Structure & Scope

T.J. Jones presented himself as a turnaround specialist to the Chairman of the Board of Central State Corporation, a medium sized, public company, a mid-western manufacturer of computer equipment, who hired him to take over a large, but under-performing division of the company.  Jones immediately set out lofty goals for sales and profits and very quickly replaced all the existing senior staff of the division with new hires loyal to himself. To meet his inflated goals, two of Jones’s managers, in addition to legitimate equipment sales, shipped bricks to distributors and recorded some as sales of equipment to retail distributors and some as inventory out on consignment. No real products left the plant for these “special sales.” The theory was that actual sales would inevitably grow, and the bricks could be replaced later with real products. In the meantime, the unwitting distributors thought they were holding consignment inventory in the unopened cartons.

The result was that overstated sales and accounts receivable quickly caused overstated net income, retained earnings, current assets, working capital, and total assets. Prior to the manipulation, annual sales of the division were $135 million. During the two falsification years of the fraud, sales were $185 million and $362 million. Net income went up from a loss of $20 million to $23 million (income), then to $31 million (income); and the gross margin percent went from 6 percent to 28 percent. The revenue and profit figures outpaced the performance of Central State’s industry category. The accounts receivable collection period grew to 94 days, while it was 70 days elsewhere in the industry.

All the paperwork was in order because the two hand-picked managers had falsified the sales and consignment invoices, even though they did not have customer purchase orders for all the false sales. Shipping papers were in order, and several co-operating shipping employees knew that not every box shipped contained disk drives. Company accounting and control procedures required customer purchase orders or contracts evidencing real orders. A sales invoice was supposed to indicate the products and their prices, and shipping documents were supposed to indicate actual shipment. Sales were always charged to a customer’s account receivable.  During the actual operation of the fraud there were no glaring control omissions that would have pointed to financial fraud. Alert auditors might have noticed the high tension created by concentration on meeting profit goals. Normal selection of sales transactions with vouching to customer orders and shipping documents might have turned up a missing customer order. Otherwise, the paperwork would have seemed to be in order. The problem lay in Jones’ and his managers’ power to override controls and to instruct some shipping staff to send dummy boxes.  Confirmations of distributors’ accounts receivable may have elicited exception responses. The problem was to have a large enough confirmation sample to pick up some of these distributors or to be skeptical enough to send a special sample of confirmations to distributors who took the “sales” near the end of the accounting period. Observation of inventory could have included some routine inspection of goods not on the company’s premises.

The overstatements were not detected. The auditor’s annual confirmation sample was typically small and did not contain any of the false shipments. Tests of detail transactions did not turn up any missing customer orders. The inventory out on consignment was audited by obtaining a written confirmation from the holders, who apparently over the entire period of the fraud had not opened even one of the affected boxes. The remarkable financial performance was attributed to good management.

The fraud was revealed by one of Jones’ subordinate managers who was arrested on an unrelated drug charge and volunteered as a cooperating witness in exchange for the dropping of the drug charge.

This hypothetical case is a good example of the initial situation confronting management when a fraud affecting the financial statements comes to light, often with little or no warning. Everyone involved with company management will have a strong intuitive sense that an investigation is necessary; but the fact is that the company has now lost faith in the validity of its own public disclosures of financial performance.

That will need to be fixed. And it is not enough to simply alert markets that previously issued financial results are wrong; outsiders will want to know what the correct numbers should have been. The only way to find out is to dig into the numbers and distinguish the falsified results from the real ones. Beyond the need to set the numbers straight, the company will need to identify those complicit in the fraud and deal with them. This is not only a quest for justice but the need to restore credibility, and the company will be unable to do so until outsiders are satisfied that the wrongdoing executives and staff have been identified and removed.  Thus, the company needs an audit report on its financial statements. The need for a new audit report arises from the likelihood that, once a company’s financial statements have been found to be unreliable, the company’s external auditor will want to pull its existing, inaccurate,  report.

As a practical matter, pulling its report involves the external auditor’s recommendation that the company issue a press release that previously issued financial statements are not to be relied upon. Once the company issues such a press release, it will be out of compliance with any number of SEC regulations. It will no longer satisfy the threshold prerequisites for trading on the company’s securities exchange. It will be viewed by many, and certainly the plaintiff class action bar, as coming close to having admitted wrongdoing. And everyone on the outside, not to mention its own board of directors, will want answers fast. A critical step in the restoration of important business relationships and a return to compliance with regulatory requirements is the new auditor’s report. And, where fraudulent financial reporting has been discovered, an in-depth and comprehensive investigation is often the only way to get one.

A critical issue at the outset of a financial fraud investigation is its structure and scope. A key attribute for which the external auditor, as well as the SEC, will be on the lookout is that the investigation is overseen by the audit committee. In public companies, it is the audit committee that has explicit legal responsibility for oversight of financial reporting, and accounting fraud falls squarely within the orbit of financial reporting.  In addition, the audit committee, as a matter of statutory design, is structured to be independent and possessed of a level of financial sophistication that makes it the most viable subset of the board of directors to oversee the investigative efforts in this case. It’s also the audit committee that has the statutory power to engage and pay outside advisers even without the consent of management, a statutory power that can be vital if management, or part of management, as in our hypothetical case above, is a participant in the fraud.

The audit committee’s role is to oversee the investigation, not actually conduct it. For that it needs to look to outside professionals, and there are two types. The one is the outside counsel to the audit committee. If the audit committee has not already engaged outside counsel, it needs to do so. It’s audit committee counsel who will conduct the interviews, comb through the financial records, and present factual findings for audit committee consideration. Individual audit committee members may choose to sit in on interviews, and that is their choice. But it’s audit committee counsel who will conduct the investigation. The other group of professionals is the forensic accountants and/or CFEs.  Audit committee counsel, while knowledgeable of financial reporting obligations and investigative techniques, will probably not possess a sufficiently detailed knowledge of accounting systems, generally accepted accounting principles (GAAP), or computerized ledgers. For that, audit committee counsel is well advised look for help to the category of accountants and fraud examiners specifically trained in digging into financial records for evidence of fraud.

What exactly is the audit committee looking for in such an investigation? There are primarily two things. The first, obviously enough, is what the actual numbers should have been. Often fraudulent entries involve judgment calls where the operative question is not whether the number matches the underlying financial records but whether the judgment behind the number was exercised in good faith.  The operative question for the investigators is whether the executive exercised his judgment in good faith to make the best estimate allowed by reasonably available information. Sometimes it’s not so easy to tell.

Beyond the correct numbers, the second thing for which the investigators are looking is executive complicity. In other words: who did it? Again, the good faith of those potentially involved comes into play. The investigators are not seeking simply whether executives reported financial results that turned out to be wrong. The issue rather is whether the executives tried to get them right. If they did and made an honest mistake or estimated incorrectly, that does not sound like fraud and may not even be a violation of GAAP to begin with. The main point here is that, when it comes to executive complicity, the investigators are ordinarily looking for evidence of wrongful intent (scienter). In other words, they are looking for an intentional misapplication of GAAP or an approach to GAAP that is so reckless as to constitute the equivalent of an intentional misapplication.

The scope of the investigation, then, should not pose too difficult an issue at the outset.  Initially, the scope will be largely defined by the potential improprieties that have been uncovered. The tricky question becomes: how far should the investigators go beyond the suspicious entries? The judgment calls here are formidable. One of the key issues involves the expectations of the external auditor and, beyond that, the SEC. If the scope is not sufficiently broad, the investigation may not be satisfactory to either one. Indeed, an insufficient scope can place the external auditor in a particularly awkward spot insofar as the SEC may subsequently fault not only the audit committee for inadequate scope but the external auditor’s acceptance of the audit committee’s investigative report.
An additional complicating factor involves the way fraud starts and grows. A critical issue to consider is that, overtime, as the Central State example illustrates, the manipulations will often get increasingly aggressive as the perpetrators spread the fraud throughout many line items so that no single account stands out as unusual but a substantial number are affected. For example, to prevent the distortion of accounts receivable from getting too large, Jones and his accomplices spread the fraud into inventory, then asset capitalization, then net income. The spread of the fraud is analogous to pouring a glass of water on a tabletop. It can spread everywhere without getting too deep in any one place.

So, once fraudulent financial reporting has been identified, even in just a few entries, the investigators will want to consider the possibility that it’s a symptom of a broader problem. If the investigators have been lucky enough to nip it in the bud, that may be the end of it.  Unfortunately, if the fraud has gotten big enough to be detected in the first place, such a limited size cannot be assumed. Even where the fraud ostensibly starts out small the need for a broader scope has got to be considered.

The scope of the investigation, therefore, can start out with its parameters guided by the suspicious entries revealed at the outset. In most cases, though, it will need to broaden to ensure that additional areas are not affected as well. Throughout the investigation, moreover, the scope will have to remain flexible. The investigators will have to stay on the lookout for additional clues, and will have to follow where they lead. Faced with an ostensibly ever-widening scope, initial audit committee frustration is both to be expected and understandable. But there is just no practical alternative.

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