s CPAs it is important to understand both the methods and motivations at play when otherwise ethical executives participate in fraudulent financial statement schemes. According to a 1999 study by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), in three-quarters of fraud cases the chief executive officer is directly involved. So try to trade places—in your mind—with the CEO of any public company. Imagine:
The market analysts have been pestering you, the CEO of the company, and your brother, the CFO, for advance information on the upcoming quarterly earnings announcement. They are predicting your company will earn 75 cents per share, just as in the last 9 quarters. But you know something they don’t: The company will be lucky to earn half that amount. Because the product recently introduced isn’t selling well, profits are going to take a big hit. When that happens, the stock price is bound to tumble. You wouldn’t and couldn’t tell the analysts this terrible news.
You’ve always considered yourself honest and ethical. Everyone in the company looks up to and admires you. Ironically, if the real truth about the earnings becomes public knowledge, many of the people who think so well of you will likely lose their jobs. You could go, too. And all of this is your fault. You believed in the new product line so much that you gambled the company’s whole future on it.
What do you do? The choice seems obvious. The lesser of two evils would be to fix the numbers before the quarterly report goes out. “Good grief, this is terrible,” you think to yourself. “But if we can just get past this quarter.”
IT STARTS WITH PRESSURE
In his book “Accounting Irregularities and Financial Fraud: A Corporate Governance Guide,” Michael R. Young points out the principle characteristics of fraudulent financial reporting. “Rather than starting with dishonesty, fraudulent financial reporting starts with a certain kind of environment…in which two things are present,” he says. “The first is an aggressive target of financial performance. The second is a vivid realization that a failure to attain that target would be viewed as unforgivable. In other words, fraudulent financial reporting starts with pressure.” Young also observed that most financial frauds begin with hazy areas of financial reporting such as revenue recognition issues and grow over time.
You’ve decided to consider fudging the numbers for just this one quarterly report. Since you don’t know exactly how that’s done, you talk to your brother. He looks at you hard. After a long silence, he tells you the company has already taken advantage of all the accounting gray areas to boost earnings. Nothing, he says, can further increase the profits. Nothing, that is, except for outright fraud.
FIVE METHODS FOR FINANCIAL STATEMENT FRAUD
People can commit fraud in financial statements in one of five interrelated ways: fictitious revenues, fraudulent timing differences, concealed liabilities and expenses, improper or fraudulent disclosures or omissions, and fraudulent asset valuations. This article will cover fictitious revenues, which the COSO study says is the most popular method to commit financial statement fraud and accounted for over half the cases in its analysis. The technique has a significant advantage—the inventory account (if there is one) is rarely involved. Indeed, in a prison interview videotaped in 1992, convicted swindler Barry Minkow of the infamous ZZZZ Best case said, “Accounts receivable are a wonderful thing for a fraudster like me. They immediately increase profits. But they also do something else—they explain why my company doesn’t have any cash; it’s all tied up in accounts receivable.”
Defining fictitious revenues. FASB Concepts Statement no. 6, Elements of Financial Statements, defines revenue as “actual or expected cash inflows (or the equivalent) that have occurred or will eventually occur as a result of the enterprise’s ongoing major or central operations.” Fictitious revenues, then, happen when purposeful attempts are made to book income that will not “eventually occur.” Defining the many complex accounting components of revenue is one thing, but the emphasis here is not on good faith disagreements on accounting principles; it is on the word “purposeful.” In legal parlance, that means intent. Simply put, financial statement fraud cannot be committed accidentally; one must have trickery in mind.
False journal entries. One of the easiest ways to book non-existent revenue is simply to create journal entries debiting accounts receivable and crediting sales. Sometimes phony supporting documents are created, sometimes not.
In discussions with the CFO, you suggest he simply make a journal entry to increase the revenues and receivables. He tells you the auditors might detect this method very easily. They could notice there is no offsetting inventory adjustment. Moreover, simply making a journal entry will create an imbalance in the general ledger; it will not agree with the sales journal or accounts receivable detail. And finally, he says, there is obviously no way to collect fake receivables. Therefore, the false entry would have to be reversed after the end of the quarter. That, he tells you, would stick out like a sore thumb in subsequent periods.
False sales to existing customers. A more sophisticated way to phony up income is to fabricate sales to existing customers. Under this method, appropriate supporting documentation, such as sales invoices and shipping documents, actually are prepared. Smart perpetrators select transactions with a few major customers, such as large organizations and governmental agencies, that they know will be difficult to confirm. If that doesn’t work, sometimes a major vendor is willing to help out by providing false confirmations to the auditors.
After hearing his explanation about booking false sales to existing customers, you tell the CFO that this seems to be the best method. You know several friendly vendors who may be willing to assist, or perhaps the best method is to charge fake sales to that big federal government contract. But your CFO cautions you: Sharp auditors will see that the “sales” have been booked near the end of the quarter, and may become curious. They could actually pick up the phone and call some of the credit customers, which might lead to discovery. And since the federal government is a major customer, the auditors would also likely examine those contracts. Out of desperation, you suggest another plan: “Invent” some new customers.
False sales to fake customers. Another method for creating fictitious sales involves billings to customers that don’t exist. In some cases, customers are made up out of thin air. The customer’s address usually is the key to detection. Sometimes, it is completely phony and not listed in the phone book. In other situations, a post office box or an employee’s home address is used.
The CFO tells you that false sales to non-existing customers also run the risk of quick detection by the auditors. And, he points out, any major attempt to add fictitious receivables and sales will throw the books out of whack, which auditors will quickly notice when they apply their analytical techniques. Finally, the CFO says, “Anything we do this quarter will come back to haunt us next quarter. The only right thing is to take our lumps and go on.”
Perhaps now you can better appreciate the temptations company leaders face and design your audit accordingly. Fortunately, most CEOs do not commit fraud. But Michael Weinstein wasn’t like most chief executive officers.
CASE STUDY: COATED WITH FRAUD
Michael Weinstein used to chuckle a lot. He smoked big cigars and lived well. He owned 10 airplanes, several helicopters, seven luxury automobiles (including two Rolls Royces) and two mansions. But under the glitter, Weinstein felt a lot of pressure.
Like so many others, he didn’t start out to be dishonest. At the age of 19, the enterprising Weinstein borrowed $1,000 from his father to acquire a drugstore. By the time he was in his 30s, he had parlayed his original investment into a chain of stores that he sold for several million dollars. For a while, Weinstein enjoyed the fruits of his labors, but then decided he was too young to retire. Besides, he liked the image of being a corporate giant. So Weinstein went into business again. That turned out to be the wrong decision.
Weinstein purchased Coated Sales, Inc. The company’s highly specialized business was coating fabrics used in parachutes, conveyor belts, helmet liners, camouflage uniforms, life vests and other items. Even though Weinstein initially knew nothing about the industry, he used his characteristic zeal and prowess to drive annual company revenues from $10 million to $90 million. BusinessWeek and Forbes wrote adoring articles about him, describing Coated Sales as the “fourth fastest growing company in the country.”
But even with the increase in sales, Weinstein started losing serious money in his quest for growth. After all, it takes a lot of cash to expand markets, build factories, develop cutting-edge products and buy companies. To keep the dollars flowing and to support his high maintenance lifestyle, Weinstein had come up with an idea.
All he had to do, Weinstein reasoned, was get past his current cash crunch. He needed money, but no bank would loan to Coated Sales if it knew the real financial picture. Indeed, if the facts were known, Weinstein could lose everything, including the luxury he had become accustomed to. So he went to his senior financial staff to seek its aid in carrying out his plan. The accounting staff tried to talk Weinstein out of it, so he threatened their jobs if they didn’t go along with his scheme. In less than three years, Weinstein would overstate profits and equity by $55 million and use those false profits to secure $67 million in bank financing.
Weinstein’s staff could have dummied up sales to a fake customer. In this case, though, they used a real customer’s account and added millions in phony sales. Unfortunately for Weinstein, the scheme fell apart when an auditor routinely called a luggage manufacturer to confirm it had purchased 750,000 pieces from Coated Sales. The company said it had never placed such an order.
The alarmed auditor then analyzed the books and didn’t like what he saw. While sales and accounts receivable were mushrooming, cash was actually decreasing. And although the inventory count was correct, the ratio of inventory to receivables showed the latter had grown considerably. Receivable turnover was slowing, and cost of sales was also decreasing. The auditor knew these tests were not conclusive, but the trends were consistent with phony sales and receivables. So he kept looking. By the time the smoke cleared, he determined that fully half of the receivables were fake. The auditing firm resigned from the engagement, and Coated Sales, Inc. was thrown into bankruptcy. Estimated losses: investors, $160 million; creditors, $17 million. Had the auditor not uncovered the scheme when he did, the damage would have been even greater.
As it was, Weinstein and his inner circle were slapped with a 46-page federal indictment. As part of his plea bargain, Weinstein was forced to give up all his assets, consent to a $55.9 million civil judgment, and serve 57 months in prison.
There are three valuable lessons to be learned from the Coated Sales case. The first is the most fundamental: Financial statements should tell a story that makes sense. All other things being equal, it doesn’t appear logical that a company with rapidly increasing sales and receivables would have decreasing cash. In almost all major financial statement frauds, the numbers tell the story.
The second lesson: Accounts receivable are attractive fraud targets, primarily because of the way receivables are viewed by lenders. Unlike inventory or fixed assets, accounts receivable—in the eyes of financiers—are the next best thing to cash. So there is more temptation for cash-strapped businesses like Coated Sales to fake it. Because the mechanics are simple, sales/receivables fraud schemes lead the fraudulent financial statement pack. If there are risk factors present, auditors should scrutinize a company’s accounts receivable.
The third lesson: Know with whom you’re dealing. People do things for a reason, and you should always factor that into the risk assessment. Michael Weinstein is typical of this genre of financial criminals. He acquired Coated Sales, was a major shareholder and installed himself as the CEO. That provides an extremely powerful motivation to commit fraud. If Coated Sales failed, so would Weinstein. Any time top management has a significant financial stake in the company, an auditor should carefully look at the numbers management generates.
Joseph T. Wells, CPA, CFE, is founder and chairman of the Association of Certified Fraud Examiners, Austin, Texas. He can be reached at email@example.com .