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Potentially costly accounting standards on the horizon

For a number of years we experienced a “lull” in significant accounting standards issued by the FASB.  However, just within the last two years, the FASB has issued two significant, complicated accounting standards that will have far-reaching implications for companies.

These two accounting standards affect how companies recognize revenues and recognize leases.  Based on my experience, I expect that just about every company whose financial reporting framework is U.S. GAAP will be affected by at least one, if not both, of these standards.  As such, today’s post will focus on what these two standards are and how they will affect companies.

Revenue recognition

In May 2014, the FASB issued Accounting Standards Update (ASU) No. 2014-09, Revenue from Contracts with Customers (Topic 606).  This standard is designed to achieve a number of goals.  First, the standard removes inconsistencies and weaknesses in revenue requirements and provides a more robust framework for addressing revenue issues.  Second, the standard improves comparability of revenue recognition practices across entities, industries, jurisdictions, and capital markets (particularly companies that have adopted IFRS).  Third, it provides more useful information to users of financial statements through improved disclosure requirements.  Finally, the standard simplifies the preparation of financial statements by reducing the number of requirements to which an entity must refer.

The core principle of the guidance in Topic 606 is that an entity should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services.  With a move away from industry and more prescriptive guidance on recognizing revenue, this standard uses the following five-step model:

  1. Identify the contract(s) with a customer
  2. Identify the performance obligations in the contract
  3. Determine the transaction price
  4. Allocate the transaction price to the performance obligations in the contract
  5. Recognize revenue when (or as) the entity satisfies a performance obligation

The desired goals of this standard seem nice on paper and I believe they are a significant step toward improved financial reporting.  However, what this means for companies is that they will need to apply a significant amount of resources and thought to achieving the objectives set forth in the standard.

ASU No. 2014-09 has been subsequently amended as follows:

Accounting for leases

Earlier this year the FASB issued ASU No. 2016-02, Leases (Topic 842).  The key change from the existing leasing accounting standard (Topic 840) is that, under the new standard, lessees will need to recognize lease assets and lease liabilities for leases classified as operating leases.  For leases with a term of 12 months or less, a lessee is permitted to make an accounting policy election by class of underlying asset not to recognize lease assets and lease liabilities.  If a lessee makes this election, it should recognize lease expense for such leases generally on a straight-line basis over the lease term.

This standard is effective for fiscal years beginning after December 15, 2018 for publicly traded companies.  Although 2019 seems like a long way into the future, many companies will need to make significant endeavors to effectively implement this accounting standard.

Internal coordination a must

It goes without saying that departmental decisions within a company tend to have an effect on accounting and financial reporting.  With this in mind, in implementing these new accounting standards companies will need to coordinate internally to ensure that all of the relevant facts and circumstances are gathered for accounting and financial reporting consideration.

In the spirit of coordinating between the accounting function and other departments to ensure that business operations are not adversely affected by adoption of these new accounting standards, following are things to consider:

  • Legal – In implementing the new lease standard, leases with terms greater than 12 months will be included in the balance sheet.  Companies will need to revisit their contractual terms, particularly with lenders, to ensure that the accounting changes on the balance sheet do not adversely affect compliance with debt covenants.  Further, companies will need to consider implications of adopting these two standards on securing financing.  Finally, companies may wish to revisit the terms and conditions, including pricing structure, in customer contracts and consider how adoption of the new revenue recognition standard may affect the timing of revenue recognition.
  • Financial planning and analysis – Companies will need to consider the timing of revenue recognition for internal budgeting and forecasts.
  • Information technology – Companies will need to revisit their accounting and operational systems and processes.  Specifically, systems and processes will likely need to be reconfigured and/or reports may need to be modified or created to obtain relevant data for appropriate accounting and more extensive accounting disclosures.
  • Human resources – Often times variable compensation is based on key financial metrics, such as revenues, earnings, and EBITDA.  With the adoption of the new accounting standards, because the timing of revenue recognition may change, companies will need to revisit their variable compensation arrangements with employees to ensure that targets are reasonable and achievable.  Moreover, companies will need to ensure there is adequate staffing with the right level of experience and technical skills to implement these standards.
  • Tax – With expected changes in the recognition of revenue, for example, companies will need to consider the impact on income taxes.
  • Investor relations – Companies will need to consider changes to guidance provided to the street on revenues, EPS, and non-GAAP measures (such as EBITDA) as these metrics will be affected by adoption of these new accounting standards.  Furthermore, companies will need to consider the nature and extent of communications with users of their financial statements regarding expected changes to business practices from adopting these standards.

As I indicated in a previous post, just like individuals, companies can procrastinate decision-making until it becomes costly.  Of particular concern in light of these two significant accounting standards is that companies may lack sufficient resources to effectively adopt them, either in terms of quantity or quality of headcount.

Likewise, companies may not provide adequate budgeting for additional resources needed to effectively adopt these standards.  Many companies, whether by choice or out of necessity, may find themselves hiring consultants carrying price tags higher than internal resources to accomplish the following two objectives.  First, they will need to meet the adoption requirements in the accounting standards.  Second, they will need to satisfy their external auditor of compliance with these accounting standards.

Potentially costly audits

In my line of business, hiring outside assistance to pass financial statement audits can become costly in a relatively short period of time.  With this in mind, in connection with an audit of financial statements, public companies should be mindful of the implications that the adoption of these standards will have on internal controls over financial reporting.

In essence, there are multiple “types” of internal controls:  IT general, application, automated, manual, and IT-dependent manual controls.  As is typical of significant changes in accounting and disclosure, the adoption of these new standards will likely require more manual-type controls to verify that financial reporting is reliable.

In light of this, companies will need to consider the increased risk of material misstatement that manual controls introduce to an audit.

Next steps

For these reasons companies should begin now planning for these scenarios.  In reality, these new accounting standards are a significant undertaking and companies should approach implementation of these standards with a high degree of determination.

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SEC settles charges with publicly-traded company for internal controls violations

Earlier this year the SEC announced that it had brought charges against a publicly traded company, Magnum Hunter Resources Corporation (MHR), a diversified natural gas, natural gas liquids and crude oil exploration and production company based in Texas.

The SEC’s charges are not based on material misstatements in MHR’s 2011 financial statements on Form 10-K. Rather, because of high growth arising from multiple business acquisitions, the company’s accounting staff could not keep up with the ever-increasing demands to maintain effective internal controls over financial reporting (ICFR).  As a result, the SEC claims there existed a material weakness in MHR’s ICFR and that MHR did not adequately disclose this in its 2011 SEC filing.

The SEC imposed a Cease-and-Desist Order on MHR in March 2016, which states in part:

This proceeding concerns failures by MHR and its management to properly implement, maintain, and evaluate [ICFR] for the fiscal year-ended December 31, 2011 and to maintain ICFR sufficient to keep pace with MHR’s growth from at least the fiscal year-ended December 31, 2011 through the quarter-ended September 30, 2013.

The SEC Order also states that this failure was, in part due to improper evaluations of the severity of internal control deficiencies by both MHR’s SOX consultant and external auditor.

Material Weakness

To put all of this into context, SEC Regulation S-X defines a material weakness as:

…a deficiency, or a combination of deficiencies, in [ICFR] such that there is a reasonable possibility that a material misstatement of the registrant’s annual or interim financial statements will not be prevented or detected on a timely basis. [Rule 1-02(a)(4)]

This is consistent with the definition of a material weakness in U.S. auditing standards, which is:

a deficiency, or a combination of deficiencies, in [ICFR], such that there is a reasonable possibility that a material misstatement of the company’s annual or interim financial statements will not be prevented or detected on a timely basis. [PCAOB AU 325, par 3]

Note these definitions use the term “reasonable possibility” to describe the likelihood of a material misstatement occurring.  This term carries the same meaning as in ASC 450 (formerly SFAS No. 5), which I discussed in a previous post.

Charges by the SEC

In essence, the SEC’s charges hinge on the premise that, even though it did not find any material misstatement in MHR’s financial statements, because a material misstatement could have occurred, MHR should have made appropriate disclosures in its 2011 financial statements. Of interest is that MHR’s assessment of the effectiveness of ICFR concluded that a significant deficiency existed, not a material weakness.

In its audit work papers MHR’s external auditor documented that the control weaknesses arising from inadequate accounting staff did not rise to the level of a material weakness for the following key reasons: (1) the audit work did not identify material errors for the reporting period and (2) the auditor understood that MHR had recently hired additional accounting staff and that the existing staff, while overworked, was competent.

Despite the auditor’s documentation for its conclusion, the guidance in PCAOB AS No. 5 states that “[t]he severity of a deficiency does not depend on whether a misstatement actually has occurred but rather on whether there is a reasonable possibility that the company’s controls will fail to prevent or detect a misstatement.” (see par. 64)

Take-aways

Companies required to comply with SEC regulations should take note of these charges brought by the SEC. Further, companies should take seriously the requirements to maintain effective ICFR and disclose information that is pertinent to users of their financial statements.

In the end, it is the responsibility of the company’s management to not only prepare its financial statements, but to also maintain a system of ICFR sufficient to provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in conformity with GAAP (see SEC Exchange Rule 13(b)(2)(B) at 124).

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The proliferation of forensic accounting

I had the pleasure of being a guest speaker last week at a university in Denver.  I presented to students enrolled in a forensic accounting course on the topic of litigation services and expert testimony.  The audience, consisting mostly of graduate students, was highly engaged during the presentation.

Certainly, I see a strong level of interest in the field of forensic accounting, not just within the professional world, but also within colleges and universities.  Contrast this with when I was in school.  Although it doesn’t feel like a long time, when I finished my university studies in 2005 there seemed to be less talk within the business school of forensic accounting careers.

Today, forensic accounting is a multi-billion dollar industry and its growth is expected to continue for the foreseeable future.

Where to begin

During my presentation, I could sense the eagerness of the students to find their career fit within forensic accounting.  At the completion of the discussion they asked me how I would recommend they tap into the field.  Of course, I was happy to respond because I was in their shoes at one point in my career and I’ve always appreciated meaningful career counsel.

First, I believe those interested in this field should find out what type of industry or practice-area they are most interested in.  It could be financial services, manufacturing, technology, communications, etc.  Next, I recommend they build a strong foundation in whatever industry or practice-area they choose by gaining at least a few years of diverse experience.

If they still desire to be a forensic accountant once they establish a strong foundation, then I recommended they search for the right fit with patience, relying as much as possible on their network of contacts.

Experience is critical

Unfortunately, too often I think college graduates do themselves a disservice when they seek to jump right into forensic accounting without any real-world experience.  Of course, this isn’t always the case, but I have worked with enough junior professionals within the industry to make this observation.

I make the following case to illustrate my point.  Auditors are trained to approach their work with “materiality” in mind.  Those in criminal justice approach their work with “beyond a reasonable doubt” in mind.  Statisticians often approach their work with “statistical significance” in mind.  Forensic accountants, on the other hand, may or may not approach their work with these concepts in mind.  Truly, the application of concepts or principles depends on the facts and circumstances of a case.

For this reason, I believe a forensic accountant should have sufficient experience so that he or she can appropriately apply professional judgment, no matter the circumstance.

With ever-changing regulations and increasing complexity of the world we live in, I believe the role we forensic accountants provide will become increasingly valuable.

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Takeaways from a recent study on Daubert challenges

Financial experts must constantly be aware of threats to their work.  Similarly, financial experts engaged in disputes understand there are risks associated with the Daubert challenge.  With this in mind, studies on this subject matter can provide meaningful information to inform practitioners on areas of increased sensitivity.  This is where PwC’s annual study on Daubert challenges comes into the conversation.  PwC, a Big 4 CPA firm, released a few months ago its 2016 edition of its study, which spans written court opinions from the last 16 years.

History

To put the study into context, there are two notable court cases addressing the standard for admitting expert testimony in U.S. federal courts.  These cases expanded the role of the trial judge as a gatekeeper for expert testimony:

  • Daubert v. Merrell Dow Pharmaceuticals Inc., 509 U.S. 579 (1993)
  • Kumho Tire Co. vs. Carmichael, 526 U.S. 137, 119 S.Ct. 1167, 1179 (1999)

In essence, the court found in the Daubert v. Merrell Dow Pharmaceuticals Inc. case that trial judges are to ensure expert witness testimony is based on a reliable foundation and is relevant to the task at hand.  Furthermore, this court ruling may be dissected into two parts:

  • Is the expertise and testimony of the expert witness relevant to matters at issue in the trial?
  • Is the testimony of the expert witness reliable because the theory or technique used by the expert?

The second question on expert testimony reliability might be further analyzed as follows:

  • Can and has been tested?
  • Has been subjected to peer review and publication?
  • Identifies the known or potential error rate?
  • Is standardized and generally accepted within the relevant peer community?

A few years later, in the Kumho Tire Co. v. Carmichael case, the court ruling expanded the gatekeeping function of the trial judge under Daubert v. Merrell Dow Pharmaceuticals Inc. to all (not just scientific) expert testimony based on scientific, technical, or other specialized knowledge, including experience-based technical testimony.

Study background

In connection with its study, PwC identified written court opinions issued between 2000 and 2015 that cited the Kumho Tire case and that related to financial experts.  The resulting pool of cases totaled 2,014 Daubert challenges for further analysis in the study.

Study observations

Of course, there are multiple aspects of the study, some of which I do not intend to cover in today’s post.  Nevertheless, the study identified the following trends in the last 16 years:

  • Often, rather than excluding financial expert testimony, judges prefer that flaws in the testimony be exposed through cross-examination at trial.  The study observed, on average, that approximately 53% of financial experts admitted by courts after being challenged.
  • The use and misuse of data is a common stumbling block for financial experts and the most common reason for financial expert exclusion.  The study observed that financial experts are excluded for various reasons, including not providing sufficient support for calculations and not performing due diligence on data received from clients.
  • Rule 702 of the Federal Rules of Evidence states that experts may testify if they are qualified based on their knowledge, skill, experience, education, or training. However, the interpretation of what that requisite knowledge, experience, and skill is can vary widely.
  • In 2011 the Federal Circuit made a landmark decision in Uniloc USA, Inc. v. Microsoft Corp., Nos. 2010-1035, 2010-1055 (Fed. Cir. Jan. 4, 2011).  The court described the royalty rate rule of thumb in intellectual property cases as a “fundamentally flawed tool” that fails to tie the royalty rate to the specific facts and circumstances of the case.  The PwC study identified other instances in 2015 where expert testimony was excluded due to the use of rules of thumb and generalizations that did not relate to the specific facts of the case.
  • In the past few years, the study observed several instances where the court allowed the expert to remedy challengeable issues in his or her original report by submitting a revised report.  While a Daubert exclusion typically means “game over” for an expert’s involvement in a case, the study has recently observed that courts provide financial experts a chance to revise or update their testimony before providing a final decision on the expert’s admissibility.
  • Financial expert testimony is often excluded if the court considers it a legal conclusion.  Such legal conclusions are typically the domain of the trier of fact.  The study notes that this can often happen when financial experts opine on contractual obligations or conclude on the interpretation of disputed contracts in the context of their financial testimony.

Some of the above observations may seem self-explanatory and straight-forward, yet they continue to surface as reasons for Daubert challenges and exclusions.

The study identified lack of reliability (as opposed to relevance or qualification) as the number one cause of financial expert exclusion in the last 16 years.  Moreover, the study calculated that approximately 44% of financial experts have been excluded over the same time frame.  Another statistic of relevance is that plaintiff-side financial experts experienced almost twice as many challenges as defendant-side experts, but only had a slightly higher exclusion rate of 47%.

More information

The study includes additional statistics not covered in this post which may be of interest to practitioners.  Those interested in learning more can find the study here.

Additionally, the Daubert Tracker database is a valuable resource for checking “gatekeeping history” of experts, which is a benefit to AICPA Forensic and Valuation Services (FVS) members.

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New going concern auditing standard proposed…so what?

Last week the AICPA’s Auditing Standards Board (ASB) released its exposure draft entitled “The Auditor’s Consideration of an Entity’s Ability to Continue as a Going Concern.”  This proposed standard is designed to supersede SAS No. 126 (AU-C 570).  So, what should we learn from it?

To begin, the ASB made it clear that it wants to achieve three main goals with the exposure draft.  First, the ASB wishes to provide interpretative guidance on key aspects of the going concern assumption.  This interpretative guidance is, in part, designed to incorporate into the auditing standards the FASB’s ASU No. 2014-15 on going concern issued in 2014.  Second, the ASB wishes to converge the U.S. GAAS auditing standard on going concern (currently SAS No. 126) with International Standard on Auditing (ISA) No. 570 (revised).  And third, the ASB has designed this exposure draft to apply to different financial accounting standards, thereby necessitating a going concern standard written in a neutral accounting framework manner.

While the implications of this exposure draft may be varied depending on the circumstances in which it may be applied, I wish to focus today’s post on one aspect of this exposure draft–that of the definition of “substantial doubt.”

Substantial doubt

Paragraph A4 to this exposure draft reads:

A4. The FASB standards define substantial doubt about an entity’s ability to continue as a going concern as follows:

Substantial doubt about an entity’s ability to continue as a going concern exists when conditions and events, considered in the aggregate, indicate that it is probable that the entity will be unable to meet its obligations as they become due within one year after the date that the financial statements are issued (or within one year after the date that the financial statements are available to be issued when applicable). The term probable is used consistently with its use in topic 450 on contingencies.

Other applicable financial reporting frameworks may use different terms that are similar to substantial doubt. For example, International Financial Reporting Standards (IFRS) use the terms material uncertainty and significant doubt. Also, other applicable financial reporting frameworks may not use probable as their threshold. For example, IFRS uses “may cast significant doubt on the entity’s ability to continue as a going concern.” This SAS uses the terminology of the FASB standards and GASB statements; if an audit is performed under another financial reporting framework, the requirements and application guidance may need to be adapted as necessary. (emphasis added)

Clarification

Since the issuance of ASU No. 2014-15 there has been a disconnect in terms of the above definition of “substantial doubt” between U.S. accounting standards and U.S. auditing standards, which I discussed in a previous post.  In fact, this disconnect became a hot topic in one of my former consulting engagements of a Fortune 1000 company.  However, with the expectation that this definition will find its way in a new auditing standard on going concern, we should see agreement between these two sets of standards.  If adopted, the exposure draft will be effective for audits of financial statements for periods ending on or after December 15, 2017.

I find this a big step in the right direction to clarify auditing standards on this point.  Should practitioners take interest in this topic and wish to provide feedback to the ASB, comments are due on September 5, 2016.

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Effective interviewing techniques

Recently I attended a training by my local Association of Certified Fraud Examiners (ACFE) chapter addressing the topic of conducting interviews.  I thought the topic was interesting and certainly applicable in my line of business.  For this reason I’m writing today’s post on this topic.

To begin, television shows and movies too often seem to portray interviewing techniques that are wholly ineffective in most circumstances.  For example, in the movie L.A. Confidential the good cop-bad cop scene shows essentially every signal of aggression.  As expected, the bad cop plays really tough with the subject, who eventually submits to his wishes.  In reality, when faced with such drastic circumstances, an interviewee may say whatever the interviewer wishes, even giving a false or unreliable admission.  Experience dictates that this is not truly effective interviewing.

Rapport

Effective interviewing requires rapport building with the interviewee.  Indeed, there are various techniques to do this.  Examples include listening, asking follow-up questions, understanding the interviewee psychologically, saying “I want you to relax,” and asking the interviewee “tell me about your life/yourself.”

Of course, not having a checklist mentality is very important as well.  This is because a checklist mentality does not sufficiently accommodate for changes in plan or approach that often times are necessary on the fly.  I discuss the practice of check listing in another post.

Another key aspect of building rapport is deciding the best approach to take.  Appealing to reason or logic, rather than fear, is more likely to create an effective bond with the interviewee.  Moreover, the interviewer generally shouldn’t dominate the conversation, but rather seek to make the power neutral between the interviewer and the interviewee.

Interviewers should also think about what type of support network the interviewee may have.  For example, one might ask if there are other perpetrators or victims that may not already be identified.

What’s going on in the interviewee’s mind?

As a means of trying to anticipate potential issues or identify appropriate questioning techniques during an interview, interviewers should understand what is going on in the interviewee’s mind.  There are at least three things that an interviewee is thinking through, whether consciously or sub-consciously.  These include an interviewer assessment, a subject assessment, and asking him or herself “what about me” questions.

The interviewer assessment

  1. Do I like the interviewer?
  2. Do I trust the interviewer?
  3. Is the interviewer judging me?

The subject assessment

  1. Why is the interviewer talking to me?  The interviewer has responsibility to explain this up front.
  2. Do I have the information that the interviewer seeks?
  3. How much does the interviewer know?
  4. How much can the interviewer find out from other sources?

“What about me” questions

  1. What happens if I disclose the information?
  2. What happens if I do not disclose the information (fired, jail, fine, etc.?)
  3. Am I comfortable?

Voluntary disclosure

Of course we want the interviewee to voluntarily disclose information.  As such, an interviewer should take an approach that encourages the interviewee to do this.  Think of the art of persuasion, using the sales pitch to appeal by being genuine, compelling, and using logic and reason.

Awareness

Equally important to effective interviewing is situational awareness.  Sun Tzu, a 6th century BC Chinese military strategist, identified three attributes of awareness that are relevant to this topic and the ACFE training adapted these attributes to effective interviewing as follows:

Know yourself as an interviewer

As an interviewer, I need to identify my strengths and weaknesses, mold my techniques to my strengths, and create my style of interviewing.

Know your “enemy”

As an interviewer, I need to understand the interviewee’s motivations, strengths, and weaknesses.  Furthermore, I need to try to answer the 10 questions (listed above) on behalf of the interviewee beforehand.  Finally, I should acknowledge that every interviewee is different and that my approach should be fluid and flexible to accommodate changes in plan.

Know the terrain

As an interviewer, I need to understand the laws applicable to the facts and circumstances (e.g., employment law, criminal law).  In addition, I need to understand company policy and procedures as well as the corporate culture.  Ultimately, I need to understand the BIG picture in focus.

Application

When one gets into the details of effective interviewing, today’s post identified a number of factors to consider.  For some, thinking through each factor can be overwhelming.  With this in mind, consistent practice is what I believe makes an interviewer more effective.

I received permission from the authors of the training (Travis Boyd, CPA, Johnnie Bejarano, DBA, CPA, CFE, and Doug Laufer, PhD, CPA, CFE) to share the slide deck here.

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What an in-house fraud investigation looks like

Because in-house fraud investigations can vary in terms of structure, resources, and performance, sometimes we wonder what does an in-house fraud investigation typically look like.  Well, thanks to the Association of Certified Fraud Examiners (ACFE), we can answer this question.

Last year the ACFE released a report entitled Benchmarking Your In-House Fraud Investigation Team, which analyzed various engagement metrics from over 800 survey responses.  I think you’ll find the results quite interesting.

To frame today’s post, I’ll cover the report’s findings for each of the following critical components of a fraud investigation:

  • Oversight of fraud investigations
  • Outsourced vs. in-house investigation team
  • Time to resolution
  • Disciplinary actions against or prosecution of perpetrators, and
  • Recovery of fraud losses

Oversight of fraud investigations

As for structure, approximately half of survey respondents indicated that the investigation team reports either to internal audit leadership (28.3%) or senior management (22.1%).  Interestingly, only 6.4% reported to in-house legal counsel.  The below chart demonstrates that there is diversity in oversight of fraud investigations, perhaps dependent on the nature of the fraud (financial statement fraud, compliance fraud, asset misappropriation, etc).

SNAG-2

Outsourced vs. in-house investigation team

When it comes to in-house fraud investigations, overwhelmingly the survey respondents (68.2%) indicated they are always performed in-house as opposed to being outsourced.  Furthermore, approximately 23% of organizations outsource their investigations up to 25% of the time.  One reason for organizations infrequently outsourcing fraud investigations could be due to the fact that over 73% of survey respondents indicated their organizations had over 1,000 employees.   Perhaps larger organizations (those with over 1,000 employees) generally have sufficient personnel capacity to perform the investigations.

SNAG-3

Time to resolution

As practitioners understand, resolving investigations in a timely fashion is paramount to (1) effective detective internal controls and (2) setting an appropriate tone within an organization.  According to the report, nearly six in 10 fraud investigations (59.8%) were closed within 30 days.  Conversely, just over 10% of fraud investigations took more than one quarter to close.  Of course, the duration and extent of a fraud investigation is heavily based on the degree of complexity of the alleged fraud.

SNAG-4

Disciplinary actions against or prosecution of perpetrators

Although organizations prefer to prevent fraud from occurring, the reality is that fraud is impossible to completely eliminate from all organizations.  Therefore, when it comes to effective internal controls, management should strive to set a “zero tolerance” policy for fraud.  In essence, how management reacts to known or suspected fraud, therefore, is critical to setting an appropriate tone within the organization.

The following chart shows the percentage of investigations that resulted in disciplinary action.  Less than a third (31%) resulted in disciplinary action between 76% and 100% of the time.  On the other hand, approximately the same amount of investigations (31.6%) resulted in disciplinary action between 0% and 25% of the time.

SNAG-5

The next chart shows an interesting trend in prosecution referrals.  The majority of investigation teams (59%) decided to refer their case for prosecution between 1% and 25% of the time.  Conversely, 9.8% of investigation teams referred their case for prosecution between 76% and 100% of the time.  As one may expect, there are a number of factors involved with the decision to prosecute.  These may include sufficiency of evidence to prosecute, reputational risk, and cost vs. benefit analysis.  Hence, the decision to prosecute must be weighed carefully by an organization.

SNAG-8

Recovery of fraud losses

In the end, just because investigation teams substantiate allegations of fraud does not mean the losses are automatically recovered.  In light of this, I believe the following chart is one of the most relevant statistics in this report.  According to the survey results, the majority of investigation teams surveyed (54.6%) indicated that less than a quarter of the fraud losses were recovered.  In contrast, 13.0% and 13.9% of investigation teams indicated that 51% to 75% and 76% to 100% of fraud losses were recovered, respectively.

SNAG-6

Final observations

These results are interesting, to say the least.  With a focus on continuous improvement, fraud investigation teams should think about how these findings could affect their existing structure, resources, and performance.

In the end, fraud investigation teams will vary in their look and feel, depending on the nature and complexity of the fraud being investigated.  Having adequate staffing of in-house investigations with the right level of experience and bandwidth will put teams in the best position to be efficient as well as thorough in their efforts.

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What others have said in the past and why it matters

In the past I’ve worked on a number of financial disputes dealing with improper accounting for liabilities, among other things.   In one such instance, the plaintiff alleged that the defendant understated certain liabilities and, as a result, the defendant’s historical financial statements were materially misstated.

To support his opinion, the plaintiff’s expert relied on certain documents produced in the litigation that my team believed were taken out of context.  What was somewhat comical about the situation was that the alleged understatement was so large that it left a number of us scratching our heads.  We wondered why would anyone have gone into that particular business at the time if they “knew” (using the plaintiff expert’s words) they had to record certain liabilities as large as what the plaintiff’s expert claimed.  Indeed, no company in the industry at the time was recording liabilities anywhere near the extent that the plaintiff’s expert alleged should have been recorded by the defendant.

As experienced forensic accounting practitioners and expert witnesses understand, hindsight provides a clear picture of what took place and whether or not it was reasonable.  On the other hand, hindsight can be difficult to justify its reliance.  In particular, if the facts and circumstances known to an entity at the time were the best available information, then they may be considered reliable and reasonable.

Contemporaneous understanding

This brings me to my topic for today, that of understanding what others were saying and doing at the time.  More specifically, to follow my story through I will discuss the importance of identifying (generally speaking, without disclosing confidential information) what the plaintiff in this case was saying at the time and why it matters in a dispute.

For privately-held businesses, obtaining contemporaneous information may prove to be a challenge.  This is because private companies tend to disclose less (or sometimes no) information to the public.  In contrast, publicly-traded companies are held to a higher standard of public disclosure through various means.  These public disclosures can prove to be a treasure chest of information.

Back to my story of the plaintiff, which happened to be a publicly-traded company and a user of the defendant’s financial statements.  The plaintiff’s expert claimed there were all sorts of red flags at the time that the defendant prepared its financial statements.  Further, the plaintiff’s expert alleged that the defendant “should have” noticed these red flags and incorporated them into its accounting decisions.

What I find intriguing is that during the time period in dispute the plaintiff publicly disclosed that it believed the market factors affecting these accounting liabilities were not of big concern.  This was important because the plaintiff’s public statements lent credence to the liability accounting decisions made by the defendant.  Were we able to find these public statements by the plaintiff in the plaintiff’s complaint?  Of course not.

When an entity is in the public light, it provides information to the public in multiple ways.  So, knowing where to look for these types of public statements made our job easier.

SEC resources

A fabulous resource for identifying public statements is the SEC’s website.  For those less familiar, the SEC’s website archives various public filings.  In my experience, the following resources are helpful in identifying historical public statements:

  • Form 10-K – This is probably the most commonly known SEC form.  SEC registrants are required to file this annual report with the SEC, including annual financial statements, related schedules and various textual information.  SEC registrants also include discussion and analysis of financial trends within a section called Management Discussion and Analysis (MD&A).
  • Form 10-Q – SEC registrants are required to file this quarterly report with the SEC, consisting primarily of the company’s quarterly financial statements.  These forms also include a section on MD&A.
  • Form 8-K – These SEC forms can contain a wealth of information.  SEC registrants are required to file these forms with the SEC when certain significant, reportable events occur.  Examples include: quarterly press releases, major acquisitions, material contracts, and legal proceedings.
  • Comment Letters – Generally, the SEC publishes comment letters that it sends to SEC registrants, which can be identified by filtering for “UPLOAD.”  Similarly, the SEC publishes letters it receives from registrants on the SEC’s website, which can be identified by filtering for “CORRESP.”  Because the SEC is a regulator with a heavy hand, what a company writes to the SEC matters greatly.  Therefore, practitioners should pay specific attention to letters between the SEC and registrants.

Other resources

I have found the following other resources to also be worthy of digging through in search of relevant information:

  • Company website – Companies issue press releases and post them on their website.  Practitioners should be aware that not all company press releases are filed with the SEC via Form 8-K.
  • Industry news and reports – Depending on in which industry a company operates, there may be industry publications from reputable sources.  Again, these sources can provide reliable information that was known or communicated at the time.
  • General media communications – Media outlets may overlook or de-emphasize some aspects of company press releases.  In order to attempt to have a degree of control of the narrative, companies often have relationships with major media outlets.  Running web searches of public statements made by company personnel can generate interesting results.

Relevance

As one can gather from my story, it certainly doesn’t help the plaintiff’s case when it was disclosing to the public a certain narrative at the time, but then it switched gears and makes contradictory allegations later in support of its lawsuit.  Therefore, when looking to the correct sources, experienced forensic accountants can find valuable information.  This information can help to obtain a more full, or correct, understanding of the facts and circumstances at the time to assist their clients in all types of dispute matters.

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Fraud auditing, a new trend

We all know that fraud is alive and well in today’s society.  On a daily basis, it seems, we hear unpleasant fraud statistics and read eye-catching news headlines about new fraud schemes or deceptions.  Indeed, businesses today are no less vulnerable to fraud than before.

Because of its ever-presence in today’s business world, a new trend of fraud auditing is becoming more and more popular.  So, what is it?  In essence, fraud auditing is a two-phase exercise.  First, one designs a fraud risk assessment to identify areas where a company may be susceptible to fraud.  Second, in response to findings of this assessment a monitoring and reporting program is put in place as a tool for management oversight.

Preventive vs reactive measures

When I was a former Big 4 auditor I incessantly heard complaints from my clients about audit fees being too high.  Indeed, financial statement audits can be expensive because they are designed to cover all aspects of the financial statements.  In contrast, fraud auditing doesn’t have to be expensive.

Moreover, as a preventive measure, one of the benefits of fraud auditing is that the cost of such an assessment can in large part be determined by the company’s management.  Conversely, as it relates to reactive measures, the cost will depend greatly on the motivation by the company for having the fraud audit conducted in the first place.  Examples of motivations imposed on a business may include: response to fraud already identified within the company, restatement of financial statements, or a decision to bolster internal controls because of restrictions imposed by a regulator, to name a few.

We can probably agree that human nature tends to be more reactive than proactive at different phases of life, such as wellness and personal finance.  In a similar vein, too often companies wait to respond to fraud risks until they manifest themselves through fraud or abuse.  Said another way, companies often do not perceive sufficient value in conducting a meaningful fraud risk assessment and, therefore, they wait until the stakes are much higher.  Oh, how relevant today is Benjamin Franklin‘s famous adage that “an ounce of prevention is worth a pound of cure!”

Consideration examples

Next, I wish to give some definition to the look and feel of a fraud risk assessment.  Depending on the nature and extent of a fraud audit, following are some examples for consideration to begin to understand risks and exposure:

  1. Domination of management by a single person or small group.  This gets at the heart of the tone within an organization.  Regardless of the extent of internal controls (even at the transactional level), if there is management domination by one or a few individuals, this can have a pervasive effect on the organization as a whole.
  2. A practice by management of committing to analysts, creditors, or other third parties to achieve aggressive or unrealistic forecasts.  One can see that being overly aggressive can be an area of risk and exposure.  Conversely, for businesses not beholden to outsiders (such as creditors or investors) this, of course, is irrelevant.
  3. Ineffective communication, implementation, support, or enforcement of the entity’s ethical standards by management or the communication of inappropriate ethical standards.  This really goes without saying. If management doesn’t enforce its own rules, then why have them in the first place?
  4. Recurring negative cash flows from operations while reporting earnings and earnings growth.  Financial pressures placed on management to generate favorable results should be considered when assessing the adequacy and effectiveness of business performance reviews.
  5. Rapid growth or unusual profitability, especially compared to that of other companies in the same industry.
  6. Significant, unusual, or highly complex transactions, especially those close to the period end.
  7. Significant related-party transactions not in the ordinary course of business.  A review of an entity’s financial statements or records can reveal the nature and extent of transactions with related parties.
  8. Recurring attempts by management to justify marginal or inappropriate accounting based on materiality.  Although this one may be difficult to assess, an effective fraud audit should incorporate inquiries of multiple company personnel at varying levels within an organization.
  9. Restrictions on the limitation of access to people, information, or communication by the board of directors or those charged with governance.  

I adapted the above points from the PCAOB’s AU 316, Consideration of Fraud in a Financial Statement Audit.  Although the above list is not exhaustive, it can be a good start to identify areas of heightened risk exposure for a company.  Equally important is that AU 316 was specifically designed to apply to external auditors in connection with the performance of financial statement audits.  Despite this, I believe the principles and guidance within this AU can apply to a variety of circumstances and not just financial statement audits.

Checklisting

It seems that in more recent years auditors have gravitated more toward a “checklist” mentality to discharging of their professional duties.  I believe this is heavily influenced by feedback from regulators.  Of course, checklisting has its place within a professional service engagement to mitigate legal and regulatory exposure.  However, as one can gather from my post above, it is important to exercise professional judgment by inserting a healthy degree of flexibility between checklisting activities and allowing free thinking and creativity.  After all, thinking through the “what ifs” of a situation is always an effective way to identify areas of risk and exposure.  To add to this thought, because risk factors can vary greatly depending on the industry and company-specific factors, it is imperative to tailor the nature and extent of a fraud audit to the needs of an organization.

Less rigorous is still better than nothing

In ideal circumstances companies want to get to the right answer from the beginning.  While this sounds good, the reality is that, as I touched upon earlier, many businesses do not place fraud auditing as an area of focus until they are forced to.

One way to assist companies in overcoming the resistance to a full blown fraud audit is to perform a less rigorous fraud risk assessment.  As a valuable resource the Association of Certified Fraud Examiners (ACFE) offers a Fraud Prevention Check-up.  While I recommend any such assessment be performed with the assistance of experienced professionals familiar with the issues, this check-up exercise could, in theory, be performed by the business itself.  In any case management should take the assessment seriously, standing ready to take action should there be cause for concern.  Additionally, I strongly recommend that, if possible, general counsel be aware of and participate in this process for legal protection to the company.

Altogether, companies that take seriously their obligations to protect company assets and stakeholder value should equally take seriously their oversight and monitoring of financial fraud risks.  Fraud audits provide an excellent means of fulfilling these obligations.

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Changing the U.S. GAAP hierarchy over time

As accounting practitioners, we live and breathe accounting standards.  Without them we wouldn’t have a basis to record transactions or take supportable accounting positions.  So, it goes without saying that reliance on accounting standards are necessary for fair, consistent presentation of financial statements.  Those less familiar with accounting standards and the history behind them may make the mistake of assuming that any and all accounting standards are equally authoritative.  This is simply not the case and for this reason I will focus today’s post on the hierarchy of U.S. GAAP and how it has changed over time.

History

To begin, a little history lesson may be helpful.

1975

Way back in 1975 the AICPA issued SAS No. 5, The Meaning of “Present Fairly in Conformity With Generally Accepted Accounting Principles” in the Independent Auditor’s Report (SAS 5).  Beginning at ¶ 5, the Auditing Standards Board of the AICPA explained that there is no single source for U.S. GAAP standards, but that there are a number of resources, with Rule 203 of the AICPA Code of Professional Conduct requiring compliance with FASB standards, APB opinions, and AICPA accounting research bulletins.  The degree of authoritative GAAP sources trickled down from there.

1992

Next, in 1992 the ACIPA issued SAS No. 69, The Meaning of Present Fairly in Conformity with Generally Accepted Accounting Principles (SAS 69).  This auditing standard clarified the GAAP hierarchy by introducing four levels, (a) through (d).  As auditing practitioners implemented SAS 69, criticisms began to surface for a variety of reasons.  First, this standard, similar to SAS 5, only really applied to auditors, not preparers of financial statements.  Second, this standard was complex.  And third, the GAAP hierarchy ranked the FASB’s Financial Accounting Concepts (CON), which are subject to the same level of due process as FASB SFASs, below industry practices that are widely recognized as generally accepted but that are not subject to the same due process (see ¶ 10 and 11).

2008

In response to these criticisms, in May 2008 the FASB issued SFAS No. 162, The Hierarchy of Generally Accepted Accounting Principles (SFAS 162).  The purpose of the standard was two-fold.  First, it was designed to improve financial reporting by identifying a consistent hierarchy for selecting accounting principles to be used in preparing financial statements presented in conformity with U.S. GAAP (for non-governmental entities).  Second, it was directed to entities (and not auditors) because it is the entity (not the auditor) that is responsible for selecting accounting principles for financial statements that are presented in conformity with GAAP.  In a manner similar to SAS 69, SFAS 162 identified four levels in the hierarchy of U.S. GAAP standards, beginning with level (a) and ending with level (d), as depicted in the chart below.  Once SFAS 162 was issued, the Auditing Standards Board of the AICPA withdrew SAS 69.

GAAP Hierarchy

Just looking at the above chart can spin one’s head because let’s assume, for instance, that a widely recognized and prevalent industry practice is identified.  This falls within level (d), the lowest level, in the above SFAS 162 GAAP hierarchy.  However, in order to perform a thorough due diligence of the matter, one needs to either be familiar with or go searching for other applicable guidance that may be more authoritative, falling into levels (a), (b), or (c).

2009

Only a year later, the FASB rolled out the Accounting Standards Codification (ASC), with an effective date for interim and annual periods ending after September 15, 2009.  Of interest is that the ASC makes it clear which accounting standards are “authoritative” and which are not.  Simply put, if an accounting standard is included in the ASC, then it is “authoritative.”  Conversely, if an accounting standard is not included in the ASC, then it is “non-authoritative.”  An exception to this is that SEC-issued rules and regulations, applying only to SEC registrants, are authoritative even if they are not included in the ASC.

Understanding the way things were

As a forensic accountant, I deal with litigation involving accounting issues from the past.  As I previously blogged about (see “Understand what standard or guidance was applicable at the time”), it’s imperative to put into context the accounting decisions that were made by knowing what accounting standard(s) applied a the time and, if multiple standards were in effect, which was/were most authoritative.  I think it’s helpful to frame the issue by asking some relevant questions:

  1. What time period(s) is/are relevant to the accounting or disclosure issue?
  2. Depending on the answer to question 1, which of the above U.S. GAAP hierarchy standards was in effect at the time?
  3. If the issue relates to transactions post-ASC implementation, have there been any Accounting Standards Updates (ASUs) related to the standard?  Although ASUs are not authoritative standards, it’s important to be aware of them.

Keep in mind that the FASB began issuing ASUs after the Codification went into effect.  ASUs are numbered in the following format:  Year first, then ASU number for that year (e.g., ASU 2009-14 was the 14th ASU to be issued in 2009).

By keeping the above understanding in mind practitioners can successfully apply the relevant GAAP standards to a historical transaction.

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