Financial Statement Fraud Casebook

Baking the Ledgers and Cooking the Books

Joseph T. Wells, Joseph T. Wells

• Publisher: Wiley
• Year: 2011
• ISBN:
  9781118077061
• Edition: 1
• Topic: Business
• Subtopic: Auditing
• Index: Business

A comprehensive look at financial statement fraud from the experts who actually investigated them

This collection of revealing case studies sheds clear insights into the dark corners of financial statement fraud.

• Includes cases submitted by fraud examiners across industries and throughout the world
• Fascinating cases hand-picked and edited by Joseph T. Wells, the founder and Chairman of the world's leading anti-fraud organization? the Association of Certified Fraud Examiners (ACFE)? and author of Corporate Fraud Handbook
• Outlines how each fraud was engineered, how it was investigated and how the perpetrators were brought to justice

Providing an insider's look at fraud, Financial Statement Fraud Casebook illuminates the combination of timing, teamwork and vision necessary to understand financial statement fraud and prevent it from happening in the first place.

Chapter 1

Keep On Trucking

Ralph Wilson

Jenny Baker was viewed by her associates as a brilliant CFO. She was known for her ability to predict the outcome of future uncertainties with startling accuracy. She was also known to be very demanding, even intimidating at times. Many of her staff had experienced one of her famous outbursts; consequently, they didn't always feel comfortable asking her many questions. She had started her career as a staff auditor for one of the Big Four accounting firms, where she specialized in the transportation industry and was well regarded for her understanding of the nuances of sometimes complex financial transactions.

Using her experience as a launching pad, Jenny had taken a job in regulatory accounting for a regional trucking firm and had moved quickly through the ranks to become the CFO. Not content with a regional firm, she had made several strategic career moves that finally landed her a job as vice president of finance at a national transportation company. During her tenure there, Jenny had gained the confidence of those around her, including the CEO and many of the directors on the company's board.

While pursuing her career, Jenny had also found time to marry and have two children; she even had three grandkids. When she wasn't working, she loved to spend time with her grandchildren; she would even plan her vacations as family events so that she could include them. She was in her mid-fifties, had a nice home, a country-club membership and was no longer driven to advance in her career. She was satisfied with where she was in life. Her long-term plan was to retire early and enjoy all of the things she had worked so hard to earn.

Atkins Trucking

Atkins Trucking Company had been founded in the late 1930s as the economy began to recover somewhat from the Great Depression. The company began as a local trucking firm in a major metropolitan area in the northeast. The founder, Daniel Atkins, had prided himself on delivering high-quality service and always pleasing the customer. Over the years, the company had acquired a reputation for integrity.

After World War II, the transportation industry really began to grow and Atkins Trucking expanded from a local operation to a regional firm and eventually became a national player in the field of transportation. As a result of the expanded transportation market and to recognize new service lines, the company had changed its name to Atkins Transportation Services. Because of family influence, however, the company remained closely held. The only public financing of company activities came from the debt markets. The company made regular use of commercial paper and occasionally issued bonds for long-term capital investments. Atkins Transportation employed 3,500 people concentrated at corporate headquarters, as well as in strategic transportation hubs located throughout the United States.

Always Learning

I was the internal audit director for Atkins Transportation Services. My department consisted of six employees, one of whom was designated as a special projects auditor. One of the things we liked to do was proactively look for fraud. We often undertook data mining to look for improper expenditures or unusual vendor relationships. Sarah Harrington, the special projects auditor, routinely brainstormed with me about new approaches for finding fraud. One day we received a brochure describing a forensic accounting class focusing on financial statement analysis. Since neither of us had taken such a class before, we signed up for it. It turned out to be a wise investment.

Forensic financial statement analysis typically includes techniques involving horizontal and vertical relationships among the basic financial statements — the balance sheet, the income statement, and the statement of cash flows. I remember the instructor specifically telling us to focus on “time-sensitive interdependencies” to identify possible manipulation. In other words, look at what happens over time, not just the current year or the previous year. He also said the most important indicator of earnings manipulation is the correlation of reported earnings with reported cash flows from operations. After completing the class, we had lots of new tools at our disposal to look for fraud.

Armed with this information, I downloaded ten years of company financial data into a spreadsheet and began the process of selectively graphing the relationships we had been taught in class. This was a tedious process, but it began to reveal some unusual patterns. For the early years on the graph, the reported earnings did correlate well with the cash flows from operations; however, the most recent five years showed a remarkable divergence in correlation. Moreover, an analysis of the allowance for doubtful accounts showed entirely unexpected results. For example, during a period of strong revenue growth, the allowance had increased dramatically. According to what I had heard, the company was doing a great job at collecting accounts receivable. What I was seeing painted a different picture.

This was all new territory to me. We weren't quite sure what to do next. However, I remember thinking, “This is exciting . . . this stuff really works!” Almost every day, I would call in Sarah or one of the other auditors to show them what I had found. “Look at this,” I said. “Do you understand why this is happening?” No one had any explanations.

As I continued my analysis, Sarah began to download journal entries from the company's accounting system. She organized the entries and looked into some of the accounts that didn't make sense. One day Sarah came into my office and said, “I found some journal entries with the notation ‘Jenny's entry’ as the explanation for the transaction.” I asked, “Is there any other information about the purpose of the entry?” “No, that's all there is,” she said.

Sensing that we had found something significant, we began to discuss what to do. Soon a consensus emerged that we should talk to our external audit firm. They were already onsite with only six more weeks until the annual report was completed. We scheduled a meeting and showed the engagement partner and the auditor in charge our financial statement analysis. Then we talked about the transactions we had found with the unusual notations. They seemed interested in our work, but their initial response was, “We need to finish the engagement . . . our opinion is due by the 30th of next month.” This didn't sound promising, but they said they'd get back to me.

After a few days, I received an e-mail from the engagement partner saying they were not going to pursue the issue this year. They had looked at their work papers and they were satisfied with the explanations they had received from management. However, they suggested that we look more closely at the issues. I thought, “Great . . . what do we do now?”

Management by Intimidation

“Why can't the controller explain these entries?” I asked. Sarah and I had just come from a meeting with the company controller and the director of accounts receivable. Rather than take a more direct approach in our investigation, we had decided to initiate an audit of accounts receivable. That way, we could gather more information and not raise too much concern.

Our meeting had started off well, but soon became uncomfortable when we asked about some of the entries that had been made to the allowance for doubtful accounts. We showed the controller, Stewart Wood, some of the journal vouchers with the notation “Jenny's entry” and asked if he could explain them. He responded, “If you want to understand those entries, you'll have to go and talk to Jenny.” “Why is that?” I said, “Don't you know the reason for these entries?” At that point, Stewart became defensive and said, “Those entries are communicated to me by management; you'll need to talk to them.”

Not wanting to concede so easily, I changed tactics and said, “These entries are affecting our bottom line, Stewart. Some of them increase the bottom line and some of them decrease it. What do you think management is trying to do here?” Stewart was unwilling to respond, so Jack, the director of accounts receivable, intervened and said, “I've worked in this industry for a long time and this kind of thing is not unusual. Management is just trying to smooth out the peaks and the valleys. This is fairly common; you shouldn't be too concerned about it.”

Next we turned our attention to some of the bad debt accounts related to the allowance for doubtful accounts. Jenny was very exacting in her demands for information, so the controller had set up several accounts to keep track of bad debts by service line. There was a bad debt account for short-haul service, one for long-haul service and one for international service. There was even an account called “Bad debt — NA.” I showed this to Stewart and asked him what “NA” meant. He responded, “It means ‘not assigned.’” “What do you mean by that?” I said. Stewart explained, “This account is not assigned to any of our service lines; management uses this account to make occasional adjustments to bad debt expense.” “Is this part of your normal monthly process?” I asked. “No,” Stewart replied. “Management decides when we make entries to this account.”

I asked Stewart to explain the methodology for determining the amounts to book to the NA account. He said he didn't know the methodology. I then asked to see the substantiation for some of the entries. He said he didn't have any. I asked him who approved the entries to this account and he told me that no one approved them. “These entries are made at Jenny's direction,” he said. “No one needs to approve them.”

This was astounding to me. There were absolutely no controls over some very material accounting entries. How could the external auditors have missed this? I knew from prior audits that the monthly process for estimating bad debts was well substantiated and that all entries were required to be approved. We had apparently stumbled into a dark closet and we soon discovered that no one appreciated us trying to shine some light in there.

Before proceeding further though, Sarah and I decided to dig into the accounting records some more. We downloaded all the entries made by Stewart over the past five years and then performed text searches looking specifically for the words “Jenny's entry” in the description field. We learned that Jenny concentrated her unusual activities in two areas: accounts receivable and regulatory reserves. We already knew what was happening in accounts receivable so we began to focus on the regulatory reserves.

Regulatory reserves were contingent liabilities established for settling accounts with various taxing authorities. In the transportation industry, licensing fees and taxes were subject to audit and sometimes the taxing authorities would make adjustments to what the company had already paid. The reserve accounts were established to estimate potential audit adjustments.

Next, I charted the balance in the reserve accounts over ten years to see what was there. Not surprisingly, I saw the same unusual pattern of increasing and decreasing balances that seemed unrelated to underlying business conditions. “Those must be some of the peaks and valleys,” I thought.

Sarah scheduled a meeting with the director of regulatory accounting to see if he could help explain the regulatory reserve transactions. Soon after scheduling the meeting, Sarah received an e-mail from the director explaining that he was headed away on vacation and he would like to delay the meeting until after he returned. That seemed strange; he knew about his vacation when he scheduled the meeting. Why did he want to delay it? Soon we learned that Jenny had ordered him not to meet with us until he returned.

The next morning, I received a call from the CEO, Todd Martin. He wanted me to know that he had received a call from Jenny Baker. She had complained that I was being unprofessional in dealing with her staff. She said that I had told her staff that she was manipulating the accounting records. I told Todd that all we had done was ask questions about some accounting entries that didn't make sense. We didn't know what was happening and the only way to find out was to ask questions. Todd replied, “Just be aware that Jenny isn't happy about what you're doing. Watch your step.”

Later that day I received an e-mail from Jenny telling me that she wanted to know the scope and objectives of our audit. She said her people were busy doing their work and didn't have time for all of the questions we were asking. I replied that we had sent a memo to the director of accounts receivable announcing the audit and that she had been copied. I also explained to her that once we began collecting information, we had found some entries that didn't make sense. I stated, “As auditors, we have the responsibility and the authority to follow the trail wherever it leads.” I copied the CEO on my response. Jenny didn't reply.

After the director of regulatory accounting returned from his vacation, we succeeded in scheduling a meeting. Sarah met with him and got the same story we had already heard. The director kept track of all of the known regulatory liabilities, but Jenny directed him to create reserves for unknown liabilities. The director couldn't explain the methodology for estimating these reserves. The amounts were determined by Jenny based on her years of experience in the transportation industry. He had no reason, nor desire, to question Jenny about the reserves. If we wanted to know more about them, then we'd have to ask Jenny.

After talking it over with Sarah, we decided to go directly to Jenny for answers. We scheduled a meeting for the following Monday. When we arrived, we noticed several of her high-ranking staff members arriving in the conference room as well. We had expected to be meeting with Jenny alone. Perhaps this was an intimidation tactic — Jenny was famous for intimidating her own employees. Now it was our turn. I leaned over to Sarah and whispered, “Looks like this is going to be a big meeting.”

Once the meeting got started, we proceeded to explain our concerns about the accounting entries we had found. We reported that internal controls over certain transactions were nonexistent and asked Jenny if she could explain what was happening. Her response was unusual. Rather than discuss the specific transactions, she began by talking about the complexity of the transportation industry. She talked about all of the regulatory and economic uncertainty and how it affected financial reporting. She then reviewed all of the experience that she and her staff had and said they were more than qualified to account for all of that uncertainty by including reserves in the company's financial statements. We, conversely, didn't have the same experience that she had; we were not experts in the industry. I admitted to her that we didn't have the same experience that she had, but we could understand the accounting if someone explained it to us.

Although she didn't say it, her message to us was that we had to rely on her experience rather than normal accounting rules. That's where I turned my attention next. Prior to the meeting, I had brushed up on internal controls over accounting estimates as well as the rules for recording contingent liabilities. I asked her, “So, you're telling me that with all of the uncertainty in the transportation industry, it's hard to estimate things like bad debts and tax liabilities?” “Yes,” she replied. “It's almost impossible to estimate things like bad debts or regulatory reserves. We look at our financial statements each month and if the numbers don't look right, we make adjustments as needed based on our experience. We try to reflect the underlying business.”

I informed her that according to FASB No. 5, Accounting for Contingencies, contingent liabil...