Accounting treatment for fraud- losses

We received question from our Accounting & Auditing readers on what would be the accounting entries for losses arising from fraud incidence.

In most of the circumstances, the losses arising from fraud wil be recorded in profit & loss statement. For instance, if a Company sufferred misappropriation of cash, the following accounting entries should be recorded:

Dr. Loss (Profit & Loss)
Cr. Cash

If the losses arising from fraud incident is material, this fact (i.e. fraud incident) need to be disclosed in the financial statement of the Company. Management of the Company need to consider the local laws & regulations on the disclosure requirement of fraud.

Fraud- Nortel trial- Nearly billiton dollars in reserves "incorrectly" booked

It is reported that Nortel conducted a comprehensive review and found out that nearly a billion dollars worth of accounting reserves ``incorrectly'' booked, dating to as far back as 1999. The internal review also found two ``material weaknesses'' tied to the use of the accrued liabilities, the first being a breach in public disclosure rules, the second a violation of Nortel's own accounting practices.

It is evident that certain management of Nortel had manipulated the results by using the accrued liabilities account.

$952 million in accrued liabilities were set up without the appropriate documentation, and weren't filed in accordance with generally accepted accounting practices (GAAP). Citing one account, called the ``out-of-balance'' provision that was stored within the firm's corporate or non-operating books, the accountant said: ``It's not warranted to have an out-of-balance account.''

Tens of millions of dollars in backlogged provisions were entered to cover anticipated costs such as contract liabilities and lawsuits. When those costs weren't realized, Nortel flowed the provisions back into earnings in later periods. Yet, they ``should have been recognized in real-time,'' not deferred.

This so-called ``earnings management'' practice was used by the three top executives in Nortel to tip the flagging tech giant back into profitability in 2003, triggering $73-million in bonuses, of which they collected $12-million combined.

Fraud- Improper segregation of duties in handling cash

Misappropriation of cash is one of the common fraud reported in the corporate world.

In Nov 2010, it is reported that Malaysian unit sufferred a loss of RM 1.5million (approximately S$622k) due to the issuance of unauthorised cheque. It's not clear how this had occurred.

In general, one of the possibilities a cash fraud could occur is when certain individual forge the authorised signatories on the cheque. By forging the authorized signatories, the individual is able to direct the fund to his / her bank accounts. How can the internal controls of the Company helps to minimize the risk of cash fraud then?

Possible solutions are:
- to set dual authorized signatories requirement for the Company's cheque facilities
- existence of proper segregation of duties between cheque book-keeper, preparer of cheque, review of cheque amount, approver of cheque
- cash book review be performed by appropriate senior finance personnel
- review the cash movement by bank account on a monthly basis

The existence of above controls and/or procedures can help to mitigate the risk of cash fraud.

Olympus scandal: hid investment losses in the past 20 years

Japanese company, Olympus Corp has finally admitted that they used inflated acquisition costs ( specifically: advisory fees) to hide investment losses incurred in the past 20 years.

Earlier on, the market was vigorously discussing on the scandalous US$687 million payment for financial advice and expensive acquisition of companies unrelated to its mainstream businesses.

Olympus issued a statement saying that an independent panel investigating the allegations had found that the acquisitions were used to cover up losses on investments dating to the 1990s. During that time in Japan known as the "Lost Decade," many Japanese companies took to making speculative investments in securities to offset sluggish sales following the bursting of Japan's economic bubble.

Olympus Corp's president, Takayama also confessed that the corporation needed higher level of corporate governance to ensure that similar things will not happen in the future.

UBS CEO has resigned after unauthorized trading incident

UBS CEO Oswald Grübel has resigned on 24 September 2011, after the recent unauthorized trading scandal, which has caused the bank to suffer from US$2.3billion losses arising from unauthorized transactions. Sergio Ermotti, a veteran Merrill Lynch executive, has been named as the interim CEO to lead the company.

Despite achieving impressive turn-around and strengthened UBS’ fundamentals during his tenure, Oswald Grübel stepped down after the unauthorized trading done by the rogue trader, 31-year-old Kweke Adoboli.

The board and the management of this Swiss bank are in the midst of investigating this scandal.

This entire incident re-emphasized the importance of having a strong internal controls system in place. CEO might not be the individual designate the internal controls in-place. However, a CEO needs to ensure that strong internal controls are in place to prevent/ identify unauthorized transactions. Hence, it appears to the public that Oswald Grübel has stepped down as he assumed the responsibility of unauthorized trading occurred.

There are five key elements in an internal control system, namely:
a. control environment,
b. risk assessment,
c. control procedures,
d. information & communication, and
e. monitoring

It’s evident that CEO need to be heavily involved in “information & communication” and “monitoring” components. To illustrate, there must be proper channel for all necessary information to be heard / listened by senior management,. It’s also crucial to ensure that appropriate level of monitoring activities been carried out.

#101- Fraud cases in Singapore- China Hongxing and Hongwei Technologies

Accounting irregularities are detected in two S-chip companies in Singapore, namely: China Hongxing Sport and Hongwei Technologies. Coincidentally, the financial auditor of these two companies is Ernst & Young LLP.It's noted that the auditor is facing difficulty in ascertaining certain assets, liabilites, and expenses. Details are as below:

Hongwei Technologies- the auditor is facing difficulty in confirming the cash and bank balances

China Hongxing- the auditor noted irregularities in the cash and bank balances, accounts receivables, accounts payables, and other expenses

The board of directors have engaged independent investigator in resolving the issues highlighted by Ernst & Young LLP.

Singapore Fraud Cases- Fibrechem and Oriental Century

2 Singapore-listed China entities are reported to be involved in fraud scandals recently, namely: Fibrechem Technologies and Oriental Century.

Fibrechem Technologies' auditor, Ernst & Young Singapore have encountered difficulties in the firm final audit of ascertaining the Cash and Trade Debtor balance of the Group. Fibrechem Technologies is a China-based entity involved in producing chemical fibres and synthetic leather.

Whereas, Oriental Century's auditor, KPMG face a similar problem in ensuring the existence of cash and trade debtor balance. Oriental Century is a china-based education company, in which Raffles Education (SGX-listed education Group)holds 29.9% stake with cost of investment amounted to S$34.6mil. In worst case scenario, Raffles Education might have to write- off its investment in Oriental Century if Oriental Centruy could not operate on a going concern basis.

Similarly, in previously reported Satyam Fraud Case in India, Satyam's founder and CEO has mis-appropriated its cash balance in its balance sheet. How could the auditors being mis-led ?

Corporate Fraud again- Stanford Fraud case

US$8billion dollar fraud by United State banker, Allen Stanford. The scam is widely perceived as Allen Stanford utilising the ill-regulated offshore banking industry in Antigua.

Stanford financial group has allegedly offerred US$8bilion worth of certificates of deposits that promised unreasonably high interest rate. CAS Hewlett, Antigua-based accountancy firm is the auditor. Unfortunately, the where-about of the chief executive is unknown.

CAS Hewlett gave unqualified audit opinion to the statutory account of Stanford.

Nevertheless, what regulators concern are the representation of the bank, as quoted below:

'The defendants have misrepresented to CD purchasers that their deposits are safe, falsely claiming that the bank re-invests client funds primarily in 'liquid' financial instruments (the portfolio); monitors the portfolio through a team of 20-plus analysts; and is subject to yearly audits by Antiguan regulators.'

Satyam Fraud Case- Implication of Bank Confirmation / Bank Certificate

Subsequent to our previous post of " Saytam Fraud Case- Misrepresentation of Cash" , our further examination reveals that the misrepresentation pertains to misrepresentation of the Company's Fixed Deposit. The CEO, Raju, is personally in charge of the Fixed Deposit! An improper segregation of duties ( improper corporate governance) has given the CEO committed the fraud.

Investigation into the fraud case is on-going, and media widely reported that the investors are questioning what audit procedures have the Stayam auditor, Pricewaterhouse Coopers performed to ensure the existence of the asset.

The implication of Satyam Fraud Case highlited the importance of obtaining independent bank confirmation from the bank directly. No audit engagement should be closed without obtaining the bank confirmation as an audit evidence. Bank confirmation replies will also reflect any contingent claims by the bank towards the entity. As such, the auditors can ensure the completeness of the disclosure of Company's contingent liabilities.

In short, an independent bank confirmation / cash certificate is an important audit evidence, as evident in Satyam's fraud case.

Satyam's Fraud Case- Misrepresentation of Cash

Recently, the profession is hit by the significant fraud case involving India's IT Giant- Satyam. Satyam admitted that he has committed fraud, part of the action includes: inflating cash and bank balances by $1 billion dollar!!!

The professions are wondering how could the auditor miss out such a huge misrepresentation in cash and bank balance. In general, audit procederes include:

- agreeing cash and bank balance per Trial Balance amount to Bank Statement
- most importantly, obtaining bank confirmation directly from the client's banker

The confirmations and bank statements provide a certain level of audit comfort zone, given that it's an independent party confirmation, rather than client-generated evidence.

Nevertheless, Pricewaterhouse Coopers, who are the auditor for Satyam Computer Services Ltd, claims that the audits were conducted in accordance with applicable auditing standards and were properly supported by audit evidence. Apparently, the fraud cannot be easily discovered by obtaining bank confirmation. If not, it wuld have been discovered, given that Pricewaterhouse Coopers has been the auditor of Satyam for several years.

We shall wait for further news / reports then.

#63 Impact of client's Key Performance Indicator on audit

During current credit crunch climate, auditors must be aware and gain an understanding of the management's Key Performance Indicator, as it represents the risky areas, where the management is likely to manipulate the results in order to meet the Key Performance Indicator.

Meeting a Key Performance Indicator means that the management might receive higher remunerations / incentive, and the jobs are highly secured with low risk of being retrenched.