Investigator: Meet My Friend, the Accountant

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Catherine Lofland, CPA
ACFE Research Specialist

Imagine a small business owner who catches an employee stealing inventory from his store. The owner calls the police, who arrest the employee. What the small business owner doesn’t realize is that the same employee has also been writing checks to himself under a pseudonym for months, in what is known as a fictitious vendor scheme. A fraud investigator would likely uncover this scheme by examining the financial records; however, if the officers investigating the inventory theft don’t have the accounting knowledge necessary to decipher the financial records, the employee might get away with the embezzlement.

When I tell people I write educational materials in the research department at the ACFE, their response is often, “So, you write courses for forensic accountants?” There is a common misconception that “fraud investigation” and “forensic accounting” are synonymous. While these concepts are related, they are in fact distinct. A fraud investigation is conducted by either financial or non-financial professionals and refers only to fraud matters. Forensic accounting, on the other hand, refers to work done by accountants in anticipation of litigation and doesn’t necessarily involve fraud.

Although ACFE members include many CPAs and accountants, a large portion of our membership work in non-financial professions, including law enforcement, attorneys, private investigators, detectives, consultants and compliance professionals. Many of these people have limited or no formal accounting education.

It is important for any fraud examiner to understand the nature of financial transactions and how they affect a company’s books. When conducting a fraud investigation, one must be on the lookout for indications within financial reports and data that reflect financial statement manipulation, theft of assets or corruption. However, analyzing a set of books might be daunting to someone who has never taken an accounting class. For those of you with a limited exposure to basic accounting concepts, I encourage you to check out our new online self-study course, Financial Investigations for Non-Financial Professionals. This course walks you through the three essential financial statements, the basic accounting principles driving the numbers on these statements and simple financial analysis techniques that can quickly highlight suspicious activity.

Since fraudulent acts are often of a financial nature, it is important for a fraud examiner to have a fundamental knowledge of accounting principles and a familiarity with the structure of financial statements in order to conduct a thorough fraud investigation.

A $1.7 Billion Fraud Born of Earnings Management and a Poor Ethical Culture

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Sheila Keefe, CFE, CPA

Principal, BDR Advisors LLC

The $1.7 billion Olympus fraud, discovered through whistleblowing of the outgoing CEO Michael Woodford, has sent shockwaves throughout the corporate governance world as many wonder if such a fraud could occur at other organizations. To consider this validity of this concern, let’s look at the accounting piece and the role of poor corporate culture that allowed this fraud to continue for 13 years.

The Numbers

The accounting piece of the Olympus fraud was facilitated by the now-outlawed practice of tobashi, in which organizations spread the recognition of losses over multiple periods rather than immediately. To state it simply, tobashi is a form of earnings management. Olympus executed its tobashi scheme by selling devalued investments to an ‘unrelated’ entity under common control at historical costs. In this way, no loss was recorded by Olympus on the sale of the investment. The losses were recorded eventually as impairment of goodwill.  To do this, Olympus would buy the ‘unrelated’ entity that held the investments, with the price set at the lower market value and then add in significant goodwill to the acquisition such that the new subsidiary would be bought for an amount equivalent to the historical cost of the devalued investments. Olympus would then gradually write-down goodwill from the acquisition of the previously ‘unrelated’ entity as a permanent impairment. At the end of the tobashi scheme, the devalued investment would be restored to Olympus’ balance sheet at the lower market value, and the losses would be recorded through the income statement but not as investment income but rather as impairment of goodwill.

While the tobashi scheme that Olympus initiated is no longer legal, earnings management is still popular with companies interested in avoiding shocks to stock prices. As recently as 2009, General Electric was fined $50 million by the SEC for earnings management.

The Role of Olympus’s Poor Ethical Culture

Accounting issues aside, Olympus has been criticized for having a poor corporate culture. In an investigation report issued by a third-party committee in December 2011, several suggestions for improving Olympus’s corporate culture were outlined:

• Outside directors should be truly independent, not connected to those in management or the organization’s trade partners.
• The importance of candid conversations and dissenting opinions in creating a culture of accountability and transparency. Per the report: “Fear of rocking the boat or formalities should be eliminated. Developing people who can discuss what he really thinks.”
• The need for the board directors to question the consultation of its advisors. As the report instructs, board members should “thoroughly pursue the truth of the transactions” and not allow a “worthless report of an outside expert” to be “blindly trusted.” This applies to all organizations in that board members should be sure that the approval to take on highly complex transactions is supported by a discussion by management that explains how the transaction generates economic growth. Such discussions would identify transactions that are more form than substance. 
• Use of a whistleblower hotline to “prevent misconduct by executives.”

The report closes with an observation common to many victim organizations that speaks to the need to pursue an ethical work culture as part of any fraud response program, stating, “Olympus had originally been a sound company, with diligent employees and high technical strength. Not all part of the company was involved in this misconduct. Olympus should remove its malignant tumor and literally renew itself.”  Strong words, for certain, but not overstated.

Olympus whistleblower Michael Woodford will formally accept the ACFE's Sentinel Award and speak as a keynote at this June's ACFE Annual Fraud Conference and Exhibition in Orlando, Fla.

To read more about Sheila or to follow her blog, Business Done Right, go here.