter, bigger problem….




F O R E N S I C                                               17
                  Fraudulent Financial Reporting (continued)

                  Case study – What happens?

                  Hypothesize a company that goes public at a time of extraordinary economic
                  expansion and wonderful market performance…

                  Unfortunately, the company’s industry is beginning to slow down…

                  Senior management panics…

                  A division head feels the pressure of the unrealistically aggressive earnings target and
                  the potential consequence of failure…

                  New quarter, new problem….

                  Another quarter, bigger problem….

                  The situation deteriorates…




F O R E N S I C                                               18
                  Fraudulent Financial Reporting (continued)

                  Case study – The Pattern

                  Even though the hypothetical is fairly simple and straightforward, there is a distinct,
                  observable and recognizable pattern that is fairly typical.

                       Greed or drive to achieve

                       Pressure

                       Fear of failure

                       Gray areas of accounting that can be rationalized/opportunity to manipulate

                       Full-blown fraud




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                  Fraudulent Financial Reporting (continued)

                  Red Flags

                       Sales and income are decreasing while accounts payable and receivable
                        increase

                       Large number of account write-offs

                       Increased inventory not accompanied by increased revenues

                       Operating income significantly exceeding cash flows

                       Acquisitions or “restructurings” with no apparent business purpose/ frequent
                        restructurings

                       Line of credit “maxed” out for long periods of time

                       Debt covenant issues/waivers




F O R E N S I C                                               20
                  Fraudulent Financial Reporting (continued)

                  Red Flags (continued)

                       Limited or seemingly incomplete disclosures

                       Lack of disclosure of impact of new accounting rules

                       Management compensation predominantly linked to short-term performance

                       Significant related party transactions with minimal disclosure

                       Increasing intangible assets not supported by increased operating income

                       Allowances that are not correlated with receivables

                       Revenue or profit growth out of line with the industry or inconsistent with the
                        degree of risk, i.e. significant profits in products which are inherently low risk




F O R E N S I C                                               21
                  Fraudulent Financial Reporting (continued)

                  Red Flags (continued)

                       Revenues that are not correlated with balance sheet items

                       Expenses that are not correlated with revenues and reasonably explained

                       Less than robust disclosure of critical accounting policies

                       Critical accounting policy disclosure that implies aggressive accounting

                       Earnings that consistently and precisely meet analyst expectations




F O R E N S I C                                               22
                  Fraudulent Financial Reporting (continued)


                      The aforementioned red flags are general in nature and could relate to or be
                       discovered in a routine review of financial statements, footnotes, and
                       management’s discussion

                      A few examples of specific purchasing and inventory fraud follow, along with the
                       red flags that might be observable with a more detailed analysis

                      These represent examples of the types of items that auditors might encounter
                       during audits




F O R E N S I C                                             23
                  Fraudulent Financial Reporting in Purchasing

                  Manipulation of rebates and discounts — Examples

                       Rebates taken conditional on levels of purchases from the supplier. The
                        conditions may not be included in the written purchase contract. They may form
                        part of some hidden contract terms or a side letter.

                       Misrepresentation or forging of confirmations and contract details regarding
                        rebates




F O R E N S I C                                              24
                  Fraudulent Financial Reporting in Purchasing
                  (continued)

                  Manipulation of rebates and discounts — Red flags

                       Abnormal numbers and/or value of credit memos around period ends

                       Volume discounts/rebates not monitored independently against quantities
                        bought

                       Stock surpluses (indicating possible over-purchasing) to trigger volume
                        discounts




F O R E N S I C                                              25
                  Fraudulent Financial Reporting in Purchasing
                  (continued)

                  Hidden contract terms — Examples

                       Side letters with suppliers to manipulate invoicing to enable favorable expensing
                        or capitalization of services rendered or products delivered



                  Hidden contract terms — Red Flags

                       Unusual trends just before and after period end.

                       Supplier billing descriptions are unusual/different

                       Unusual business relationships and transactions




F O R E N S I C                                               26
                  Fraudulent Financial Reporting in Purchasing
                  (continued)

                  Delaying/advancing payments — Examples

                       Non-standard payment agreements with suppliers to reduce or inflate apparent
                        prices to shift profits/losses from one period to the next




F O R E N S I C                                            27
                  Fraudulent Financial Reporting in Purchasing
                  (continued)

                  Delaying/advancing payments — Red flags

                       Vague terms in contracts and no detailed review of charges such as travel,
                        advertising, consultancy fees, recruitment, maintenance and leasing

                       No competitive bidding




F O R E N S I C                                           28
                  Fraudulent Financial Reporting in Inventory

                  Improper Valuation – Examples

                       Inflated valuation of raw materials

                       Inflated valuation of work in progress

                       Improperly capitalized costs

                       Losses on unprofitable contracts recorded against work in progress of profitable
                        contracts




F O R E N S I C                                                  29
                  Fraudulent Financial Reporting in Inventory (continued)

                  Misvaluation – Red flags

                       Profit or bonus targets reached in latter part of the year with increased inventory
                        and flat performance otherwise

                       New explanations about salability of inventory and market conditions

                       Unusual trends in the valuation of particular product lines or work-in-progress
                        and/or margins




F O R E N S I C                                               30
                  Fraudulent Financial Reporting in Inventory (continued)

                  False status of inventory – Example

                       Forged or altered information regarding the prospects of disposal or realizable
                        values of inventory

                       Misrepresentations regarding ownership

                       Inflated or fictitious consignment inventory

                       Inventory sold or leased at the time of an inventory count counted as unsold
                        inventory




F O R E N S I C                                                31
                  Fraudulent Financial Reporting in Inventory (continued)

                  False status of inventory – Red flags

                       New or unexpected explanations for valuation

                       Obsolescent or slow-moving stock lines which miraculously find a new market –
                        for example a distributor in an emerging market where the status of the counter-
                        party and the distribution channel is clouded in secrecy

                       Increased level of inventory in relation to recent history or sales

                       Change in correlation between recently received inventory and related accruals




F O R E N S I C                                                32
                  Fraudulent Financial Reporting in Inventory (continued)

                  False quantity of inventory – Example

                       Inclusion in inventory of items already sold to third parties

                       Maintaining empty storage crates

                       Manipulation of cut-off

                       Falsification of records regarding inventory in transit

                       Falsification of inventory count sheets or receiving reports




F O R E N S I C                                                33
                  Fraudulent Financial Reporting in Inventory (continued)

                  False quantity of inventory – Red flags

                       Close monitoring by management of products/items being checked by auditors

                       Different handwriting on certain count sheets which are part of a sequence
                        counted by one person

                       Unusual trends in stock levels




F O R E N S I C                                             34
                  Three Components to Managing Fraud and Misconduct

                              Integrity Compliance                         Internal Audit Group




                                          Prevention                            Detection




                                                      Investigation




                                                 Fraud Investigative Unit
                       Inclusion of these groups within an organization leads to enhanced control environment
F O R E N S I C                                                      35
                  Managing Fraud and Misconduct Risk (continued)

                  Detecting Fraud

                  Not simple or easy – since by its definition/nature, fraud involves:

                       Concealment
                          •   Withholding Information
                          •   Misrepresenting Information
                          •   Falsification of Documents
                          •   Collusion
                                  –   Management
                                  –   Employees
                                  –   Third Parties

                       Willful




F O R E N S I C                                             36
                  Managing Fraud and Misconduct Risk (continued)

                  Detecting Fraud (continued)

                  Not simple or easy – but not impossible

                       Effective detection requires:
                          •   Strong corporate fraud risk management policies and procedures aligned
                              with business strategy
                          •   Understanding of fraud red flags
                          •   Understanding of proper business processes
                          •   Understanding of business environment and the people in the business
                          •   Appropriate techniques
                          •   Appropriate tools
                          •   Experienced, and sufficient professionals to detect
                          •   Feedback loop for lessons learned from internal/external audits and
                              investigations




F O R E N S I C                                              37
                  Managing Fraud and Misconduct Risk (continued)

                  Detection

                       Analytical Analysis

                          – The application of comparisons, computations, inquiries, inspections and
                            observations to analyze and develop expectations about relationships
                            among financial and operating data for comparison to recorded account
                            balances or classes of transactions.

                       Types of analytical and expectation procedures

                          – Reasonableness analysis

                          – Trend analysis

                          – Ratio analysis

                          – Vertical Analysis

                          – Horizontal Analysis




F O R E N S I C                                            38
                  Managing Fraud and Misconduct Risk (continued)

                  Vertical and Horizontal Analysis




F O R E N S I C                                      39
                  Managing Fraud and Misconduct Risk (continued)

                  Vertical and Horizontal Analysis




F O R E N S I C                                      40

								
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