There is a fast-growing string of public companies that are admitting that their prior financial statements inflated real business trends. This increase in restatements, which included a fair amount of corporate scandals, prompted the Department of Justice to issue a three-part formal definition describing the illegal activities that encompass corporate fraud: (Part I) Accounting Fraud (sometimes called “Earnings Management”) (Part II) Self-Dealing by Corporate Insiders (Part III) Obstructive Conduct In this article, we examine Part I – Accounting Fraud. We provide an overview of the trend in reporting “corrections” or financial restatements by US public companies; we highlight some of the commonly exploited areas of fraudulent accounting; and finally, we highlight some areas of consideration for legal counsel involved in financial reporting investigations.

Financial Restatements Trend

Table 1 below, which is an excerpt from a study performed by Huron Consulting Group LLC (“the Huron Study”), indicates that the total number of public companies that restated their previously reported financial statements totaled 323 in 2003, a slight decrease from 330 restatement filings in 2002, and up from 270 in 2001 and 233 in 2000. Many of these restatements were due to accounting decisions taken by corporate executives that could be categorized as errors and incorrect application of accounting rules, adoption of aggressive judgment positions within the rules, and/or outright accounting fraud (Table 1: Year 1999, 2000, 2001, 2002, 2003 Number of Restatements respectively 216, 233, 270, 330, 323).

• Aggressive Targets – usually tied to executive compensation;
• Earnings Growth Pressures – must “make the numbers”, i.e., analyst expectations;
• Loan Covenants Requirements – including threat of bankruptcy;
• Poor Corporate Governance Practices – fiduciary duties neglected;
• Inadequate System of Controls – including poor “checks and balances”;
• Greed – unethical corporate behavior and culture.

A typical accounting fraud scenario starts with small manipulations of accounting entries (“one-time acts”) due to the pressures referenced above. These entries eventually have a snowballing effect that perpetuates itself with each successive reporting period. Before long, these one-time acts escalate into a deliberate pattern of continuous fraudulent reporting.

1. Cookie Jar/Rainy Day Reserves - Management may overestimate these reserves in the current period when business results appear strong (higher expense recorded), and dip into the cookie jar in the future to reduce the inflated reserve and related expenses when business results appear weak. Earnings are thus “managed” to allow growth to appear “smoother” and more predictable over time. The opposite occurs as well where reserves are underestimated in current periods of bad results and increased in future periods of good results. The DOJ also listed some common fraudulent revenue recognition schemes deployed by management are as follows.
2. Revenue Acceleration - This scheme includes inappropriately booking future period revenues into current period. Some of the common examples include recording revenues for goods that have not been shipped or accelerated reporting of percentage of completion contracts.
3. Phantom Sales - This includes recording sales for goods that were never sold (fake invoices created) or services never performed. An example of this scheme is “parked inventory sales” where sales are recorded for goods shipped to a site (warehouse, parking lot), which in reality is controlled by the seller. This provides the appearance that a valid sale occurred.
4. Swap Transactions - Some companies inflate revenues by conspiring with other companies and exchanging services and payments solely for the purpose of recording these swap “transactions” or agreements as valid sales.
5. Channel Stuffing - Some companies oversell their products to distributors and retailers in this scheme. In the future, this excess product is either returned to the seller or a deep discount is given to the customer.

The primary schemes associated with the fraudulent recording or nonrecording of expenses incurred by companies are as follows.

• Capitalization of Expenses - If a cash outflow is treated as an “expense” on the books, it reduces net earnings, while recording the outflow as an “asset” does not reduce earnings. Some companies mistreat these outflows while initially recording them in the books, while others reclassify expenses as assets at the end of the year.
• Deferred or Undisclosed Expenses - In this scheme, the company “does not record the expense at all” and keeps it “off the books”, whereas in the capitalization scheme discussed previously, the company records the expenses incorrectly to inflate net earnings.

References

[1] Tamika Langley Tremaglio, JD/MBA, is a Managing Director and Kofi Boxill, CPA and Sumit Dangi, CPA/CFA, are associates at Huron Consulting Group’s Washington, D.C. office. If you have questions, please contact Ms. Tremaglio at 202 756-4554 or ttremalglio@ huronconsultinggroup.com.