Fictitious earnings
This is the concept not that we’re going to steal money from the company but we’re actually going to steal money from investors, from stakeholders such as lenders and other parties. And we are going to make them believe that our organization is worth a lot more than it actually is and in today’s market that is typically done as it has been done in yesterday’s market—by creating the expectation of earnings that are going to happen in the future that frankly don’t warrant that expectation.
If you have real earnings your first clue is that your sales are going to go up. So what happens when sales increase? Well if you want to increase your revenues, what are you actually going to do? You are going to expand your market. The market is actually going to expand itself and that does happen or you are going to steal some of that market share from your competitors. So lets say we’re in some relatively mature industry and what’s going to happen when we increase those sales?
Margin constant or decreases
Well is your margin going to increase when you increase sales at the same time? I don’t think so. Typically, you are going to have to do that by some price competition, some advertising, some combination of marketing strategy that will allow you better penetration. It is unlikely that your margin will increase and it will probably decrease. If you are going to increase sales it’s because you have taken some steps to do so.
Sales expenses increase
Typically, it will be associated with an increase in selling expenses. You have to pay your sales people more commission, you have to put a greater infrastructure in delivery and distribution.
Receivables turnover static – receivables increase
Your receivables turnover will be probably static. Your sales will go up but your receivables will go up. Now you might get movement, yes, but all things being equal, you’ll probably get a relatively static relationship between receivables and sales.
Bad debts as a percentage of sales static or weakens
What will happen to bad debts? Well if you are selling more and you are trying to penetrate the other sectors of the market you may expose yourself to greater credit risks. Chances are your bad debt experience is not going to improve, it’s probably going to deteriorate or at least stay static.
Inventory turnover static – inventory increases
What’s going to happen to your inventory turnover? Well the inventory itself ought to increase because you have more throughput going through but your cost of sales is going to increase so the relationship between cost of sales and inventories may not change a bunch.
Payables turnover static – payables increase
Your payables will be somewhat similar. You’ll have more payables but you will have more throughput on your purchases.
Increase in cash from operations
If all things work well for you, you should have an increase in cash from operations. I mean that is the objective of the exercise. One thing that I can also guarantee, just as I can guarantee that you don’t get credit memos from fictitious suppliers, you don’t get cash from fictitious earnings.
Inflating earnings/increase sales
So what happens if you inflate earnings fictitiously? You increase sales. And let say there is this wonderful tool that we have, double entry bookkeeping, it’s fabulous—one of the best kept secrets in accounting is there is another side to the entry. So what are you going to do? If you are going to credit sales what are you going to debit? Well let’s say for the sake of argument we’re going to debit receivables. There are a number of things that we could debit but let’s say we debit receivables. Well what happens if you debit receivables?
- Well your sales have increased but your cost of sales haven’t gone up so your margin has improved. That’s not what happened before is it?
- Your receivables turn over. Your receivables have increased but your turnover hasn’t.
- Your bad debts as a percentage of sales probably improves because your sales have increased and your bad debts haven’t changed.
- Your inventory turnover is probably static which it normally wouldn’t be. The inventory itself is static because you haven’t done anything with inventory because you haven’t actually got anything that’s happening.
- And there is no increase in cash from operations.
So that’s a different picture. The relationships among the elements of the financial statements are different than they are if you get real activity. What happens if instead of debiting receivables you debit inventory? You get similar anomalies in these sets of relationships that exist in comparison to what happens normally. If you go back to the example that we looked at with the fictitious supplier what we are doing is comparing what happens in a fictitious case to what happens in a normal case. If we know what normal looks like then we can hypothesis what the fraud is going to be that we are looking for then we can figure out what it is that fraud would look like compared to normal activity. And to the extent that we can distinguish it from normal activity then we can find it.
Back to my homily that if you want to find fraud you have to know what it looks like. And you can identify what it looks like. These are very simple, unsophisticated types of analysis that we are talking about. There are lots and lots of other evidence sources available to you. You are going to look at three case studies later on this morning and I would encourage you to think about the analysis that you can do in each of those case studies that might have enabled people to detect the existence of irregularity in each of those cases before it actually occurred.
Other evidence sources
The other evidence sources. All of this activity, in a public corporation, requires explanation. There is extensive disclosure of information in the management’s discussion and analysis of financial statements.
Are there MD&A explanations? Do they make sense? What are they not explaining?
In many cases if you find that there is something irregular and MD&A probably doesn’t explain it so it is as important to look for things that aren’t explained that should have been as the things that are explained that don’t make any sense. Is there, if you look at some of the classic frauds, you know, the equity funding, salad oil swindle, going back in years now telling how old I am, but those are cases where if you took the financial statements and looked at data outside that little set of information that’s in the financial statements, there was more salad oil inventory than there was in the whole of the United States. If you looked at some of the realities, I mean the equity funding growth in insurance premiums, these are categorically unsustainable. But people are focussed on a very narrow set of data. There is a lot more data available to you and I would encourage you to think about using it. As I said at the outset of dealing with management fraud, it never produces cash. And cash frankly is one of the things that auditors ought to be able to verify—they actually do get bank confirmations I think still.
Is it getting worse?
It is also a case that it’s a little bit like having a bad tenant you know, if you can’t collect your rent, the guy says I’m going to pay you next month can you hold off? Well, I mean, that’s really bad policy to agree to that because if the person can’t pay today, how is he going to pay next month not only what he owes next month but what he owed before. And that’s typically what happens in cases of fraudulent financial statements. That it creates, it builds up a debit that doesn’t go anywhere and that debit sometimes, somehow or other has to get turned through the income statement so that you’re building up a problem and in order to deal with that problem you have to create more fictitious activity to hide that. And it becomes compounding until the whole thing collapses in most cases.
So it tends to be a situation you can track over time and it’s very relevant if you are looking at case study material not just to look at the financial statements as they were at the time that the business went down but at the continuity of those financial statements over the past two, three, four or five years.
Is this a fourth quarter issue?
And typically chickens come home to roost when people have to report their public earnings and they have to do that at quarter ends and the one the people obviously pay the most attention to is the year-end financial statements. This is a chestnut. It has been around forever but look for fourth quarter adjustments.
What do other evidence sources indicate?
Do people continually exceed forecast and expectations? If they do, what the heck is it that they are doing different? One of the things might be that they are committing a fraud and it’s important that you think about the possibility that they are committing a fraud. Is there a counter trend going on here? Is there are growth pattern in a volatile industry that is very consistent? What is it that’s happening? I mean, I don’t know if you people remember crazy Eddie from the United States, but here was a business in the retail sector that was just going gang busters, multiple, multiple earnings year after year after year of this consistent growth in an industry that it doesn’t happen in. It just doesn’t make sense.
Most of the management fraud that I see at a relatively low level that you don’t see in the business papers although the sort of case studies you are going to look at today, you find this problem of people trying to confuse and obfuscate what is really going on. And one of the ways to do that is to hide things in plain sight but make it very complicated. So if you have a business structure that’s unnecessarily complicated, nine times out of ten there is a reason for it that is not a good reason.