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CPE for Government Auditors

Chapter 13: Fraudulent Financial Statements


  • Identify how government statements can be fraudulently misstated
  • Identify what would motivate a government to misstate their financial statementsDefine risk

“Yes! Finally captured Martha Stewart. You know, with all the massive and almost completely unpunished fraud perpetrated on the American public by such companies as Enron, Global Crossing, Tyco and Adelphia, we finally got the ringleader. Maybe now we can lower the nation’s terror alert to periwinkle.”
-John Stewart, American Comedian and Actor

On the last branch of the fraud tree, we have fraudulent financial statements and other fraudulent statements.  In this chapter we’ll cover fraudulent financial statements and in the next chapter we will cover the ‘other’ fraudulent statements.

Fraudulent financial statements are designed to mislead the users of the financial statements.  Such users might invest in the company, contract with them, or loan the company money.

AU-C Section 240 focuses entirely on financial statement fraud. And that makes perfect sense since AICPA’s Clarified Auditing Standards cover one audit objective only – whether the financial statements are presented in accordance with generally accepted accounting principles (GAAP).

Not too long ago, financial statement fraud seemed to be the fraud of choice. When Enron imploded, it took $11 billion of investors’ money down with it.

Most of us own Apple stock, although we might not have chosen it ourselves.  Our mutual funds own it.  So if a significant corporation like Apple collapses, most of us take the hit.

But that’s the corporate world. Financial statement fraud in government is rarer. Occasionally though, governments are motivated to mislead the public, a bond rating agency, or a regulator.

Luckily for governments, government financial statements are so thick and useless that 99.9% of people (that is my own, unsubstantiated number) don’t read them!  My government accounting professor, who is now a member of the Government Accounting Standards Board, said at a governmental conference that government financial statements are pretty worthless.  Straight from the horse’s mouth!

Political numbers
Politically, it is best to have a fund balance that is near zero.  That way you look like a great financial manager because you extracted from your citizens only what you needed to operate.  But it is harder in government than it is in our personal lives to keep a balanced budget because government has its hands in so many different distinct businesses: emergency protection, healthcare, education, environment, and on and on and on…

I remember losing my affinity for Al Gore when I heard him propose an emergency fund for the Federal government.  The theory was that the feds would save for a rainy day.  What day isn’t rainy?  And darn it!  I want that money in my personal household rainy day fund, not in the Federal government’s rainy day fund.

Or, what about the way the Postal Service creates a budget?  The Postmasters are held to a three-year budget, and the future cycle’s budget is based on the last year’s expenditures and revenues.  So whatever they do in the third year is what they live with for the coming three years.  But in order to keep everyone honest and high performing, the Postal Service decided to pay a bonus to Postmasters who exceeded expectations – or brought in more revenue or spent less than expected.  I am sure you figured out the game – the Postmasters do everything they can to perform well in the first two years of the cycle to earn their bonus and then tear through every expectation in the third year; they overspend and under-earn.  Is that ethical? Is that fraud? Hmmm. Money is so tricky!

Let’s look at some manipulations of the financial statements

Asset/Revenue Overstatements

When a company overstates assets or revenue, the balance sheet shows higher numbers for such items.

I was absolutely riveted by an article in Vanity Fair[1] about the collapse of Greece’s economy.  Here is an excerpt:

… Moody’s, the rating agency, had just lowered Greece’s credit rating to the level that turned all Greek government bonds into junk – and so no longer eligible to be owned by many of the investors who currently owned them. The resulting dumping of Greek bonds into the market was, in the short term, no big deal, because the International Monetary Fund and the European Central Bank had between them agreed to lend Greece – a nation of about 11 million people, or two million fewer than Greater Los Angeles – up to $145 billion.  …

That was the good news.  The long-term picture was far bleaker.  In addition to its roughly $400 billion (and growing) of outstanding government debt, the Greek number crunchers had just figured out that their government owed another $800 billion or more in pensions. … “The way they were keeping track of the finances – they knew how much they had agreed to spend, but no one was keeping track of what he had actually spent. …”

… In just the past decade the wage bill of the Greek public sector has doubled, in real terms – and that number doesn’t take into account the bribes collected by public officials. The average government job pays almost three times the average private-sector job. … The Greek public-school system is the site of breathtaking inefficiency; one of the lowest-ranked systems in Europe, it nonetheless employs four times as many teachers per pupil as the highest-ranked, Finland’s.

When Papaconstantinou (the new minister of finance) arrived here, last October, the Greek government had estimated its 2009 budget deficit at 3.7% … and actually turned out to be nearly 14%. … Each day they discovered some incredible omission.  A pension debt of a billion dollars every year somehow remained off the government’s books, where everyone pretended it did not exist, even though the government paid it; the hole in the pension plan for the self-employed was not the 300 million they had assumed but 1.1 billion euros; and so on. “At the end of each day I would say, ‘O.K. guys, is this all?’ And they would say “Yeah.’  The next morning there would be this little hand rising in the back of the room; ‘Actually, Minister, there’s this other 100-to-200 million-euro gap.’”

This went on for a week.  Among other things turned up were a great number of off-the-books phony job-creation programs. “The Ministry of Agriculture had created an off-the-books unit employing 270 people to digitize the photographs of Greek public lands,” the finance minister tells me.  “The trouble was that …(t)he actual professions of these people were, like, hairdressers.”

… “We had no Congressional Budget Office,” explains the finance minister.  “There was no independent statistical service.”  The party in power simply gins up whatever numbers it likes, for its own purposes.

Once the finance minister had the numbers (revising the deficit from 7 billion to 30 billion), he went off to his regularly scheduled monthly meeting with ministers of finance from all the European countries. … After the meeting the Dutch guy came up to him and said, “George, we know it’s not your fault, but shouldn’t someone go to jail?”

As he finishes his story the finance minister stresses that this isn’t a simple matter of the government lying about its expenditures. “This wasn’t all due to misreporting,” he says.  “In 2009, tax collection disintegrated, because … (t)he first thing a government does in an election year is to pull the tax collectors off the streets.”

And, as you are probably aware, government sponsored pension plans are in big trouble around the country.  New Jersey tried to save its pension plan, but the Security and Exchange Commission did not appreciate their fraudulent resuscitation technique. Here is their press release on the subject:

SEC Charges State of New Jersey for Fraudulent Municipal Bond Offerings[2]

The Securities and Exchange Commission today charged the State of New Jersey with securities fraud for misrepresenting and failing to disclose to investors in billions of dollars worth of municipal bond offerings that it was underfunding the state’s two largest pension plans.

According to the SEC’s order, New Jersey offered and sold more than $26 billion worth of municipal bonds in 79 offerings between August 2001 and April 2007. The offering documents for these securities created the false impression that the Teachers’ Pension and Annuity Fund (TPAF) and the Public Employees’ Retirement System (PERS) were being adequately funded, masking the fact that New Jersey was unable to make contributions to TPAF and PERS without raising taxes, cutting other services or otherwise affecting its budget. As a result, investors were not provided adequate information to evaluate the state’s ability to fund the pensions or assess their impact on the state’s financial condition.

New Jersey is the first state ever charged by the SEC for violations of the federal securities laws. New Jersey agreed to settle the case without admitting or denying the SEC’s findings.

“All issuers of municipal securities, including states, are obligated to provide investors with the information necessary to evaluate material risks,” said Robert Khuzami, Director of the SEC’s Division of Enforcement. “The State of New Jersey didn’t give its municipal investors a fair shake, withholding and misrepresenting pertinent information about its financial situation.”

Elaine C. Greenberg, Chief of the SEC’s Municipal Securities and Public Pensions Unit, added, “Issuers of municipal bonds must be held accountable when they seek to borrow the public’s money using offering documents containing false and misleading information. New Jersey hid its financial challenges from the very people who are most concerned about the state’s financial health when investing in its future.”

The SEC’s order finds that New Jersey made material misrepresentations and omissions about the underfunding of TPAF and PERS in such bond disclosure documents as preliminary official statements, official statements, and continuing disclosures. Among New Jersey’s material misrepresentations and omissions:

  • Failed to disclose and misrepresented information about legislation adopted in 2001 that increased retirement benefits for employees and retirees enrolled in TPAF and PERS.
  • Failed to disclose and misrepresented information about special Benefit Enhancement Funds (BEFs) created by the 2001 legislation initially intended to fund the costs associated with the increased benefits.
  • Failed to disclose and misrepresented information about the state’s use of the BEFs as part of a five-year “phase-in plan” to begin making contributions to TPAF and PERS.
  • Failed to disclose and misrepresented information about the state’s alteration and eventual abandonment of the five-year phase-in plan.

The SEC’s order further finds that New Jersey failed to provide certain present and historical financial information regarding its pension funding in bond disclosure documents. The state was aware of the underfunding of TPAF and PERS and the potential effects of the underfunding. Furthermore, the state had no written policies or procedures about the review or update of the bond offering documents and the state did not provide training to its employees about the state’s disclosure obligations under accounting standards or the federal securities laws. Due to this lack of disclosure training and inadequate procedures for the drafting and review of bond disclosure documents, the state made material misrepresentations to investors and failed to disclose material information regarding TPAF and PERS in bond offering documents.

The SEC’s order requires the State of New Jersey to cease and desist from committing or causing any violations and any future violations of Sections 17(a)(2) and 17(a)(3) of the Securities Act of 1933. New Jersey consented to the issuance of the order without admitting or denying the findings. In determining to accept New Jersey’s offer to settle this matter, the Commission considered the cooperation afforded the SEC’s staff during the investigation and certain remedial acts taken by the state.

Mary P. Hansen and Suzanne C. Abt in the SEC’s Philadelphia Regional Office conducted the SEC’s investigation in this matter.

 Timing Differences

In 1992, I was tasked with creating a ‘popular’ report analyzing the finances of the state of Texas. ‘Popular’ meant that the average citizen could read it.  My team and I created a 16-page report with graphics, color, and interpretations.  It isn’t such a big deal to imagine now, but in 1992, it was quite an undertaking.

Our graphics depicted how the state was doing overall, which in the days before Government Accounting Standards Board (GASB) pronouncement 34 was hard to decipher. Before GASB 34, there were no overall indicators of financial health presented in the financial statements; the user had to add up a series of numbers to find out whether the state was a good steward of his money.  It was very messy – even for a bunch of government accountants.

What we found was that the state was playing games with the fund balance. Before GASB 34, governments reported Reserved Fund Balance and Unreserved Fund Balance for governmental funds. In the general fund, the largest fund for the state, the state had set aside more fund balance than actually existed.  So they had a negative unreserved fund balance. This, in essence, meant that they were running a deficit. But because of the tricky language and the political turmoil that this information would cause, no one talked about it to the legislature, the public, or the press. That is, until our report was released.

As a matter of fact, the comptroller of the state at the time, John Sharp, proudly told the legislature that we ended the year with plenty of cash.  John had ambitions to be governor and didn’t want to share what he knew about the deficit with the legislature or the public.  He was the elected steward of our resources, and that would make him look very bad.  But accountants know that fund balance and cash are not the same thing.

One significant reason that the state’s cash was pretty while it ran a deficit is a little timing trick that the state instituted to make the financial statements look better. When I first started with the state, I was paid once every two weeks.  Then they changed the pay period to once a month on the last day of the month.  August 31 is the state’s year-end.  In order to make the financial statements look good, the legislature changed the payday to the first day of the month.  So on August 31, the state was flush with cash.  But the next morning, on September 1, it was all gone!  Because it was a short-term expense, it was not set up as a payable and made the state’s finances look very good indeed.

States have had difficulty balancing their budgets these past few years.  Arizona came up with a novel, but stupid, idea to sell its capitol building to an investor. Then the state could lease it back over a period of 20 years for double the purchase price.  Brilliant!

And then, in Illinois, legislators decided that the only way to balance the state’s 2009 budget was by not paying some $3.8 billion worth of bills until the next fiscal year. Not only was this quite a strain on vendors, it probably cost the State more money in future years. When entities pay their bills late, vendors often add a premium – as much as 5 percent – to compensate for not getting paid promptly.[3]

Following is a corporate example of messing with numbers near the end of the reporting period. The company, Sensormatic, needed their year-end numbers to look better, so they made it happen using a creative technique.
Before the

Release No.  39793 / March 25, 1998

Release No.  1019 / March 25, 1998

File No.  3-9565
In the Matter of               :
                                            :        ORDER INSTITUTING PUBLIC
                                            :        MAKING FINDINGS, AND ISSUING
Respondent.                     :        CEASE-AND-DESIST ORDER
________________  :

The Commission deems it appropriate that public administrative proceedings be, and they hereby are, instituted against Thomas H. Pike (“Pike”) pursuant to Section 21C of the Securities Exchange Act of 1934 (“Exchange Act”).

In anticipation of the institution of these administrative proceedings, Pike has submitted an Offer of Settlement (“Offer”), which the Commission has determined to accept. Solely for the purpose of these proceedings, and any other proceeding brought by or on behalf of the Commission or to which the Commission is a party, Pike, without admitting or denying the findings contained in this order, consents to the issuance of this Order Instituting Public Administrative Proceedings, Making Findings, and Issuing Cease and Desist Order (“Order”), the findings contained herein, and the imposition of the relief set forth below.

The Commission makes the following findings:
1.  Summary
From at least July 1, 1993, through July 10, 1995, Sensormatic Electronics Corporation, a company engaged in manufacturing and selling electronic security systems, improperly recognized revenue in order to manipulate its quarterly revenue and earnings to reach its budgeted earnings goals and thereby meet analysts’ quarterly earnings projections. Sensormatic employed the following practice, among others, to improperly and prematurely recognize revenue. At the end of each quarter Sensormatic turned back the computer clock that dated and recorded shipments. Based on these computer-generated documents reflecting shipments, Sensormatic then prematurely recognized revenue on shipments made past the end of the quarter.

Pike, Sensormatic’s then Director of Management Information Systems (“MIS”) and for part of this period, also its Director of U.S. Operations, was responsible for Sensormatic’s computer and information systems and the accounting records and other reports generated by Sensormatic’s computer. Pike supervised the individuals who circumvented the internal controls, reset the computer clock, and generated documents bearing false dates. Pike, by permitting the process to be implemented, caused the falsification of Sensormatic’s books and records and Sensormatic’s violations of the internal controls provisions of the federal securities laws. Pike also understood or should have understood that the acceleration of revenue recognition into a prior quarter was not in conformity with generally accepted accounting principles (“GAAP”) and that Sensormatic was using the inaccurate information generated by the computer to prepare its financial statements. Based on the false shipping documents, Sensormatic reported inaccurate revenue figures and misstated its earnings in financial statements that were contained in its periodic reports filed with the Commission. As a result, Pike also caused Sensormatic’s violations of the reporting provisions of the federal securities laws.

2.   Respondent:  Thomas H. Pike
Pike, age 45, was Sensormatic’s Director of MIS from July 1991 through October 1995, when he resigned. From February 1994 through April 1995, Pike also served as Sensormatic’s Director of U.S. Operations. As the Director of MIS, Pike was responsible for the company’s information systems, its computer network, and the reports and records generated by these systems. As Director of U.S. Operations, Pike had oversight responsibility for the general accounting and controllership functions for U.S. operations, which included responsibility for the preparation of the general ledger and other accounting records that were used in preparing the company’s financial statements. Pike is a certified public accountant, licensed since 1983 by the State of Florida, but he has not practiced public accountancy since then.

3.   The Issuer:  Sensormatic Electronics Corporation
Sensormatic, a Delaware corporation with its principal executive offices in Boca Raton, Florida, manufactures and markets electronic security systems used, among other things, to deter shoplifting.  Sensormatic’s common stock is registered with the Commission pursuant to Section 12(b) of the Exchange Act and is traded on the New York Stock Exchange. During the relevant time Sensormatic was required to file reports with the Commission pursuant to Section 13(a) of the Exchange Act.  During the relevant period, Sensormatic reported that it generally recognized revenue upon shipment of equipment.

4.   Falsifying Sensormatic’s Computer and Accounting Records
From at least July 1, 1993 through July 10, 1995, Sensormatic improperly recognized and recorded revenue in the quarter that had just ended on shipments made past the end of the quarter (“out-of-period shipments”). Sensormatic improperly recognized revenue by resetting the computer clock that dated and recorded shipments.
Shortly before midnight on the last day of the quarter, Sensormatic’s computer system was “brought down” so that the computer clock date would reflect the last day of the quarter. The computer then recorded shipments made during the first days of the new quarter as having occurred on the last day of the prior quarter.  Consequently, Sensormatic’s records reflecting shipment dates were false.
The false shipping records were then used in determining the quarterly revenue figures.  As a result, Sensormatic’s books and records improperly and prematurely recorded revenue from out-of-period shipments.  During the relevant period, the amount of revenue improperly recognized on out-of-period shipments ranged from $4.6 million for the second quarter of fiscal year 1994 to over $30 million for the third quarter of fiscal year 1995.  This revenue information was then included in Sensormatic’s periodic reports which were filed with the Commission and disseminated to the public.  Sensormatic’s periodic reports misstated its quarterly revenue, and thereby misstated Sensormatic’s quarterly net income and earnings per share.  The false and misleading reports include the quarterly and annual reports on Forms 10-Q and 10-K filed for the first quarter of 1994 through the third quarter of 1995.  Sensormatic’s misstatements of net income ranged from an understatement of approximately $1.9 million or 9.1 percent for the second quarter of fiscal year 1994, to an overstatement of $6.7 million or 38.3 percent for the third quarter of 1995.  In addition, Sensormatic also issued a press release that materially inflated preliminary estimates of its net income for the fourth quarter of 1995 and for fiscal year 1995.

5.   Pike’s Role in Turning Back the Computer Clock
At the end of certain quarters in 1994 and 1995, Pike received internal Sensormatic memoranda that estimated the amount of revenue Sensormatic still needed to record in order to meet its quarterly sales goals.  Pike was aware or should have been aware that these revenue figures could not be attained without improperly holding the quarter open.
As Director of MIS, Pike was responsible for Sensormatic’s computer system, which included responsibility for the accuracy and integrity of the documents and data generated by it.  Yet, under Pike’s supervision and despite his concerns — which he conveyed to his superior — that the resetting of the computer date could affect the integrity of computer data, the computer clock was turned back each quarter during the relevant period. Thus, Pike facilitated the practice of holding the quarter open.
Employees under Pike’s supervision approached him and raised concerns about the propriety of creating false documents and about the disruption and potential damage caused by turning back the computer clock.  Nevertheless, Pike told these employees to reset the computer clock.  He advised them that other companies engaged in similar conduct.  As a result of Pike’s instructions, Sensormatic’s shipping records reflected false shipping dates. Pike, therefore, caused the falsification of these records.
Pike also knew or should have known that the false information contained in these records would be used in determining Sensormatic’s quarterly revenues and reflected in other books and records prepared and maintained by the company. In addition, Pike understood or should have understood that revenue would be recorded on out-of-period shipments and that this practice did not conform with GAAP.  Moreover, he understood or should have understood that the company used the improperly recognized revenue in preparing its financial statements, which were contained in Sensormatic’s periodic reports described above.

1.   Pike Violated Rule 13b2-1 under the Exchange Act
Exchange Act Rule 13b2-1 prohibits any person from, directly or indirectly, falsifying or causing to be falsified any book, record, or account subject to Section 13(b)(2)(A) of the Exchange Act.
By supervising the employees who reset the computer clock in order to falsify dates on shipping records and prematurely recognize revenue, Pike violated Rule 13b2-1 under the Exchange Act.

2.   Pike Caused Sensormatic’s Violations of the Reporting, Recordkeeping, and Internal Controls Provisions of the Exchange Act
Section 13(a) of the Exchange Act and Rules 13a-1 and 13a-13 thereunder require issuers with securities registered under Section 12 of the Exchange Act, such as Sensormatic, to file annual reports on Form 10-K and quarterly reports on Form 10-Q with the Commission.  Pursuant to instructions applicable to Form 10-K and Form 10-Q, the financial statements contained in these periodic reports must conform with Regulation S-X which requires conformity with GAAP.  17 C.F.R._ 210.4-01(a)(1).  In addition, Exchange Act Rule 12b-20 requires the inclusion of any additional material information that is necessary to make required statements, in light of the circumstances under which they were made, not misleading.  An issuer violates these provisions if it files a periodic report that contains materially false or misleading information.  See e.g., Laser Photonics, Inc., Securities Act Release No. 7463 (Sept. 30, 1997); and Spectrum Information Technologies, Inc., Securities Act Release No. 7426 (June 25, 1997).
Sensormatic violated these provisions by filing materially false and misleading periodic reports during the relevant period of time.  As discussed above, these reports misstated the company’s results of operations, including revenue and net income.  They also falsely stated that the company recognized revenue upon shipment during the stated periods, whereas in fact the company intentionally and prematurely recognized revenue on out-of-period shipments and did not comply with GAAP.
By supervising the resetting of the computer clock, Pike caused Sensormatic’s reporting violations.  Pike knew that the computer clock was reset at the end of each quarter to falsely record shipment dates.  He also knew or should have known that the company recorded and reported revenue on the out-of-period shipments based on the backdated shipping documents.  Therefore, Pike knew, or should have known, that his actions in furtherance of the improper recognition of revenue would contribute to Sensormatic’s violations of Section 13(a) of the Exchange Act and Rules 13a-1, 13a-13, and 12b-20 thereunder.
Under Section 13(b)(2)(A) of the Exchange Act, Sensormatic was required to make and keep books and records which accurately reflected its transactions and disposition of assets.  Section 13(b)(2)(B) of the Exchange Act requires issuers such as Sensormatic to devise and maintain a system of internal accounting controls sufficient to provide reasonable assurances that, among other things, transactions are recorded as necessary to permit preparation of financial statements in conformity with GAAP and to maintain accountability for assets.  Sensormatic’s conduct related to the resetting of the computer clock violated both of these provisions.  Sensormatic routinely created documents bearing false dates that were relied upon in Sensormatic’s preparation of other books and records, including those that recorded revenue from shipments made past the end of a quarter.  By resetting the computer clock, Sensormatic failed to devise and maintain internal controls that would ensure that its financial statements were prepared in conformity with GAAP.
By the same conduct described above, Pike caused Sensormatic’s violations of Sections 13(b)(2)(A) and (B) of the Exchange Act.  Pike knew, or should have known, that his role in resetting the computer clock would result in the falsification of Sensormatic’s books and records and the subversion of existing internal controls.

Based on the foregoing, the Commission finds that:
A.   Pike violated Exchange Act Rule 13b2-1; and
B.   Pike caused Sensormatic’s violations of Sections 13(a) 13(b)(2)(A), and 13(b)(2)(B) of the Exchange Act and Rules 12b-20, 13a-1, and 13a-13 thereunder.

Fictitious Revenues

My mouth can’t help but water while writing this section. Weird, I know. But I associate fictitious revenues with Krispy Kreme donuts. Those donuts tasted so good when I had constant access to them in Atlanta. Thirty years after I moved to Texas, I finally got my precious glazed donuts back and even bought stock in the company, which was hot for a few years. But then the stock tanked because Krispy Kreme got creative with its financial statements and triggered an SEC investigation.[5]

By August 2003, KKD was trading at nearly $50 on the New York Stock Exchange, up 235 percent from its initial public offering price of $21 on Nasdaq, and Fortune magazine was calling Krispy Kreme the “hottest brand in the land.” …

The company’s woes surfaced in May 2004, when then-CEO Scott Livengood blamed low-carbohydrate diet trends for Krispy Kreme’s first-ever missed quarter and first loss as a public company. …

The Securities and Exchange Commission came knocking in July 2004, making an informal inquiry into Krispy Kreme’s buybacks of several franchises. As the stock price plunged, shareholders filed suit. Franchisees alleged channel stuffing, claiming that some stores were getting twice their regular shipments in the final weeks of a quarter so that headquarters could make its (revenue) numbers. The SEC upgraded its inquiry to “formal” status in October 2004. Average weekly sales, a key retailing measure, fell even as the company continued to add stores. In January 2005, Krispy Kreme decided to restate its financials for much of fiscal 2004. (The CEO) was replaced by turnaround specialist Stephen Cooper, who also kept his other job: interim CEO of Enron.

Fudging the Numbers

The company reacquired a seven-store franchise in Michigan, called Dough-Re-Mi Co., for $32.1 million. …

Krispy Kreme … rolled into the (purchase) price (of Dough-Re-Mi Co.) the costs of closing stores and compensating the operating manager and principal owner of the Michigan franchise to stay on as a consultant. Both of these expenses became part of the intangible “reacquired franchise rights” asset on the company’s balance sheet, rather than costs that would have reduced the company’s reported earnings. Krispy Kreme announced in a December 2004 8-K filing that it would need to make a pretax adjustment of between $3.4 million and $4.8 million to properly record the compensation as an expense. …

Do these creative accounting guys run in packs?

It is a good thing the Krispy Kreme guys didn’t open stores in China! The Chinese government put a securities trader to death in December of 2009 for embezzlement of $9.52 million. Conscious that the growing gap between rich and poor could generate resentment, China is battling corruption and stock trading abuses. It has used the death penalty as a deterrent in serious cases.[6]

Concealed Liabilities

Recently, the Government Accounting Standards Board issued some controversial standards regarding Other Post Employment Benefits, but I believe them to be absolutely necessary to disclose the true obligations of government.

Most governments participate in pension plans. But some go further and promise other benefits in retirement (post employment benefits) such as healthcare. But, up until the Government Accounting Standards Board made them report other post employment benefits, governments had not been in the habit of reporting this information in their financial statements. It was a concealed, but enormous, liability. In order to fund healthcare promises, governments should be saving and putting money aside for the future payments.

Oregon is an example, but they aren’t alone!

Oregon is only one of many examples of governments not funding for other post employment benefits debt. As of April 2010, only a mere 13% of Oregon’s governments made annual required contributions to cover these costs.

In 2010, Oregon Capital News reported that Portland’s transportation system, Trimet, carries over one-fifth of the state’s other post employment benefits debt, totaling over $630 million. These coverages for retirees and spouses include complete medical, dental, and vision insurance premiums.

For 2009, TriMet’s liability for these same benefits totaled $55 million, of which it paid only $13 million. The remaining debt falls in the lap of future taxpayers.[7]

Improper Disclosures

Calpers, the California Public Employees Retirement System, the largest pension fund in the United States, blames credit rating agencies such as Moody’s and Standard and Poor’s for giving high ratings for dicey investments with poor financial disclosures.

I find this very interesting, as the California Public Employees Retirement System is arguably a highly sophisticated investor and could have evaluated the investments in detail for themselves.  However, they relied on rating agencies and purchased $1.3 billion in subprime mortgages that were creatively packaged by hedge funds and touted by the rating agencies.  The security packages were so opaque that only the hedge funds that put them together – Sigma S.I.V. and Cheyne Capital Management in London, and Stanfield Capital Partners in New York – and the ratings agencies knew what the packages contained. Information about the securities in these packages was considered proprietary and not provided to the investors who bought them.

The California Public Employees Retirement System is also righteously indignant about the inherent conflict of interest created when the hedge fund pays the rating agency to package and rate the securities. Fees received by the ratings agencies for helping to construct these packages would typically range from $300,000 to $500,000 and up to $1 million for each deal.[8]

Improper Asset Valuations

I enjoyed listening to National Public Radio’s Planet Money program as they bought Toxie – a $1000 toxic asset and then watched her die.  Over a period of a year, Toxie earned less than half of her investment back $449. Toxie was a portion of a bundle of mortgages that were packaged by Wall Street for sale to investors.

When the housing bubble burst, the families that owed on the mortgages stopped making payments, and no one was interested in investing in the package – hence the term “toxic” or poisoned investments. Since the underlying mortgages were improperly valued (some poor souls purchased at the height of the market only to find their house worth a third of their mortgage commitment), it was hard for investors to place a value on the bundle of mortgages. Would the families default or would they keep paying? National Public Radio lost its investment in Toxie because the underlying mortgages either defaulted or were refinanced through government programs.[9]

Did I already mention that I don’t trust the investment community?

SEC Charges Ohio-Based Investment Advisers for Fraudulently Overstating Assets[10]

The Securities and Exchange Commission today charged Ohio-based investment advisers Robert Pinkas and Brantley Capital Management (BCM) with securities fraud for overvaluing assets in an investment portfolio they managed in order to generate higher investment advisory fees. The SEC also charged another BCM official.

SEC Complaint

The SEC alleges that BCM, Pinkas, and CFO Tab Keplinger substantially overstated the value of equity and debt investments in two failing private companies that represented more than half of the investment portfolio of Brantley Capital Corporation, a New York-based investment company. The SEC further alleges that BCM, Pinkas, and Keplinger made material misrepresentations and failed to make required disclosures about the two companies to Brantley Capital’s board of directors, independent auditors, and investors.

“When asset values are overstated in public filings, investors are unable to make appropriate investment decisions,” said Christopher Conte, Associate Director in the SEC’s Division of Enforcement. “Investment advisers are required to promptly adjust the values of their assets as financial conditions dictate, and uphold their fiduciary duties to their clients.”

During the alleged misconduct from 2002 to 2005, BCM was the investment advisory firm that managed the investment portfolio of Brantley Capital. According to the SEC’s complaint, Pinkas was the CEO of both Brantley Capital and BCM, and directed all of BCM’s investment decisions and valuation recommendations. Keplinger was the part-time CFO of both entities and generally acted at the direction of Pinkas.

The SEC’s complaint, filed in U.S. District Court for the Northern District of Ohio, alleges that BCM, through Pinkas and Keplinger, advised Brantley Capital’s board that its equity investment in Flight Options International (FOI) was worth $32.5 million. The value of Brantley Capital’s interest in FOI, which represented approximately 50 percent of its total investment portfolio, was derived primarily from FOI’s ownership interest in Flight Options LLC, a private airline that was consistently losing millions of dollars.

The SEC alleges that Pinkas and Keplinger understood that Flight Options faced severe financial difficulties, and Pinkas knew that it was able to remain in business only because another investor in Flight Options repeatedly loaned it money. Pinkas and Keplinger not only failed to disclose these financial difficulties to Brantley Capital’s board and investors, but they also misrepresented the financial performance of Flight Options to Brantley Capital’s board and its independent auditors, cited various false rationales to support their $32.5 million valuation, and concealed third-party valuations of Flight Options indicating that Brantley Capital’s investment in FOI was worth substantially less than what Pinkas and Keplinger were representing.

The SEC’s complaint also alleges that BCM, through Pinkas and Keplinger, directed Brantley Capital to overstate the value of its debt investments in Disposable Products Company (DPC), a now-defunct company that comprised 4 to 8 percent of Brantley Capital’s total investment portfolio. Pinkas and Keplinger repeatedly advised Brantley Capital’s board that DPC would repay most of these loans, when in fact DPC could not repay the loans because the company was losing ever-increasing amounts of money. DPC also consistently missed its financial targets by large margins, remained in business only because Brantley Capital continued to loan it money, and lacked sufficient assets to cover Brantley Capital’s loans in the event of liquidation. Despite knowing these facts and that the value of Brantley Capital’s loans to DPC were essentially worthless, Pinkas and Keplinger advised Brantley Capital’s board that only relatively minor write-downs of its loans to DPC were required.

From 2002 to 2005, BCM received more than $6.4 million in investment advisory fees from Brantley Capital, which were calculated as a percentage of Brantley Capital’s net asset value.

BCM and Pinkas are contesting the SEC’s charges.

Keplinger has agreed to settle the SEC’s charges without admitting or denying the allegations. He consented to the entry of a judgment enjoining him from violating the antifraud and other provisions of the securities laws, requiring him to pay a $50,000 penalty, and barring him from serving as an officer or director of any public company for five years. Keplinger also consented to the entry of a Commission order that will suspend him for five years from appearing or practicing before the Commission as an accountant and bar him for one year from associating with an investment adviser.

Asset/Revenue Understatements

Showing lower numbers for assets or revenue than their true value on a balance sheet is called an understatement.

Here is a case where a manufacturer understated cost of goods (inventory), which allowed them to overstate profits.

SEC Charges Thor Industries With Violating Commission Cease-and-Desist Order and Charges Former VP of Finance of Thor Subsidiary With Securities Fraud[11]

The Securities and Exchange Commission filed a settled enforcement action in United States District Court for the District of Columbia charging Ohio-based producer of recreational vehicles Thor Industries, Inc. with issuer reporting, record-keeping, and internal control violations. Thor has agreed to be permanently enjoined and to pay a $1 million civil penalty for violating a 1999 Commission cease-and-desist Order prohibiting violations of the books and records and internal controls provisions. In the Matter of Thor Industries, Inc., Exchange Act Release No. 42021 (Oct. 18, 1999). The SEC also charged Mark C. Schwartzhoff, a former Vice President of Finance at Thor’s Dutchmen Manufacturing, Inc. subsidiary, with securities fraud and other violations. Schwartzhoff has agreed to be permanently enjoined, to be permanently barred from serving as an officer or director of a public company, and to be permanently suspended from appearing or practicing before the Commission as an accountant. Schwartzhoff also agreed to pay disgorgement of $394,830, which shall be deemed satisfied by the entry of a restitution order against Schwartzhoff in a parallel criminal case.

The SEC’s complaint alleges that from approximately December 2002 to January 2007, while serving as the senior financial officer of Dutchmen, one of Thor’s principal operating subsidiaries, Schwartzhoff engaged in a fraudulent accounting scheme to understate Dutchmen’s cost of goods sold in order to avoid recognizing inventory costs that were not reflected in Dutchmen’s financial accounting system. Instead of properly recording increased cost of goods sold, Schwartzhoff concealed the costs in various balance sheet accounts by making baseless manual journal entries to falsify the financial statements and other records he provided to Thor. To cover-up his false entries, the complaint alleges that Schwartzhoff created false supporting documentation and false account reconciliations. Schwartzhoff also submitted false documents and information to Thor’s external auditor.

As alleged in the complaint, Schwartzhoff’s fraud overstated Dutchmen’s pre-tax income by nearly $27 million from fiscal year 2003 to the second quarter of fiscal 2007, and allowed him to obtain nearly $300,000 in ill-gotten bonuses. In June 2007, Thor filed restated financial statements for fiscal years 2004 to 2006, each of the quarters of fiscal 2005 and 2006, and the first quarter of fiscal 2007, reducing its pre-tax income by approximately $26 million in the aggregate.

The SEC’s complaint further alleges that Thor failed to maintain accurate books and records and adequate internal accounting controls in violation of a 1999 Commission cease-and-desist Order. The Order directed Thor to cease and desist from committing future books and records and internal controls violations of Sections 13(b)(2)(A) and 13(b)(2)(B) of the Securities Exchange Act of 1934 (“Exchange Act”), based on similar misconduct and internal control deficiencies that occurred over four years at a different Thor subsidiary.

The complaint alleges that Thor’s failure to implement adequate internal controls after the 1999 Order provided Schwartzhoff the opportunity to commit his fraud without detection. In particular, Thor failed to adequately implement and verify certain key segregation of duties within accounting and financial functions at Dutchmen, which allowed Schwartzhoff to have unfettered access rights to Dutchmen’s accounting system, the ability to create, enter and approve manual journal entries, and the ability to create and approve account reconciliations. As a result, Schwartzhoff was able to make fraudulent journal entries in various accounts and to disguise these entries through account reconciliations and supporting documents that he falsified. In addition, as alleged in the complaint, Thor failed adequately to monitor and verify account reconciliations and account information that Schwartzhoff submitted in reporting Dutchmen’s financial results. Thor also failed to implement an effective internal audit function for Dutchmen.

As the SEC’s complaint alleges, after Schwartzhoff’s fraud came to light, Thor concluded that the internal control failures at Dutchmen constituted a material weakness in Thor’s internal controls over financial reporting. Thor also determined that similar lack of segregation of duties existed in varying degrees at each of its subsidiaries. For example, senior accounting officers (Controllers and Vice Presidents of Finance) at numerous subsidiaries had the ability to create, enter, and approve journal entries and reconciliations in accounts such as accounts receivable, accounts payable, and cash. At all but one subsidiary, various individuals had inappropriate access rights to accounting and information systems, including “super user” access by senior accounting officers at some subsidiaries. In addition, the complaint alleges Thor also determined that it lacked sufficient corporate level monitoring of account reconciliations for all of its subsidiaries.

Without admitting or denying the allegations in the complaint, Thor has consented to the entry of a final judgment: (1) requiring it to comply with the 1999 cease-and-desist Order; (2) permanently enjoining it from violating Sections 13(a), 13(b)(2)(A), and 13(b)(2)(B) of the Exchange Act and Rules 12b-20, 13a-1, and 13a-13 thereunder; (3) ordering it to pay a $1 million penalty pursuant to Exchange Act Section 21(d)(3) for violating the 1999 Order; and (4) ordering it to hire an independent consultant to review and evaluate certain of its internal controls and record-keeping policies and procedures.

Without admitting or denying the allegations in the complaint, Schwartzhoff has consented to the entry of a final judgment: (1) permanently enjoining him from violating Sections 10(b) and 13(b)(5) of the Exchange Act and Rules 10b-5, 13b2-1, and 13b2-2 thereunder, and from aiding and abetting violations of Exchange Act Sections 13(a), 13(b)(2)(A) and 13(b)(2)(B) and Rules 12b-20, 13a-1 and 13a-13 thereunder; (2) ordering him to pay disgorgement of $299,805 plus prejudgment interest of $95,025, for a total of $394,830, with payment of this amount to be deemed satisfied by the entry of a restitution order against Schwartzhoff in a parallel criminal case that is equal to or greater than $394,830; and (3) permanently barring him from serving as an officer or director. Schwartzhoff also consented to the issuance of an order pursuant to Rule 102(e) of the Commission’s Rules of Practice, permanently suspending him from appearing or practicing before the Commission as an accountant.

These settlements are subject to the approval of the United States District Court for the District of Columbia. The settlement with Thor takes into account the company’s self-reporting and significant cooperation in the SEC’s investigation.

Separately, on May 12, 2011, the United States Attorney’s Office for the Northern District of Indiana filed a related criminal action against Schwartzhoff, and Schwartzhoff agreed to plead guilty to an Information charging him with one count of wire fraud and to pay restitution of approximately $1.9 million.

Next month, fraudulent non-financial statements.

[1]  Michael Lewis. “Beware of Greeks Bearing Bonds.” Vanity Fair. October 2010.

[2] United States. Securities and Exchange Commission. SEC Charges State of New Jersey for Fraudulent Municipal Bond Offerings. Press release. Washington, D.C. August 18, 2010.

[3] Katherine Barrett and Richard Green. “The State’s Stupid Budget Tricks.” Governing Magazine. November 2009.

[4] Pike v. United States Securities and Exchange Commission. Litigation no. 34793. March 25, 1998.

[5] Kate O’Sullivan. “The rise and fall of Krispy Kreme is a cautionary tale of ambition, greed, and inexperience.” CFO Magazine. 
June 1, 2005.

[6] Ben Blanchard. “China executes rogue trader, millions still missing.” Reuters [U.S.]. December 9, 2009.

[7] Jacob Szeto. “Looming Liabilities: Oregonians owe $3 Billion in post-employment benefits.” Oregon Capitol News [Salem]. April 27, 2010.

[8] Leslie Wayne. “Calpers Sues Over Ratings of Securities,” New York Times. July 14, 2009.

[9] Chana Joffe-Walt and David Kestenbaum. “Planet Money, Toxie’s Dead,” NPR. September 24, 2010.

[10] United States. Securities and Exchange Commission. SEC Charges Ohio-Based Investment Advisers for Fraudulently Overstating Assets. Washington, D.C. August 13, 2009.

[11] United States Securities and Exchange Commission v. Thor Industries, Inc., and Mark C. Schwartzhoff. Litigation no. 21966. May 13, 2011.

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