Risk & Compliance

Nouveau Fraud: Hot Recipes for Cookin’ the Books

Recent cases underscore the need for tight internal controls.
Joe St. DenisApril 23, 2015
Nouveau Fraud: Hot Recipes for Cookin’ the Books

Joe St. Denis

Joe St. Denis

CFOs are well aware of the more common ingredients of financial fraud: bogus or premature revenue recognition, improper capitalization or valuation of assets, and the misuse of accruals to smooth earnings. Along with their audit committees, they expend plenty of effort designing internal controls to prevent such misdeeds.

But as with nouveau cuisine, the recipes in the financial-fraud cookbook are constantly evolving, and it takes vigilance and determination to design and operate systems to keep them out of the kitchen or detect their presence if they sneak in. Following are some fairly recent updates to the menu.

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Artificial Ingredients

Technology-oriented companies are increasingly touting their valuations based on forward-looking metrics that are abstract and difficult to evaluate. As such components of valuation are not transparent to outsiders, financial executives are responsible for verifying that such influential numbers are reported in compliance with applicable statutes.

A district judge ruled in March of this year that plaintiffs can pursue a lawsuit against Zynga that claims executives inflated the company’s value prior to its 2011 initial public offering by concealing weaknesses in its R&D pipeline of new games, numbers of users and their purchasing patterns, and other key metrics.

Stuffing the Channels

Enticing distributors to accept or buy more product than they really need in order to boost a company’s sales and revenues is another fraudulent way to affect quarterly financials and meet Wall Street’s projections. CFOs need to understand the proper application of complex revenue-recognition guidance to their business, as well as the basis for internal projections.

In September of 2014, the CEO and CFO of a medical device company received lengthy prison sentences for channel stuffing, using wire and securities fraud to unduly inflate revenues. The fraud led to restatements and deflated securities pricing that caused shareholder and other losses of nearly $750 million.

Add In Commodities

Prices of commodities are expected to rise and fall, but CFOs must enforce specific accounting policies that mandate how and when commodity prices and payments are booked and taxes are paid. European Union regulators are investigating Starbucks’ European tax practices, which relate to the buying and selling of all the coffee used worldwide through a complex corporate structure that records hundreds of millions in sales yet reports losses in some of its largest European markets.

In another high-profile 2014 investigation, the SEC alleged that Diamond Foods and two former executives misrepresented walnut costs and payments in order to boost earnings. The company and CEO agreed to a $5 million settlement with the SEC and paid penalties without denying or admitting charges. The CFO plans to fight the charges at trial.

Hair-Rising Dough

Companies may incorrectly state the value or performance of underlying assets for numerous reasons, but savvy CFOs are expected to spot and remedy financial outliers and prevent fraud.

TIAA-CREF and several other large pension funds recently filed complaints against American Realty Capital (ARC), alleging that the company artificially inflated the price of its securities by misstating adjusted funds from operations, resulting in millions of dollars of losses to the pension funds and a dramatic drop of more than $3 billion the value of ARC stock.

In another high-profile case, the SEC alleges that Patriarch Partners and its CEO Lynn Tilton sought to inappropriately collect nearly $200 million in fees by hiding poor performance of underlying assets in three funds. Tilton and Patriarch countersued the SEC in March.

A Dash of Whistleblowing

The pressure to be transparent is growing. Recent Securities and Exchange Commission enforcement actions indicate the agency’s commitment to supporting whistleblowers in publicly traded companies. Houston-based engineering and construction firm KBR was found to be in violation of Rule 21F-17 of the Dodd-Frank Act earlier this month after it sought to prevent its employees from communicating with commission staff without the express written consent of KBR’s legal department.

The SEC also recently announced that it had paid an award of “between $475,000 and $575,000” to a whistleblower who provided information that was useful in a financial fraud investigation that led to fines and penalties of more than $1 million. The SEC’s embrace of whistleblowers and the ever-changing motivations and opportunities for financial reporting fraud mean that transparency, consensus-building, and real-time documentation of issues-identification, analysis, and resolution are of paramount importance.

New Rules for the Kitchen

CFOs must always adapt to the changing financial reporting environment, and the rise of the whistleblower has been a game-changer.

Sarbanes-Oxley Section 404, while challenging to implement, has led to a high degree of standardization among the financial reporting processes of large public companies. Many companies have developed systems to effectively manage the risks presented by both evolving fraud schemes and the rise of whistleblowers. There are still holdouts, however, especially among smaller public companies and companies in the process of going public.

The companies we see that manage these risks most effectively tend to have the following characteristics:

  • Highly experienced and rigorous technical personnel that can communicate effectively across the business to identify and resolve new and unique accounting and financial reporting issues in a timely manner, as they arise.
  • An internally transparent and well-documented process of tracking issues from initial identification through final resolution with the auditor and presentation to the audit committee.
  • Sound systems of communication and accountability across the finance organization that provide for solid internal consensus on accounting and financial reporting issues.

Competent people, careful tracking of issues, internal consensus-building, and robust systems for communication and accountability sound like good common sense. However, we often see these systems lacking in environments where misstatements and fraud can thrive.

Further, the alienation and frustration that can lead people to “blow the whistle” are unlikely to arise where strong systems of consensus-building, communication, and accountability are cultivated. Of course, there will always be the occasional malcontent seeking to misuse whistleblower protections for personal gain, but these charges will be easily addressed with contemporaneous documentation.

Joe St. Denis is a director of Riveron Consulting, a financial consulting firm to middle-market private equity funds and companies that are growing through acquisitions.