Module6_Case Study
How a CFO landed in prison
The perils of asset and revenue overstatements (and
other schemes)
JON J. LAMBIRAS, J.D., CFE, CPA
January/Fe
uary 2013
LEE PETTET AND MICHELE PIACQUADIO/ISTOCKPHOTO
A CFO, bullied by the CEO, used creative accounting and fraudulent schemes to falsely improve a
company's bottom line. Here's how he did it and what to keep an eye out for in your organization.
The chief financial officer's accounting fraud was intended to improve the company's financial
statements and inflate its stock price. Mission accomplished on both accounts. The fraud led to
increased market capitalization for the company and millions of dollars in losses for stockholders who
ought the stock at inflated prices.
The CFO succeeded in his scheme for almost two years. An astute member of the financial press
ultimately exposed the fraud, which led to criminal charges. The CFO eventually served five years in
prison for securities fraud.
This article highlights the mechanics of how he accomplished his fraud using creative schemes to boost
evenue, lower cost of goods sold and inflate net income.
In writing this article, I hope to raise awareness of his schemes and help fraud examiners prevent and
catch these kinds of accounting gimmicks.
I was involved as an attorney and CFE in civil litigation that overlapped with the criminal case. I
analyzed accounting records and audit work papers, assisted in a deposition of the CFO in prison and
attempted to piece together the puzzle of the CFO's fraud, among other things. The identities of the
CFO and the company will remain anonymous because certain information in the case was non-public
in nature.
THE PRESSURING CEO
The chief executive officer of the company heavily pressured the CFO (I'll call him Jack) to report
growing earnings. The CEO gave aggressive financial projections to the media, and then he pushed
Jack to meet the market's expectations. The CEO had a domineering, threatening personality. Jack
was relatively new to the company and was hesitant to say no to his strong-willed boss.
Jack owned shares of the company's stock. Although that was an incentive to inflate the stock price, his
main motivation was to please the CEO. Jack had no stock options or incentive-based bonuses.
The expectations of Wall Street and the CEO proved tough to meet. Jack needed a crutch to creatively
meet the push for strong financial results. Initially, he used a few minor accounting tricks to improve the
short-term bottom line; he didn't intend for them to evolve into a long-term solution or full-fledged fraud.
He planned on reversing most of the fraudulent transactions in later accounting periods. Jack hoped
that future sales growth — triggered by a new product in the pipeline — would significantly and
discreetly abso
the effects of reversing the fraudulent transactions. However, the sales growth never
materialized, and Jack wasn't able to cover his tracks.
The pattern should sound familiar to fraud examiners. It's a classic example of the motives and
snowball effect that often lead to large-scale fraud.
FICTITIOUS SALES INVOICES A key component of Jack's fraud was fictitious sales transactions. His
starting point in booking these transactions was to create false invoices in the company's accounting
system. There were no underlying customer orders, shipping documents or payments. Jack simply
entered information into the invoice system such as a real or fake customer name, item description, unit
price, quantity and sale date. When the system created the invoices, the system automatically recorded
a debit to the accounts receivable (AR) general ledger account and credit to the sales account.
Creating the invoice was easy. The tougher part was dealing with the fraudulent AR that remained on
the company's books from these transactions.
Jack subsequently cleared some of the AR off the books with cash received from unrelated
transactions to make it appear that the fraudulent account receivable was paid off. For example, in one
instance the company received cash from a large investor for the payoff of a receivable from the
investor's prior purchase of stock. When the incoming cash was received, Jack co
ectly booked it as a
debit to cash. However, he booked the credit portion of the entry to AR from the fictitious sale rather
than the receivable from the investor. Thus, the fraudulent AR balance was no longer on the company's
ooks at year-end.
In other instances, he left the AR from fictitious sales on the company's books through year-end. This
was risky because Jack knew the auditors would review and test at least some of the company's year-
end AR balances. In fact, for one of the fake receivables, the auditors sent an audit confirmation to the
listed customer. The customer was a real entity that conducted prior business with the company, but it
was run by an accomplice, who aided in the company's fraud. The accomplice signed the confirmation,
falsely agreeing that the sale took place and that the receivable was legitimate.
Jack, a former auditor, knew most of the audit procedures that the company's auditors would perform at
year-end. More importantly, he knew ways to evade them. For example, he often recorded the fictitious
sales in small amounts to avoid creating an unusually large transaction or significant accounts AR
alance that might attract the auditor's attention. He was also careful to record the sales at least five
days before year-end to avoid any cutoff tests.
SALES WITH NO CORRESPONDING COST OF GOODS SOLD Some of the fictitious sales were
ooked with co
esponding cost of goods sold (COGS) entries; however, some weren't. COGS is an
expense account that reflects the cost basis of sold inventory. The absence of COGS entries meant
that the sales were booked with a 100 percent profit margin. In other words, the entire amount of the
sale directly increased net income because no co
esponding COGS entry was booked to an expense
account to record the cost basis of the sold inventory.
To illustrate, sales entries in legitimate accounting systems are generally booked as a debit to AR and
credit to sales for the total amount of the sale. A co
esponding entry is booked as a debit to COGS and
credit to inventory for the company's cost basis of the inventory. The latter entry removes the sold
inventory from the company's books. The cost basis of the inventory is usually less than the sales price,
with the difference representing the company's profit from the sale.
In cases where no COGS entry was booked (i.e., no debit to COGS, and no credit to inventory), no
expense was recorded to net down the company's revenue from the sale. So, the entire sale amount
epresented profit flowing through to net income.
The company's accounting system automatically booked a debit to COGS and credit to inventory when
an inventory item number was listed on the sales invoice. In instances where the CFO wanted to avoid
the COGS entry, he simply excluded an inventory item number on the invoice. Alternatively, if an
inventory item number was listed on the invoice, he sometimes recorded a manual journal entry to
everse the COGS entry booked by the system. The end result was a sale transaction booked with a
100 percent profit margin.
DNY59/ISTOCKPHOTO
EXAGGERATED PROFIT MARGIN FOR OTHERWISE LEGITIMATE SALE
On at least one occasion, Jack manipulated an otherwise legitimate sale transaction, after the sale was
ooked, to exaggerate the profit margin. He did this by entering the accounting system and lowering the
quantity of goods for the inventory component of the transaction. When he lowered the quantity, the
accounting system automatically adjusted the COGS entry to decrease the amount of the entry based
on the lower quantity of goods. This caused an increase in profit margin from the sale, which flowed
through to net income.
OTHERWISE LEGITIMATE REVENUE PULLED INTO EARLIER ACCOUNTING PERIODS
Jack also pulled otherwise legitimate sales transactions into earlier accounting periods to prematurely
ecognize revenue from the sales.
He did this, after the sale took place, by changing the date on the sales invoice in the invoice system to
eflect an earlier date. The original accounting entries on the general ledger (debit to AR, credit to
sales; debit to COGS, credit to inventory) were then automatically backdated to the earlier date.
Jack usually pulled off this scheme between quarters instead of fiscal years, which minimized the
possibility of detection because he knew the auditors conducted more thorough reviews annually than
quarterly.
In conjunction with pulling revenue forward, Jack sometimes backdated otherwise legitimate shipping
documents to change the shipping dates to the earlier periods. Jack essentially replaced the actual
date on a shipping document with a false date, which coincided with the date of the manipulated sales
invoice. The underlying shipments to customers were real — he simply manipulated the dates to make
it appear that they took place in an earlier period. He used this tactic to create a more robust paper trail
for the fraudulent transactions.
PUSHED COST OF GOODS SOLD INTO LATER ACCOUNTING PERIODS
Jack also pushed COGS entries (debit to COGS, credit to inventory) for otherwise legitimate sales into
later accounting periods. This resulted in a 100 percent profit margin on the sale in the earlier period
ecause the COGS expense was transfe
ed to the later period but the sale entry (debit to AR, credit to
sales) remained in the earlier period.
Jack usually committed this scheme between quarters, instead of fiscal years, which minimized the
chances of the auditors detecting it at year-end.
This scheme left the inventory balance on the company's balance sheet temporarily overstated. To
illustrate, inventory was physically shipped to the customer in the earlier quarter when the sale took
place. But because the inventory entry (debit to COGS, credit to inventory) was pushed back to a later
quarter, the inventory balance on the balance sheet temporarily varied from the company's