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This chapter is from the book

1.3. Management Fraud Schemes

Management fraud, as the name suggests, is perpetrated by the top management of a company who has the intention of misleading investors. The most common form is through accounting manipulation, which materially misstates the financial statements of the company. The motivation behind the fraud is usually to maintain a high stock price and thereby lower the cost of capital for the company.

One of the most common ways to inflate earnings is by simply overstating or misclassifying revenue. There are many well-known fraudulent schemes that have been used to inflate revenue, such as

  • Bill and hold sales. In such schemes the company bills the customer for the sale, hence creating a perception that a legitimate sale was made, but it never ships the goods. Instead in the following accounting period it simply reverses the sale, reporting that there was a customer return.
  • Booking fictitious sales. This scheme is discussed shortly in the context of fraud committed at HealthSouth.
  • Holding books open at the end of the period. Through this method the next period’s sales are recorded in the current period, thus inflating the revenue of the current period while understating revenue in the subsequent period. This scheme was used by Computer Associates.
  • Delaying reporting of customer returns. When customers return merchandise, the revenue initially recognized from those sales must be reversed. By delaying the reporting of returns to the next period, management effectively reports higher revenue in the current period.

The overstating of revenue would in most cases also overstate accounts receivables and hence would also overstate assets.

The overstatement of revenue may not always be sufficient to inflate income to the desired level; hence management might use a combination of understating expenses along with overstating revenue. The common schemes to understate expenses include

  • The understatement of cost of goods sold by padding inventory. When a periodic inventory accounting method is used, the cost of goods sold is indirectly determined by measuring ending inventory. Inventory is overstated, causing a decline in the cost of goods sold expense.
  • Capitalization of costs in order to reduce expenses. When costs are capitalized, the resulting expense is spread over multiple years rather than reporting all of it in the current year. Capitalizing costs that should be expensed results in the understatement of expenses in the current period, leading to a overstatement of income. The capitalized costs are reflected as assets, hence also overstating total assets on the balance sheet. This scheme was used in the Worldcom fraud and is discussed in a subsequent section.
  • Extending the depreciable lives of assets, thereby reducing depreciation expense. As depreciation expense is linked to the management’s estimation of the useful life of an underlying asset, overestimating the lives of assets reduces the depreciation expense, resulting in an overstatement of income. This scheme was employed by Waste Management.

Understating expenses also leads to overstatement of assets or understatement of liability. When costs are capitalized and not expensed, it leads to higher assets. When accrued expenses are not recorded, it leads to an understatement of liability.

Balance sheet fraud is committed with the intention of reporting lower debt and liabilities than the company actually bears. This is often accomplished through the use of off-balance sheet financing. Schemes to fraudulently reduce liabilities include

  • Misclassification of leases. Although capital leases are recorded as a liability, under U.S. Generally Accepted Accounting Principles (GAAP), operating leases currently are not required to be reported as a liability. Misclassification of a capital lease as an operating lease allows a company to remove the underlying liability from its balance sheet.
  • Not recording accrued expenses. As just discussed, a failure to record accrued expenses results in the income being overstated and the liabilities being understated.
  • Concealing liabilities in the accounts of unconsolidated subsidiaries. As in the case of Enron, shell companies were created with the sole purpose of off-loading liabilities from Enron’s financials onto the financials of these shell companies.
  • Structuring sophisticated financial transactions such as Repo 105 to remove liabilities from the balance sheet. As discussed next, Lehman structured a “round-trip” transaction, which enabled them to reduce both assets and liabilities on the reporting date thereby presenting a lower leverage ratio.4

The remainder of this section discusses a few prominent cases of recent business failures in which the use and interpretation of accounting rules were questionable.

Fraud at WorldCom

WorldCom was accused of having inflated profits by $3.8 billion over a period of five quarters. The company undertook the massive fraud by capitalizing costs that should have been expensed. Capitalization of these costs allowed the company to spread the expenses over several years instead of recording all the costs as expense in the current period. Such deferral of costs allowed the company to report lower expenses and therefore inflated income.

From 1998 to 2000 WorldCom reduced reserve accounts held to cover the liabilities of acquired companies resulting in $2.8 billion in additional revenue. They misclassified expenses and marked operating costs as long-term investments. There were undocumented computer expenses of $500 million, which were treated as assets. The fraud was uncovered by the internal auditors in July 2002; soon thereafter WorldCom filed for bankruptcy.

Fraud at HealthSouth

HealthSouth, a publicly traded company headquartered in Birmingham, Alabama, with 1,600 locations spread over all 50 states and three other countries, was by many accounts the first company to be prosecuted under the provisions of the Sarbanes-Oxley Act of 2002. Its former CEO, CFO, and other senior officers fraudulently inflated the company’s reported income to meet Wall Street’s earnings expectations. The fraud began in mid-1996 and spanned for about seven years, during which time their true cumulative income was $1.7 billion or about 40% of what the company had reported. The SEC charged the senior officers in March 2003 for knowingly falsifying accounting records and designing fictitious entries to overstate cash by $300 million and overstating total assets by at least $800 million.

Evidence presented at the trials showed that facilities owned by HealthSouth submitted legitimate financial reports to the headquarters in Birmingham. However, at the corporate office those numbers were inflated at the time the consolidated financials were prepared. A fictitious account called contractual adjustments was created to book fake revenue numbers. Additionally, the company failed to properly record the sale of technology to a related company, resulting in a $29 million overstatement. Also HealthSouth twice recorded a sale of 1.7 million shares of stock in another company, netting a $16 million gain. Examiners also found fictitious assets totaling close to $2 billion.

The fraud mechanism used by HealthSouth required collusion among various employees who were known as “family” and attended quarterly “family meetings” to cook the books. Top company officials reviewed unpublished financial results and compared those with Wall Street expectations. The shortfall was termed as a gap or hole that had to be filled using “dirt.” Staff accountants were instructed to make fictitious entries to fill the “gap,” and false documents were created in an attempt to conceal the false entries from the auditors. It was common knowledge that auditors verified transactions over $5,000, hence fictitious transactions were made for amounts between $500 and $4,999. To gain a proper perspective on the sheer enormity of the fraud, it required an upward of two million falsified journal entries to overstate the income by almost $5 billion. This was a clear indication of how widespread the involvement and knowledge of the fraud was within the organization. At the conclusion of the investigation, it seemed that everyone in the organization was aware of the massive fraud—except the auditors.

Questionable Accounting Practices at Lehman

In September 2008, Lehman became the largest company in U.S. history to file for bankruptcy. Nine months earlier, Lehman had reported record revenue and earnings for 2007. In early 2008, Lehman’s stock was trading in the mid-sixties with a market capitalization of more than $30 billion. Over the next eight months, Lehman’s stock lost 95% of its value and was trading around $4 by September 12, 2008. In March 2010, Lehman’s Bankruptcy Examiner, Anton Valukas, issued a 2,200-page report that outlined the reasons for the Lehman bankruptcy.5

Lehman routinely engaged in short-term borrowing but structured some of these loans under a scheme known as Repo 105. Repo transactions are quite common in the financial industry. Under a Repo agreement a bank borrows funds and transfers assets to the lender as collateral. At a later date, the bank pays back the loan with accrued interest and repossesses the transferred assets, hence Repo. Normally, the collateral is 2% above the borrowed amount. Lehman altered the agreement slightly and transferred assets whose market value was 5% above the borrowed amount. However, instead of classifying these transferred securities as collateral for the loan, to be returned upon the settlement of the loan, Lehman would record the transfer as a sale with an agreement to repurchase on a specified date.

Interestingly, during the term of a Repo 105 transaction, Lehman continued to receive the stream of income through coupon payments from the securities it transferred. Additionally, just as in an ordinary repo transaction, Lehman was obligated to “repurchase” the transferred securities at a specified date. Moreover, Lehman used the same documentation to execute both Repo 105 and ordinary repo transactions, and these transactions were conducted with the same collateral agreements and substantially with the same counter-parties. Lehman’s usage of Repo 105 was timed around the end of reporting periods. The Examiner’s Report analyzed the intra-quarter data on the usage of Repo 105 and concluded that its usage spiked at quarter-ends and fell off on an intra-quarter basis. The amount of Repo 105 activity at period-end from late 2007 to mid-2008 ranged from $39 billion to $50 billion. The use of Repo 105 transactions enabled Lehman to remove assets and corresponding debt from its balance sheet, yielding a marked improvement to its leverage ratio. The ratings agencies and counter-parties to Lehman’s Repo transactions were concerned about the high leverage ratio of Lehman. Thus, being able to show a decrease in their leverage ratio was beneficial to Lehman. It is unclear as to whether or not the use of Repo 105 led to the demise of Lehman; however, it is evident that Lehman employed a questionable accounting treatment of Repo 105 that had no business purpose or economic significance other than to understate their leverage ratio.

Lessons Learned

As illustrated through these examples, management fraud, although not rampant, could have potentially devastating effects on the reputation and sometimes the viability of the company and the auditor. Moreover, management fraud is usually ongoing over several years. Even though cleverly concealed, many employees are aware of the scheme and usually would have raised red flags or otherwise tried to warn auditors and regulators. Complaints from former employees should not be dismissed casually as being vindictive, but due professional care has to be exercised by the auditor. Statistical techniques presented later in the book can perhaps lead to early detection of such fraudulent schemes and limit losses to investors, employees, and society.

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