Who Controls the Cash Box? Covering Up Fraud

Most examples of accounting fraud involve theft of assets or some sort of earnings manipulation. The SEC recently reported on a fraud scheme that was far more complex. This fraud occurred because of huge internal control failures over company assets and the accounting records.

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Investing extra cash, margin trading

Katsuichi Fusamae is a senior accounting officer at Molex Japan. Molex is a Chicago-based company with a Japanese subsidiary. In the late 1980s, “he began investing Molex Japan’s excess cash in riskier securities, including substantial trading of equities on margin.”

Well, these transactions bring up a host of issues. Here are just a few:

·      Segregation of duties: No accountant should be involved in any sort of investing of company assets. Segregation of duties dictates that a record keeper (accountant) cannot also have custody of assets. If an accountant has both of these duties, the company is at risk for fraud- exactly what occurred here.

·      Investment policy: All companies should have Board-approved investment guidelines for assets. Few companies would allow securities trading on margin as an investment policy. Margin means that the buyer is borrowing money to buy securities. If the value of the securities declines, the investor is required to deposit more money. This can create a financial spiral: As the securities decline further in value, more money must be deposited.

Using loans to cover trading losses

The accountant starts to accumulate trading losses over time. As the SEC explains: “He concealed the massive trading losses by taking out unauthorized and undisclosed company loans with Japanese banks and brokerage firms, and he used loan proceeds to replenish account balances and engage in additional trading.”

Even more internal control problems here:

·      Segregation of duties: Just as the accountant cannot have access to assets, no accountant should be authorized to sign off on a company loan.

·      Loan policy: Senior management should make the decision about any borrowing. The amount, loan details and the purpose of the loan should fit the company’s borrowing policy.

·      Loan approval: The first thing a commercial banker wants to know is: How will the loan proceeds be used? Obviously, the accountant wasn’t truthful.

Financial statement impact, dormant accounts

The accountant “falsified Molex accounting records and general ledger entries and intentionally utilized dormant general ledger accounts to conceal the unauthorized and undisclosed trading as well as the concealed borrowing.  At the peak of his scheme, Molex Japan had accumulated approximately $222 million in unauthorized loan obligations as a result of Fusamae’s misconduct. (Italics added)” 

The manipulation of accounting records and general ledger entries is common in an accounting fraud. Using dormant general ledger accounts, however, brings up an issue that is often ignored.

What is that account used for?

Everyone is in a hurry. Accountants are under the gun to produce financial statements. Auditors- both external and internal auditors- are trying to perform audit work efficiently. Along the way, people may not pay attention to the chart of accounts.

Hiding in the chart of accounts

The chart of accounts is the listing of all of your accounts. As you might expect, accounts get added, deleted- or simply sit dormant and unused. Now, it’s standard accounting practice to remove accounts that are dormant. They become a distraction and clutter your accounting reports.

The dormant account can be the perfect place for an accountant to “park” accounting activity that they want ignored. If senior management and auditors aren’t used to seeing that account, it might fall under the radar screen for a while. Eventually, if the balance gets big enough, it will get noticed.

The fallout

This was a massive fraud, but it has several key takeways:

·      No accountant should be involved in signing off on investment or loan activity

·      Pay attention to dormant general ledge accounts. Remove them if they aren’t being used

Have you seen an issue with dormant general ledge accounts? I’d love to hear from you.

Ken Boyd

St. Louis Test Preparation

Author: Cost Accounting for Dummies, Accounting All-In-One for Dummies, The CPA Exam for Dummies and 1,001 Accounting Questions for Dummies

 Co-Founder: accountinged.com

Image: 

David Tarwin, Cash register close up

(CC BY-SA 2.0)

Hertz, We Have a Problem: Internal Control Weaknesses

I wrote this prior post about the accounting internal controls and financial restatements at Hertz Global Holdings (the car rental firm). This post goes into more detail on what exactly happened, from an accounting standpoint.

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Restatement and revision

Companies that issue stock and bonds to the public must file annual Form 10-K and quarterly Form 10-Qs with the Securities and Exchange Commission (SEC). These firms also file Form 8-K to disclose any other issues during the interim (Between quarters). Here are the detail from Hertz’s June 6, 2015 Form 8-K:

·      Audit Committee: The Audit Committee of the Board of Directors is responsible for hiring the external auditor and overseeing the audit. Hertz’s Audit Committee reports that the 2011 financials are being restated, and the ’12 and ’13 financials are being revised.

·      Financial statement review: The Committee is supervising a complete review of ’11, ’12 and ’13 accounting processes. The review may require financial adjustments and additional financial restatements.

·      Material weakness: The Committee reports at least one material weakness in internal controls for ‘2013. Management (who is responsible for implementing internal controls) is amending the Management Report on Internal Controls over Financial Reporting. You’ll find that report in the Annual Report.

·      Adverse audit opinion: Hertz expects to receive an adverse opinion on internal controls for financial reporting in the 2013 financial statements. Page 96 of the 2013 Hertz Annual Report displays the audit opinion before any changes. Keep in mind that the date of the audit opinion is March 19, 2014- before the Audit Committee report.

Where we disagree

Page 189 (Item 9) of the 2013 Annual Report explains that management and the external audit disagree on accounting and financial disclosure. Management concluded that their controls were effective. Management then explains that the external auditor performed an attestation report on internal controls over financial reporting. Important: An attestation is not an audit. The auditor is not “opining”- giving an opinion- when they perform an attestation.

Based on the June 2015 Form 10-K, both management’s report on internal controls and the audit opinion will change.

Sources of material errors

Interestingly, each of the errors pointed out in the Form 8-K involved accounting estimates. Estimates require judgment- and that’s where disagreements can occur between management and external auditors. According to the Form 8-K (italics added):

“The most material errors identified to date relate primarily to the capitalization and timing of depreciation for certain non-fleet assets, allowances for doubtful accounts in Brazil, allowances for uncollectible amounts with respect to renter obligations for damaged vehicles, restoration obligations at the end of facility leases and certain other items.”

Choices about capitalization vs. depreciation involve judgment. So do decisions about allowance for doubtful accounts.

Have you been involved in discussion about accounting estimates? I’d love to hear from you.

Ken Boyd

St. Louis Test Preparation

Author: Cost Accounting for Dummies, Accounting All-In-One for Dummies, The CPA Exam for Dummies and 1,001 Accounting Questions for Dummies

Co-Founder: accountinged.com

(email) ken@stltest.net

(website) www.stltest.net

Image: Maciej Lewandowski, Vintage Cars, (CC By SA-2.0)

Protecting Shareholders: Accounting and the Risk of Delisting

Stock markets exist to allow companies to raise capital. In many cases, an initial public offering is performed for a business that doesn’t generate consistent sales and earnings. That’s to be expected.

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However, once a stock is trading on an exchange, there are some minimum expectations. Timely financial reporting is one of those expectations. If a company does not meet these minimum requirements, the firm runs the risk of delisting. Delisting means that the stock is removed from trading on an exchange.

SEC Acts of ’33 and ‘34

After the stock market crash of 1929, Congress found two major problems that needed to be corrected. First, companies issuing stock in the 1920s had virtually no rules on financial disclosure. Investors were not fully informed of the company's financial condition. 

The SEC Act of ’33 requires companies to sell shares by prospectus. Businesses are also required to file quarterly reports with the SEC- and to submit additional filings for any major change in the business between quarters.

The SEC Act of ’34 governs stocks once they start trading. This rule address fairness in stock trading, among other issues.

In addition to reporting requirements, a stock exchange may have other expectations. The NASDAQ exchange, for example, has a $1 rule. “Failure of a company to meet a minimum closing bid price of at least $1 for 30 consecutive trading days can trigger delisting.” 

A slippery slope

Unfortunately, an accounting issue can lead to delays in issuing financials. That delay can cause investors to lose confidence- which drives down the stock price. A lower stock price puts a company at risk of violating the $1 delisting rule. As you can see, it’s a slippery slope….

Auditor resignation

The Sacramento BusinessJournal provides an example of the slippery slope concept. Ernst & Young resigns as auditor for Cesca Therapeutics. The auditor cites material weaknesses in the internal controls for financial reporting. Essentially, the auditor is saying that accounting controls are so lax that we can’t rely on the account balances we’re auditing- serious stuff.

Because of the lack of financial controls, the quarterly reporting required by the SEC and NASDAQ is delayed. This hurts the stock price. The share price goes below $1. Now, there’s a process to avoid a delisting- but will investor confidence ever recover?

These rules are in place to protect shareholders. Investors need timely financial reporting. If a company has run completely off the rails financially, they should lose the ability to trade on a large exchange. Keep in mind that the slippery slope begins with an internal control issue.

Have you dealt with or worked for a company that has had this issue? I’d love to hear from you.

Ken Boyd

St. Louis Test Preparation

Author: Cost Accounting for Dummies, Accounting All-In-One for Dummies, The CPA Exam for Dummies and 1,001 Accounting Questions for Dummies

Co-Founder: accountinged.com

 (website) www.stltest.net

Image: Wall Street, Sue Waters CC by SA-2.0