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EPISODE 60: The year 2021 continues to be impacted by the COVID-19 pandemic, which can also affect what companies should be thinking about regarding fraud. Growthcast welcomes back Erik Lioy and Greg Faucette to discuss how COVID-19 has presented new and different opportunities for fraud, as well as what companies can do to address it.



[00:00:09] JL: Welcome to today's edition of DHG's GrowthCast. I'm your host, John Locke. At DHG, our strength lies in our technical knowledge, our industry intelligence, and our future focus. We understand business needs and are laser-focused on company goals. In this ever-changing world, DHG's GrowthCast provides insights and thought-provoking conversations on topics and trends that address growth opportunities and challenges in the current and future marketplace. Thanks for joining us as we discuss tomorrow's needs today.

[00:00:42] ANNOUNCER: The views and concepts expressed by today's panelists are their own and not those of Dixon Hughes Goodman LLP. Always consult the advice of your legal and financial professional before taking any action.


[0:00:58] JL: Today's topic is fraud and what companies should be considering at the start of a new year that continues to be impacted by COVID-19. I'm joined today by two DHG professionals with different backgrounds and perspectives on fraud. Although both have been on GrowthCast and been presenters before in the past, I'd like to welcome back Erik Lioy from our Forensics & Valuation services practice and Greg Faucette, a professional practice partner serving primarily our banking, insurance, and technology industry groups. Welcome to you both.

[00:01:30] EL: Thanks, John. It's a pleasure to be back on GrowthCast with you.

[00:01:33] GF: Yeah. It's good to be back, John.

[00:01:36] JR: We are talking about fraud today, and it seems like the accounting profession has been talking about fraud for a very long time. Companies are always challenged to develop internal controls and procedures to prevent fraud or detect it when it occurs. Over the years, I know auditors have had varying and generally increasing levels of responsibility for detecting fraud in audits or at least increasing levels of transparency of their responsibility for fraud. So what is new for us to talk about today?

[00:02:07] GF: You're right, John. Fraud's been around for essentially forever. Webster's defines it as an intentional perversion of truth in order to induce another to part with something of value or to surrender a legal right or even more shortly an act of deceiving or misrepresenting. So there's probably not a lot that's new even in our accounting and finance world, but the environment we're in has us looking at fraud in a new light. It's presented different opportunities now. Of course, with Eric's background and what he does day in and day out, I'll defer to him to some of those things that we're seeing.

[00:02:46] EL: Thanks, Greg. Let's focus on fraud by the company, and we'll talk about fraud against the company as well but focusing on fraud by the company, and we think about fraudulent financial reporting. I like to look at this through the lens of the fraud triangle, Cressey's fraud triangle, which talks about opportunity, pressure, and rationalization as being the three factors that are always prevalent in a fraud.

When you look at the environment we're in, the COVID work-from-home environment, it has an impact on all three legs of that stool, for example opportunity. We're working remotely. Control structure and controls environments of change, how we document approved transactions are all very different. Pressure is changed. Some companies are doing very well. Some are very much struggling in this environment. Some people are very much struggling in this environment. We'll talk a little bit more about that later I'm sure.

Then I look at, I think about rationalization and people that are trying to help their families. Maybe they're trying to save the company in this type of environment. So there's been a lot of impact of the world we live in for almost a year now.

[00:04:01] JL: Well, so let's look at how a company may perpetrate fraud. I assume we're talking about public companies defrauding investors.

[00:04:10] EL: Yes, John. To a large extent, that's true. But it's not just public companies. There's a lot of users. Even when you're talking about financial statement fraud, public companies have audits and financial statements. They have stakeholders, investors, bankers. All of which have an interest in having accurate financial reporting and an incentive for companies and management teams to cheat or cook the books a little bit. So if you're thinking about companies putting themselves up for sale, especially a distressed sale in this environment, renewing a loan with their bank, or just maintaining their compliance with covenants, or reporting to their outside investor. It can be public or private companies.

[00:04:55] GF: Yeah, John. Eric's absolutely right. Fraud is definitely not confined to public companies. But given their publicness, if you will, data about that is really readily available, and you asked at the outset what's new. Well, something that is new are some studies that were released in January that kind of give us some insight into fraud. One of these studies was a commissioned report commissioned by the anti-fraud collaboration, and they worked with the law firm Latham & Watkins and a global consulting firm, AlixPartners. The collaboration is a group of names people probably familiar with from the auditing profession; the Center for Audit Quality, Financial Executives Institute, the Institute of Internal Auditors, and the National Association of Corporate Directors.

That group through this collaboration engaged this report, and the report is titled Mitigating the Risk of Common Fraud Schemes: Insights from the SEC Enforcement Actions. What they did is they used a methodology to look at fraud screens of fraud schemes that have been reported by the SEC over a five and a half year period through June of 2019. This SEC reporting is in the form of what's called accounting and auditing enforcement releases. There have been 531 released during that time frame by the SEC, of which 204 addressed financial statement fraud cases. It's that population from which this group presented a report looking at trends and other relationships they could find within the data.

[00:06:31] JL: Eric, who are the usual suspects in these financial reporting frauds?

[00:06:37] EL: That's an interesting question, John. I'll break it out by industry to start and I'm going to put these kind of in buckets. Number one and not surprisingly is the tech industry. As we'll talk about later, when we talk about the types of frauds that are most prevalent, a lot of this is around revenue recognition. Revenue recognition rules are most complex in technology and most easily manipulated. That was about 21% in the study that Greg talked about.

The next group, about four industries, were between 10 and 15 percent round numbers. That's finance, energy, manufacturing, and health care. They're kind of right there in the middle of the pack. Under 10% were banking, agriculture, food, communication, and construction. That gives you the industry perspective. What we saw in looking at the study was that the companies kind of ran the gamut of size. The bad actors varies from year to year, but there's a healthy mix of the charges against the actual registrant itself, the company, and the CFOs, controllers, CEOs, kind of in that order, as far as individual bad actors that were charged by the SEC.

[00:08:01] JL: Greg, we've talked about the where and the who, so enlighten us a little bit about the what.

[00:08:09] GF: Yeah. The collaboration, they noted four prevalent financial reporting schemes, at least the way they divided up these things within the taxonomy they created. But their top four were improper revenue recognition, reserves-related issues, inventory-related issues, and then finally impairment-related issues.

[00:08:33] JL: Do you have a favorite among that group?

[00:08:37] GF: Well, there are none here that I would advocate for, but I think I know what you mean. Well, revenue recognition is at the top of the list. In the period under study, if you break it down by each year, it was either number one or number two in each of the individual years, and it kind of makes sense. If you want to affect the bottom line in terms of results, a good place to start is the top line. In fact, as we know with many tech companies that may be growing and emerging and that income number isn't yet what people imagine it will become, sometimes that top line number is really what they're being evaluated on. Again, not hard to see why it might be revenue recognition.

The schemes they would follow could range from something that affects the timing or the amount of revenues with real customers, all the way to completely creating fictitious customers. In some cases, they feel like, “Oh, we're having a bad quarter. We want to bring some revenue or accelerate some revenue in.” In fact, in some cases they say, “We're having such a good quarter. Let's try to push some off and build a little cushion for the next one.” So they're all sorts of flavors to what they may be trying to do with a revenue recognition scheme.

[00:09:53] JL: Eric, how do they do this?

[00:09:58] EL: Yeah. Great question, John. Greg touched upon this a little bit but just focusing on the revenue recognition. The most illegal way of doing it or obnoxious way is just fictitious sales, and we see this. We've seen this for as long as I've been doing this; making up, creating transaction out of thin air, falsifying customers, creating invoices, shipping documents, and trying to book those sales. That's probably one extreme. What you see also is other areas where people are playing, stepping over the line but maybe working with what was originally a real transaction or a real customer. So they might be adding or falsifying documentation to get something that's in the works, and maybe it really belongs in backlog or pipeline over the hurdle to revenue recognition.

Or they might be doing sales to a customer under a contract and then entering into a side agreement with unusual terms with rights of return that would tell you under accounting rules it's probably not revenue and then hiding those side agreements from their auditors and stakeholders. It looks like a real sale. It is a real customer. It's a real transaction but it didn't really meet the requirements because of this side agreement that when I've investigated these, what I see is one, two, three people at most know there's a side agreement with the customer. It might be the CFO dealing directly with the customer or the CFO colluding with the sales person.

Of course, there's the ever popular channel stuffing, and that's where you're pushing product that is not necessarily needed or may not be sold in a normal course of business, but you're pushing it in the channel. So you might be a manufacturer with a big distribution chain and you're pushing product to your supply chain more than they want or need to sell so that you can book the sale. Then finally, what I'd say is what we typically see by the time it gets into an enforcement action is it's some combination of these. It might start off as very discrete channel stuffing or a side letter arrangement with a couple of customers. But by the time it usually gets unearthed, it's a culmination of all of these things.

[00:12:30] GF: Hey, John. I'll share with you. It's interesting. The channel stuffing itself is not illegal. The company may have actually sold those things, good sales appropriately booked into quarter. The problem is now the company has knowledge that those sales that usually would have occurred in the future have been brought forward. The fraud, if you will, is the lack of disclosing a known trend. The known trend is the sales you may thought of would have occurred naturally we took credit for this quarter. Sales in the future may actually be lower. We know that and we're not telling you that. That's where sometimes the challenge is around channel stuffing. Not illegal but more of a disclosure issue.

[00:13:16] JL: That's really interesting. Anything else you want to highlight in those categories?

[00:13:21] GF: Yeah. I'll drop down to the last one on the impairment because, again, we kind of opened this talking a little bit about COVID as well. 2020 was a tough year and recall this study cut off in 2019, so it didn't really reflect the COVID environment. But what we've got now is companies having a bad year that may be calling into questions some of the valuations, some of the recoverability of assets they may be holding. In a bad year, maybe the last thing you want to do is take another large loss to an impairment. We see that setting up the situation where a company may be a little hesitant to recognize those impairments, even though the accounting guidance would say we do have a recoverability issue now.

[00:14:06] JL: Well, you brought up a good point about the anti-fraud collaboration study. While it was recently released, that data is a little, well, dated I guess. Is there anything more recent that you've seen?

[00:14:20] GF: Yeah. A lot of groups will put out studies on this type of stuff. One group that put out a recent study is a entity called Floyd Advisory. Their study was looking at the calendar year 2020, so that's very recent. Looked at the same type of reporting from the SEC, those accounting and auditing enforcement releases looking at 2020 and a slightly different taxonomy as they organized and categorized the issues, but their big three issues or schemes were improper revenue recognition again at the top, balance sheet manipulation, and intentional misstatement of expenses. You can think that impairment might fit into either one of those last two if it's kind of climbing the ladder here this year.

Interestingly, they also had a category failure to comply with SEC rules. That was briefly described as SEC filing offense and financial disclosure error, omissions, or otherwise misleading representations. You can read into that and think about non-GAAP measures. Again, always a hot topic with the SEC. Something that there's nothing wrong with as long as you're doing it right and disclosing it correctly, but it does put some pressure on what you're saying in there and doing in there. 

[00:15:37] JL: Eric, where does the SEC find these cases?

[00:15:41] EL: There's a number of places the SEC picks up on these things – in the press and what was being reported in the news. There are other sources, of course, that they use. It's not always that easy. So they get, of course, referrals from other SEC divisions, including the Division of Corporate Finance. Other government agencies will refer, especially when you talk about FCPA and books and records, violations. There's a dual rule between SEC and the DOJ there, so there's a lot of cross referrals. It might get referred in by the PCAOB.

Most important, to me, is this increasing number of whistleblowers. In the last several years, whistleblowers can actually get a reward for blowing the whistle on companies. The financial reward is significant. Again, going back to the Floyd Advisory study that Greg noted, there were over 40,000 tips since the SEC started whistleblower program, which I think was back in 2011. 7,000 in 2020, a record-breaking year. Also in 2020 talking about records. 175 million was paid to 39 individuals with one individual receiving 114 million and another 50 million.

So there's a lot of money out there to be had to successful whistleblowers, and I think that's going to continue to drive tips from the inside, which we always know if you go to the ACFB, Association of Certified Fraud Examiners, their study for as long as they've been doing it always says tips is one of the top ways of detecting fraud. Now, there's an incentive to blow the whistle.

[00:17:28] JL: Yeah, a big incentive. That's some serious money. Greg, did COVID have anything to do with these increases?

[00:17:36] GF: The study authors did note about 4,000 tips between mid-March and mid-May of last year. So think about that when people were being sent home and then COVID really biting hard at the very beginning. That was about a 35% increase over the prior year same period. So then the authors had to speculate a little bit but as they're thinking, and it kind of makes sense. All of a sudden, you have individuals being furloughed or laid off maybe with an axe to grind. They're working in a remote environment now away from managers looking over their shoulders day to day, so maybe they feel a little less intimidated or maybe you said differently in a safer environment from which to submit a tip. I would say, yeah, it kind of makes sense that COVID would have upped the number of whistleblower tips that would have been coming in.

[00:18:28] JL: Yeah. It makes total sense. Eric, we've talked a bit about the fraud triangle that it's presenting itself in this environment and the reporting schemes that are out there. Now, what do companies do about that? I know you've had lots of tips and suggestions, but what are your top three?

[00:18:45] EL: Yeah. If you go back to the anti-fraud collaboration study, they talk about three primary root causes. Tone from the top, high pressure environment, and a lack of personnel with sufficient accounting experience drill down real quickly in each of those. This tone from the top concept, we've been talking about it again for a decade or more. But in an organization, if the employees think that fraud or just unethical behavior is acceptable to management or worse yet encouraged by management, that presents an environment. It's a common theme you see that where there is fraud, where there are these big cases, the people believe that senior management knew about it. Sometimes, I think they encouraged it and certainly thought they condoned it.

Setting that tone right from the top, starting with the CEO, in a private company starting with the owners that we intend to operate completely ethically is so important. The high pressure environment is always another factor, and that can be sales executives trying to make their sales goals or just even operating in senior management with a large portion of their compensation being tied to the results of the company. Well, there is a lot of value, and nobody's advocating to get rid of tying compensation to performance. There has to be some real link between what they can influence and what they can't.

When you're in an environment like we've been in in the last year where for some companies there was no chance of executives making their bonuses or salespeople making their bogeys, you need to understand that and understand that an extra incentive to them to commit fraud to try to make those or they still feel pressure to do something that's maybe impossible.

Finally, and you see this a lot of time in some of the big name frauds that have been around for years, and that is this lack of people with sufficient accounting experience. It's where management has got a big pervasive fraud scheme. It's just easier to perpetrate it and to continue it on when they don't have good accountants working for them. I think good accountants tend to – Maybe they don't know exactly what's going on but they sense it and they leave behind people that don't have enough experience or education to recognize that what they're doing is wrong. So those are really the top three.

[00:21:26] JL: Eric, what are some specific examples of strategies you have seen companies employ perhaps unfortunately in remediation efforts after the fraud has been uncovered?

[00:21:36] EL: Real quickly, John, it's communicate and over communicate with your employees. That's how you start to build culture, set that tone from the top. A robust compliance and anti-fraud program is equally important. There's requirements on public companies to have this. But private companies, everybody, should have a compliance and anti-fraud program that is tailored and scaled to their business. Finally, boards need to step up and fulfill their responsibilities. They are ultimately responsible for governance and setting the structure for management to operate in.

[00:22:16] JL: Greg, anything that you would add to this>

[00:22:19] GF: Yeah. I would kind of throwback to one of Eric's earlier comments about that pressure environment. I imagine it's hard enough to find pressure coming from nooks and crannies of a company where maybe overall there's not a thought towards fraud, but maybe a division or something is suffering or facing some tough time. I imagine it's got to be hard enough in a regular environment but even harder in this COVID environment to ferret out those areas of pressure.

[00:22:46] JL: Yeah. Well, this has really been enlightening, and I appreciate the two of you sharing your perspectives. As we wrap up, just a final thought from the two of you. Greg, you might want to go first.

[00:22:58] GF: Yeah. Just two quick things. The SEC really is paying attention to this, and they've touted some of their efforts. The Division of Enforcement is looking at under what they call their earnings per share initiative. They're looking to see if people's EPS trends are making sense. If they're not, is it suggesting someplace they should look deeper in terms of earnings management? They're also going to be out there and the staff on the whole is going through this task force they have internally.

One thing they're doing is they're going to compare disclosures among companies and industries figuring companies in similar situations should likely have similar COVID-related disclosures. If everybody in the industry is disclosing a risk here but one company isn't, that's going to raise some questions as to why don't you think your investors need to know something about the same risk. Again, just two examples of programs that these the staff has to really make sure that those disclosures out there, especially in this age, are appropriate and informative to investors.

[00:23:59] EL: Great. Well, I'll jump in and just say I just want to thank Greg. He's been a great help in expanding our capabilities and helping our clients address fraud risk and get through restatements and so forth. John, thank you. I really appreciate the opportunity to talk with you today.

[00:24:14] JL: Well, great points, some valuable insights for our listeners. Thanks to you both for all the hard work and sharing all of this information today. It's been great being with you.

End of Interview

[00:24:26] JL: Well, it's clear that even something as ancient as fraud can be seen in a new light during these unusual times, and we just want to thank you for listening today to our discussion on fraud with Erik Lioy, partner in DHG's Forensic & Valuation practice, and Greg Faucette, a professional practice partner. Hopefully, you've gained additional insights that will help you to both recognize and reduce the chances of fraud in your organization. I'm your host, John Locke, and I look forward to reconnecting with you soon on another episode of DHG GrowthCast.

End of Episode

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