Global Investigations Review - The law and practice of international investigations

The European, Middle Eastern and African Investigations Review 2015

Cross-border overview: investigating accounting irregularities

Ben Johnson and Paul Brabant

22 July 2015

AlixPartners

In 2013, the Securities and Exchange Commission announced it would sharpen its focus on accounting and financial fraud cases. The agency’s aggressive enforcement of accounting cases appears to be bearing fruit; the number of cases brought by the SEC against companies increased 46 per cent over the prior year while the number of investigations into these matters rose by 30 per cent1.

EMEA regulators may also be changing their approach when it comes to accounting fraud. Several large accounting cases have been instigated recently against companies in a wide range of industries and jurisdictions within Europe.

Investigating accounting irregularities can present unique challenges for investigators. Accounting rules and standards are increasingly complex and may be subject to a range of different interpretation. Also, in large organisations, accounting functions and IT systems are often complex and may be decentralised across several jurisdictions. As a result, identifying relevant facts and underlying issues in these circumstances may not always be straightforward. This article provides an introduction to common accounting problems and discusses some of the key challenges in attempting to answer the above questions and how to deal with those challenges.

Some of the practical challenges that may exist in an investigation into accounting irregularities include:

Common questions an investigation into potential accounting irregularities should seek to answer may include:

Accounting irregularities

Before discussing some of the practical challenges involved in investigations into potential accounting irregularities, it is helpful to consider what may constitute such practices.

Accounting irregularities cover a broad set of practices that may not conform to accounting principles. They may be the product of a genuine error or an intentional attempt to deceive. Accounting irregularities can consist of misstated amounts or other information in financial statements, or omitting information that is required to be disclosed. They may be the product of genuine error or an intentional attempt to deceive.

The more deliberate end of the scale of accounting irregularities is often referred to as financial statement or financial reporting fraud, which involves the misrepresentation of a company’s financial condition. Typically, financial statement fraud is driven by a desire to boost the appearance of business performance and is achieved by intentional misstatement or omission of amounts or disclosures in the financial statements. Examples include improper revenue recognition, manipulation of liabilities or expenses, overstatement of assets and improper disclosures on financial statements. Although irregularities can often go unnoticed for extended periods, aggressive enforcement and the increased role played by whistleblowers represent ways in which such cases may be identified. Similarly, changes in a company’s ownership or management structure can also bring such issues to the forefront.

Accounting framework

Public companies are required to report financial performance in accordance with the applicable accounting principles, standards, and procedures, referred to as generally accepted accounting principles (GAAP), for their jurisdictions. In recent years, most major countries outside the United States have moved to implement a consistent set of accounting standards known as international financial reporting standards (IFRS), which are set by the International Accounting Standards Board.2 In most cases larger and public companies have to prepare their annual financial statements in accordance with IFRS while smaller, private companies can apply local GAAP.

Regardless of the set of standards used, it is important to remember that accounting standards provide principles and guidance for the appropriate preparation of accounts; there is considerable scope for the application of judgment in a variety of critical areas.

There may be a broad spectrum of what is considered to be acceptable accounting treatment. As a result, it may be difficult to establish the border between what is considered to be potential fraud and an aggressive interpretation of standards and use of judgment.

Common areas for accounting problems

There are myriad ways in which a company may manipulate its financial statements. In many cases, the areas prone to manipulation depend upon the key measures the business is assessed against. For example, for start ups and growth companies typically top-line turnover will be a key measure, whereas for a more established company it is often profitability (typically EBITDA or gross margin). For banks and credit providers it may be balance sheet strength and asset quality.

Particular care should be taken when judgmental accounting areas correlate with KPIs, as temptation to show improving KPIs can lead to inappropriate judgements. Having a deep understanding of the business and the motivations for potential financial statement manipulation is important for investigators so that risk areas can be identified. Some of the more common areas of accounting irregularities along with their drivers and at risk business types are set out in the table below:

Accounting areaDriverAt risk businesses
Aggressive revenue recognition Increase topline to support business valuation/market capitalisation Businesses with large long-term contracts, software companies
Accounting for expenses as assets Boost reported profitability Businesses with tight margins and/or struggling to meet expectations
Use of off-balance sheet financing Improve the appearance of the balance sheet and mask cash-flow problems Businesses with poor asset quality
Accounting for supplier income Tight margins/need to maximise profitability Distributors and retailers
Hiding trading losses on the balance sheet Fear of reporting true extent of incurred trading losses Investment banks, larger companies engaged in hedging activities
Failure to write down impaired assets Desire to meet market expectations Businesses with poorly performing acquisitions, banks
‘Cookie jar’ accounting (use of balance sheet accounts as ‘cookie jars’ to build and release reserves) Smooth distortions reported in the profit and loss account Low margin, volatile businesses

The approach to conducting an investigation into such issues may not necessarily change depending on the type of accounting issue involved. The fundamental challenge is to determine the facts in an objective manner.

Get the team right

Understanding accounting issues requires technical accounting knowledge but also sound commercial judgement. Every investigation is different and having the right mix of staff will help investigators to understand the underlying motivating factors and how they can be addressed. Soft skills as well as technical knowledge can be important in areas such as interviewing staff. And IT skills are important in being able to extract, process, and analyse large volumes of data, which are increasingly a fact of life for accounting investigations, particularly those of a cross-border nature. For this reason, investigation teams are often made up of experienced forensic accountants, lawyers and e-discovery specialists.

Dealing with the data

A key challenge in many investigations into possible accounting irregularities is dealing with the volume and disparate sources of data.

The first task is often to understand the company’s accounting system. In SMEs, this can be difficult because limited documentation may be available, and IT staff may not have the resources to identify the relevant data and explain its organisation. Larger corporations present different challenges – the use of different systems across the organisation can make it difficult to identify the most appropriate data. With multinationals, there may be multiple database systems across the relevant time period, either due to the upgrade of legacy systems, or redundant systems across subsidiaries left over from past mergers.

For larger investigations, and particularly those of a cross-border nature, it is often helpful to put together a team that includes the company’s finance personnel, database administrators, and forensic experts. Ultimately, the objective is to identify the relevant data to be captured.

Once this has been achieved, data can be examined by forensic investigators. Data analysis is often conducted outside the company’s offices, so as to not disrupt business operations. Data may be transferred to the forensic analyst’s lab, where the investigators will have complete flexibility to analyse and interrogate the data without having to rely on company staff to run queries and reports.

Care needs to be taken when data is transferred to protect its integrity. To this end, the transfer may be completed in collaboration with the company’s database administrator, who extracts the data in a format that can be loaded in the investigator’s own environment. Problems can arise in the transfer itself or due to a problem in the source data, in which case the investigator will need to take this into account. For this reason, the loading process typically involves initial checks to confirm the integrity and completeness of the data, as this will be important in ensuring that information derived from the data itself is suitable to be used as evidence in any subsequent proceedings. A typical task in this process is therefore to reconcile the accounting data extracted to reported financial statements so that investigators can be certain that they have a complete and accurate data set.

Components of an effective investigation

Every investigation is unique and the approach should be based on the circumstances of each case; there is no one size fits all investigation plan. There are several investigation processes that apply to most larger, cross-border investigations, although the steps to be taken will need to be considered in the particular circumstances of each case. We identify below some areas that may contribute to an effective investigation.

Electronic document review

Electronic document review and email review, in particular, can be an important part of an investigation into potential accounting irregularities. It is through a review of contemporaneous communication that the knowledge and intent of those involved is often demonstrated. Without it, establishing that those involved knew their actions violated company policy or accounting rules may be difficult. Traditionally, the focus of this will be on e-mails, but increasingly other forms of recorded communication such as instant messaging, bulletin boards and mobile phone text messages are becoming increasingly important and should be factored into the review plan.

Staff interviews

Interviews are a key component of many accounting investigations. They are important in ascertaining the facts, understanding the drivers of potential wrongdoing, and determining the culpability and intent of those involved and potential remediation steps. Typically, an interview in an investigation into alleged accounting irregularities would include a forensic accountant who understands the detailed accounting issues. The timing of the interviews will depend on the circumstances of the case and whether or not staff members are suspected of wrongdoing. Often, a plan may involve interviewing key staff at the outset of the investigation where possible to encourage them to provide as much information as possible. Staff members are then interviewed again when evidence has been reviewed and can be used to assist in understanding the conduct of those involved.

Accounts testing

Another important investigation can be testing of the company’s accounting data to ascertain the extent of problems identified, and any further problems that may not have been identified. The extent to which this is required will depend on the nature of the issue in question. If it is a case of aggressive revenue recognition the need for a detailed review of accounts payable process, for example, may not be required. However, possible manipulation in one area may raise concern and warrant a review of reporting in other areas.

Having the right experience and skills is an important part of an effective accounts testing programme where accounting irregularities are identified. If, for example, the issue in question is related to an alleged hiding of trading losses, investigators may need to understand the nature and appropriate accounting for the underlying trading transactions (eg, foreign exchange or interest rate derivative products) and the balance sheet and profit and loss accounts that would be expected to be involved.

A joined-up approach

It can be helpful for those overseeing and devising the accounts testing steps to have also been involved in other aspects of the investigation. Developing an understanding of the issues emerging from staff interviews and document review can be very useful in designing effective testing steps that will identify suspicious items included in the accounts and enable an assessment of the extent of the problems. In order to maximise its effectiveness, testing should include steps targeted to the specific emerging issues. Having detailed knowledge of the issues emerging from interviews and the document review facilitates this. In recent years, the advent of software and other sophisticated tools that may be used to analyse accounting data has helped to enhance the data gathering process. However, it may not always be possible for a standardised tool to target the issues in question for a particular investigation as each case may require new ways of thinking.

The importance of a joined-up approach and the ability to build investigative knowledge into testing processes can be particularly important in large, cross-border investigations involving companies in which transaction volumes are significant.

The volume of business of a company that is the subject of investigation may present a significant challenge to the accounts testing process. General ledgers may contain thousands of individual accounts any number of which could contain potentially irregular accounting entries making establishing a starting population for testing difficult.

Similarly, general ledgers may contain many millions of entries and an investigation may require the analysis of several years of such data for several subsidiaries and countries. Investigators should think critically to target higher risk transactions to make the volume manageable. For example, improper entries are often processed by manual journal entries rather than routine automated postings and testing may focus on these to cut down on the data.

In addition, a tailored testing programme may help to identify potentially suspicious transactions based on knowledge of the issues emerging from the investigation. Developing the focused testing steps could help to pinpoint at risk accounting entries that may require further review. Having identified at risk entries, supporting documentation for each entry may be reviewed with findings verified with accounting staff. By structuring tests to identify high-risk accounting entries, a company may be able to identify other accounting issues across their operations. The implementation of such a targeted testing programme can also help to inform any required restatement process and limit further uncertainty regarding its financials.

A successful accounting irregularities investigation should address a variety of difficult questions. Often where large public companies are concerned, a public announcement may be required that irregularities have been identified and are being investigated. The share price of companies may be sensitive to such matters because they may create uncertainty in the numbers that are reported, which can impact the company’s value. Time is therefore of the essence, but the dangers of rushing an investigation and having to subsequently readjust results because not all issues had been addressed may come at a greater cost. Completing an investigation and accounts restatement in a timely fashion may help to restore investor confidence and reduce potential adverse impact on the company’s share price.

Conclusion

There are significant challenges to getting an accounting investigation right. For the company in question, the stakes may be high and a thorough and efficient investigation can play a key role in restoring credibility to the company’s financial results

Notes

  1. ‘SEC Gets Busy With Accounting Investigations’, Wall Street Journal, 20 January 2015.
  2. US companies still apply US GAAP based on accounting standards issued by the Financial Accounting Standards Board, but there is a conversion programme in place to converge IFRS with US GAAP.

Previous Chapter:Cross-border overview: data privacy and transfer

Next Chapter:Cross-border overview: sanctions enforcement