Finding fraud: The schemers may change but the schemes are old school

I get asked a lot for an explanation of common fraud schemes and some real life examples

This article by Douglas R. Carmichael, PhD, CPA, CFE is the Claire and Eli Mason Professor of Accountancy at Baruch College, New York, N.Y., in CPA Journal, says that one of the primary motivations of the new revenue recognition standard, ASC 606 effective in 2018, was “to prevent fraud and abuse in the recognition of revenue.”

“…the requirements for contract existence are relevant to the large number of cases of improper revenue recognition involving fake contracts or contracts that were not legally enforceable.

Manipulation of contracts has been a common element in revenue recognition frauds. Some cases, such as those against ZZZZ Best and Satyam, have involved fictitious contracts. Gemstar purportedly used expired and disputed as well as nonexistent contracts; others, such as Computer Associates, MicroStrategy, and Autonomy, backdated contracts to prematurely recognize revenue. In other instances, such as the matter of Peregrine Systems, material contingencies added in oral or concealed written side agreements resulted in non-binding arrangements. No accounting guidance can prevent fraudulent contract practices, but Topic 606 should focus significant renewed attention on establishing the existence of a valid contract.” 

A study by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) of 347 financial statement fraud cases found that 61% of fraudulent financial reporting cases investigated by the SEC were focused on improper revenue recognition schemes.  

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Here’s a great resource from Deloitte Japan with definitions and explanations of many common schemes.

(And here’s some old school Chicago Soul Train, the music I listened to when I was working at the first “too big to fail” bank, Continental Illinois National Bank and Trust. Did you know the studios for Soul Train were in the CBOT building at the head of the LaSalle Street canyon?)

Improper Revenue Recognition

  • Side Agreements 

    • See Ahold: “Ahold fully consolidated several joint ventures in its financial statements despite owning no more than fifty percent of the voting shares and despite shareholders' agreements that clearly provided for joint control by Ahold and its joint venture partners. To justify full consolidation of certain joint ventures, Ahold gave its independent auditors side letters to the joint venture agreements, signed by Ahold and its joint venture partners, which stated, in effect, that Ahold controlled the joint ventures ("control letters").”

    • See Navistar (Vendor Rebates): “In some instances, certain Engine Division employees also generated side-letter arrangements with vendors that detailed that the rebates were contingent on future purchases and/or the vendor could recoup the rebate through inflated future prices by which the Company would forego agreed-upon price reductions. Additionally, these side-letters stated that Navistar would refund the rebate accordingly if the Company failed to make sufficient future purchases. These side-letters made clear that these rebates had not actually been earned at the time the amounts were recognized.”

    • See Dell (2010): “Dell did not disclose to investors large exclusivity payments the company received from Intel Corporation not to use central processing units (CPUs) manufactured by Intel’s main rival.  It was these payments rather than the company’s management and operations that allowed Dell to meet its earnings targets.  After Intel cut these payments, Dell again misled investors by not disclosing the true reason behind the company’s decreased profitability.

      The SEC charged Dell Chairman and CEO Michael Dell, former CEO Kevin Rollins, and former CFO James Schneider for their roles in the disclosure violations.” 

  • “Roundtrip” Transactions:

    • “In a round-trip transaction, an entity recognizes revenue in one transaction with the customer and, in a separately structured transaction, provides the consideration to the customer that offsets the amount to be received in the revenue transaction. Some well-known examples are Qwest and Global Crossing buying and selling line capacity between them in what was, in substance, a nonmonetary exchange. In other examples, AOL inflated online revenue recognized by paying counter-parties more than the fair value of software, hardware, or other operating equipment acquired, and Peregrine Systems paid for its customers’ software purchases by investing stock or cash in them contemporaneously.”

  • Channel Stuffing

    • See Bristol Meyers (2012): “Frederick S. Schiff, former CFO of Bristol-Myers Squibb Co. (Bristol Myers) and Richard J. Lane, former President of the Worldwide Medicines Group for Bristol Myers…at their direction, Bristol Myers engaged in a “channel-stuffing” scheme. The complaint alleged that Bristol Myers used financial incentives to induce wholesalers to buy its pharmaceutical products in excess of prescription demand in order to artificially inflate its results, which in turn was necessary in order to meet Bristol Myers’ internal earnings targets and the consensus earnings estimates of Wall Street securities analysts. The complaint alleged that by doing so, Bristol Myers improperly recognized revenue from pharmaceutical sales associated with the channel-stuffing.”

    • See Symbol Technologies (2015): “…from 1999 through March 2001, Asti participated in fraudulent revenue recognition practices, including quarter-end "stuffing" of Symbol's distribution channel to help meet revenue and earnings targets imposed by Symbol's CEO.”

  • Bill and Hold

    • See Diebold (2010):  “Diebold prematurely recognized revenue on certain F-term orders by improperly using bill and hold accounting. A significant number of Diebold's F-term orders failed to satisfy the stringent bill and hold criteria.

      13. Under GAAP, to use bill and hold accounting, the customer, not Diebold, must request that the transaction be on a bill and hold basis, and the customer must have a substantial business purpose for ordering on a bill and hold basis. Many of Diebold's F-term orders failed to satisfy these criteria.

      14. With many F-term orders, Diebold asked customers to sign Diebold's form contract -~ its standard Memorandum of Agreement ("MOA") -- which contained a boilerplate clause stating that the customer had requested Diebold to hold items for the customer's convenience. Diebold then recognized revenue when the company shipped the products from its factory to its warehouse in accordance with a "ship to warehouse" date contained in the MOA Notwithstanding the language in the MOA, Diebold's accounting was not in accordance with GAAP because generally Diebold's customers had not requested that the transaction be on a bill and hold basis.”

    • Bill-and-hold schemes, such as those by Sunbeam, Nortel, and Maxwell Technologies, have been widely reported. Cutoff schemes recognize revenues for goods or services in the current period when they are delivered in the next reporting period. These schemes, such as those by Computer Associates, Sensormatic, and Peregrine Systems, have been described as “December 37 year-ends” and “35-day months.” Similar schemes, such as those by Autonomy and U.S. Surgical, have involved shipping goods to entities other than customers, where they were parked until eventual sale or return.”

  • Holding Accounting Periods Open

    • See Computer Associates: “…the defendants manipulated Computer Associates' quarter end cutoff to align Computer Associates' reported financial results with market expectations.”

      • “During the period from at least Jan. 1, 1998, through Sept. 30, 2000, Computer Associates prematurely recognized over $3.3 billion in revenue from at least 363 software contracts that Computer Associates, its customer, or both parties, had not yet executed, in violation of GAAP.”

      • “…held Computer Associates' books open for several days after the end of each quarter to improperly record in that quarter revenue from contracts that were not executed by customers or Computer Associates until several days or more after the expiration of the quarter.”

  • Failure to Record Sales Provisions or Allowances 

Inventory Schemes

  • Inflating the Value of Inventory 

  • Off-Site” or Fictitious Inventory

    • Crazy Eddie, ZZZZBest

Other Financial Reporting Schemes

  • Fraudulent Audit Confirmations - Fraudulent audit confirmations can impact all types of accounts or transactions that are confirmed with third parties (sales, cash, accounts receivables, debt, liabilities, etc.).

  • “Refreshed” Receivables - In order to mask rising account receivable balances (including known or suspected uncollectible balances) while avoiding increasing the bad debt provision, a company may “refresh” the aging of receivables and improperly represent A/R balances as being current in nature instead of showing the true age of the receivables. 

  • Promotional Allowance Manipulations 

    • See Tesco: “The accounting errors relate to the rebates that Tesco receives from suppliers as an incentive to sell more of their products or to help the supermarket fund promotions.”

      • Also Tesco: “PwC told investors and other users of the financial statements:

        “We focused on this area because of the judgment required in accounting for the commercial income deals and the risk of manipulation of these balances.”

        PwC missed the fraud anyway.

        (Commercial income includes estimates of cash rebates to be received from suppliers based on volumes purchased by Tesco. That gross profit drops directly to the bottom line. It’s not a revenue problem but a gross margin overstatement as rebates reduce cost of good sold. It seems Tesco was recording the rebates aggressively, based on executives “estimates and judgment” in anticipation of higher purchases, even reportedly offering kickbacks to vendors to pay right away, even though sales were tanking and presumably purchases of goods would be lower as a result.)”

    • See Navistar (Vendor Rebate): “During the 2001 to 2004 time period, Navistar ramped up its engine production beyond initial expectations and correspondingly increased its purchases of engine parts from suppliers. Navistar sought to share in those suppliers’ unanticipated profits by asking them to pay a portion back to the Company in the form of rebates. Under GAAP, a company could recognize rebates only when they were actually earned, i.e., when the entity had substantially accomplished what was necessary to be entitled to such rebates. Accordingly, Navistar could record the full rebate as income in the then-current period only if no contingencies existed on its right to receive the rebate. Conversely, the Company was prohibited from booking rebates as income in the then- current period if they were based on future business.”

      • “18. During this period, Navistar booked 35 rebates and related receivables from its suppliers. Of those rebates and receivables, as many as 30 were improperly booked. While these rebates and receivables took different forms -- including volume-based rebates and so-called “signing bonuses” for Navistar’s award of new business -- all were improperly booked as income in their entirety upfront, even though, in whole or in part, they were earned in future periods.”

      • Also Navistar (Vendor tooling): “…in 2003, the Company initiated a program pursuant to which Navistar arranged to terminate certain of these amortization agreements and acquired the tooling via lump sum payments to the suppliers. However, instead of paying suppliers the remaining unamortized tooling cost as of the 2003 purchase date, the Company paid the suppliers a dollar amount equivalent to the unamortized tooling cost as of the beginning of the 2003 fiscal year. Since Navistar had already been paying amortization to the suppliers since the start of that fiscal year (i.e., November 1, 2002), the Company arranged to receive back from those suppliers a “rebate” equivalent to those year-to-date amortization payments. The Company then improperly booked these rebates into income. In addition, the Company improperly deferred depreciation costs related to the tooling buybacks.”

    • See Ahold: “A significant portion of USF's operating income was based on vendor payments known as promotional allowances. USF executives materially inflated the amount of promotional allowances recorded by USF and reflected in operating income on USF's financial statements, which were included in Ahold's Commission filings and other public statements.”

      • “The overstated promotional allowances aggregated at least $700 million for fiscal years 2001 and 2002 and caused Ahold to report materially false operating and net income for those and other periods.”

  • Adjustments to Estimates

    • See Navistar (Warranty Reserve): “The warranty accrual estimate process began with the Engine Division’s Reliability & Quality (“R&Q”) group, which generated an estimated warranty cost per unit, or CPU, for each engine sold. This calculation incorporated certain “above-the-line” items, including well-established or known steps (e.g., implemented engineering fixes) that were viewed, based on historical trends or data, to have effectively reduced warranty costs. The CPU was the primary basis for the warranty reserve amount; the higher the CPU, the higher the reserve.

      34. The warranty reserve-setting process should have been governed by accounting rules related to contingent liabilities. Pursuant to Statement of Financial Accounting Standards (“SFAS”) No. 5, Accounting for Contingencies - Appendix A; With Respect to Obligations Related to Product Warranties and Product Defects, warranty reserves must be established when it is probable that a liability has been incurred and the amount of the loss can be reasonably estimated.

      35. When R&Q’s CPU calculation was presented to Stanaway, and then ultimately to McIntosh, both typically stated that the initial estimated reserve number was too high for the Engine Division’s business plan. Without sufficient consideration for the relevant accounting rules, Stanaway and McIntosh typically then directed R&Q to add certain “below-the-line” items to the warranty reserve calculation process because they thought these items would reflect potential reductions that the Company hoped to achieve in future warranty costs. These “below-the-line” items included anticipated vendor reimbursements and engineering fixes6 that lacked historical trend or other data evidencing their likely effectiveness.”

  • Cookie Jars

    • See Dell (2010): “Dell’s most senior former accounting personnel, including Schneider, Dunning, and Jackson engaged in improper accounting by maintaining a series of “cookie jar” reserves that it used to cover shortfalls in operating results from FY 2002 to FY 2005.  Dell’s fraudulent accounting made it appear that it was consistently meeting Wall Street earnings targets and reducing its operating expenses through the company’s management and operations.” 

    • See Brixmor (2019): “The SEC’s investigation, assisted by the U.S. Attorney, the Federal Bureau of Investigation, the U.S. Postal Inspection Service and the New York State Department of Financial Services, described the whistleblower’s reports that said he believed the “core piece of this earnings management” was conducted through a particular internal ledger account—the 2617 account—which was used as a “cookie jar” to hold funds to be “taken into income somewhere down the line to help the company meet earnings guidance.” 

      The SEC’s complaint says that Carroll, Pappagallo, Splain and Mortimer improperly adjusted Brixmor’s SP NOI by selectively recognizing income from a “cookie jar” account which, for example, held deferred revenue that was recognized as GAAP income at the executive’s discretion rather than based on accounting rules. These adjustments to GAAP numbers were purposely made in amounts that fell below the auditor’s materiality threshold for review, according to the SEC’s complaint.”

  • Off-Balance-Sheet Entities and Liabilities 

    • Enron

  • Improper Asset Valuations

    • Banks and investment banks during the 2007-2009 financial crisis

  • Improper Capitalization of Expenses

    • Health South, WorldCom, SmarTalk

  • Adding Back Outstanding Checks to Cash 

  • Unjustified ConsolidationEntries

    • See Ahold: “Ahold fully consolidated several joint ventures in its financial statements despite owning no more than fifty percent of the voting shares and despite shareholders' agreements that clearly provided for joint control by Ahold and its joint venture partners. To justify full consolidation of certain joint ventures, Ahold gave its independent auditors side letters to the joint venture agreements, signed by Ahold and its joint venture partners, which stated, in effect, that Ahold controlled the joint ventures ("control letters").”

  • “Top-side entries”

    • See Waste Management (2002): “The company's revenues were not growing fast enough to meet these targets, so defendants instead resorted to improperly eliminating and deferring current period expenses to inflate earnings. They employed a multitude of improper accounting practices to achieve this objective. Among other things, the complaint charges that defendants:

      • avoided depreciation expenses on their garbage trucks by both assigning unsupported and inflated salvage values and extending their useful lives,

      • assigned arbitrary salvage values to other assets that previously had no salvage value, 

      • failed to record expenses for decreases in the value of landfills as they were filled with waste, 

      • refused to record expenses necessary to write off the costs of unsuccessful and abandoned landfill development projects, 

      • established inflated environmental reserves (liabilities) in connection with acquisitions so that the excess reserves could be used to avoid recording unrelated operating expenses, 

      • improperly capitalized a variety of expenses, and 

      • failed to establish sufficient reserves (liabilities) to pay for income taxes and other expenses.

      Defendants' improper accounting practices were centralized at corporate headquarters, according to the complaint. Each year, Buntrock, Rooney, and others prepared an annual budget in which they set earnings targets for the upcoming year. During the year, they monitored the company's actual operating results and compared them to the quarterly targets set in the budget, the complaint says. To reduce expenses and inflate earnings artificially, defendants then primarily used "top-level adjustments" to conform the company's actual results to the predetermined earnings targets, according to the complaint. The inflated earnings of prior periods then became the floor for future manipulations. The consequences, however, created what Hau referred to as a "one-off" problem. To sustain the scheme, earnings fraudulently achieved in one period had to be replaced in the next.”

      © Francine McKenna, The Digging Company LLC, 2020

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