Title
Slide
Detecting Corporate Fraud
Roddy Boyd, founder
Southern Investigative Reporting
Foundation
Sam Antar, Convicted Felon
Former Crazy Eddie CFO and CPA
IRE Conference June 25, 2014

Title
Slide
Roddy Boyd
Southern Investigative Reporting Foundation
Twitter: @BoydRoddy
Phone 917-514-3897

Title
Slide
Convicted felon, former CPA, and former
CFO of Crazy Eddie. Teaches law
enforcement, professional organizations,
businesses, and colleges and universities
about white-collar crime and how to catch
the crooks. Assists law firms on fraud
cases.
Sam Antar
Twitter: @samantar
Email: sam@whitecollarfraud.com

Title
SlideAnswer: Management’s Intentional
Misrepresentation of Financial Statements
For The Purpose Of Obtaining An Internal
Objective
Question: What is Corporate
Financial Fraud?

Title
Slide“It Pays To Do it, It’s Easy To Do and It’s
Unlikely They Will Be Caught.”
Source: Howard Schilit, Financial Shenanigans, 2002
Why Do Companies Lie To
Investors?

Title
Slide100% of All Financial Crime Violates This Precept
Common Sense: The First
Rule of Financial Fraud
Detection

Title
Slide—Merrill & Law of Large Numbers: http://tinyurl.com/mmt4snz
—AOL’s Miracle Growth: http://tinyurl.com/kd78vjg
—Brookfield’s “Paper”$: http://tinyurl.com/m5vd5kz
Common Sense “Cheats”

8
Caveat reporter
• No one red flag always indicates fraud.
• Not every example that raises eyebrows
amounts to fraud.
• Michelle Leder’s “mosaic”
principle.
• Talk to the company.
Image: Rutger van Waveren, http://flic.kr/p/bfBSC

Who’s Who: What to look for
Check it out
•Education, especially:
• Specialized degrees/expertise
• Attendance vs. degree
• Diploma mills & dubious online
schools
•Litigation
• Corporate
• Personal
• Professional
Photo by Flickr user un.sospiro

19
Who’s Who: What to look for
Don’t forget the help
•Lawyers
•PR firms
•Consultants
•Exceptions?
• Crisis PR firms
• Defense lawyers
• etc.
Scenario: Ditching the troubled founder
•Really?
•Relatives & associates
•LLCs
The blame game
Pinning operational problems on others
•Short-sellers
•The media (that’s us)
•Regulators

Who’s Who: Next steps
Who to background
•Executives
•Directors
•Major investors
•Lawyers
•PR people
•Consultants (especially in technical industries)
•LLCs & similar entities
•Reynolds Center on backgrounding people & businesses:
http://bit.ly/1js5XOJ

Ties that bind:
Related party transactions
Photo by Flickr user Simon James

Ties: What to look for
• Commodity transactions
• Why is the insider the best choice?
• Confusion, dead-ends, obfuscation
• Layers of LLCs or other private companies
• Especially if they tie back to the same
people
• Especially if those people are executives,
directors or big investors
Exceptions?
• Private-equity investors
• Founders & founding families

Ties: What to look for
Less worrisome (maybe):
•“The father of Mr. Dimon has been employed by the Firm as a
broker since 2009, and for 2012 received compensation of
$1,599,616, including annual salary, commissions, and an equity
award.” — JPMorgan Chase proxy (2013)
•Previously a broker for Bank of America
Still…
•That’s up from $447,000 in 2011.

Eliyahu “Eli” Weinstein
Sentenced to 22 Years in Prison for $200 Million Ponzi Scheme
“He also realized, authorities say, that pouring some of the money he swindled
back into local charities and religious organizations would help him maintain his
community standing and possibly help him secure future deals.”
Source: Jason Grant, The Star-Ledger, February 25, 2014

Ties that bind: Next steps
• Location, location, location
• Google
• State corporation filings
• Secretary of state, state
incorporation office, etc.
• Legal databases
• Court documents
Photo by Flickr user Daniel Moyle

Ties that bind: “Certain
Relationships”Exercise
• Nanoviricides http://tinyurl.com/lcwtg2s
• DHB Industries http://tinyurl.com/mbr73wc

Who’s Who: Buried treasure
“In December 2008, the Company purchased an extensive
collection of historical maps of the American Southwest from
[Chairman & CEO] McClendon for $12.1 million, which
represented his cost. A dealer who had assisted Mr. McClendon
in acquiring this collection over a period of six years advised the
Company that the replacement value of the collection in
December 2008 exceeded the purchase price by more than $8
million. The maps have been displayed at the Company’s
Oklahoma City headquarters for a number of years, during which
the Company has been insuring the maps in exchange for their
display. ... Our employees and visitors appreciate the maps …
The Company was interested in continuing to have use of the
map collection and believed it was not appropriate to continue to
rely on cost-free loans of artwork …” — 2009 proxy

• Background MicroStrategy CEO Michael Saylor
• Open proxy & calculate value of holdings
• Look at compensation structure
• Run keyword search: “aircraft,” “tax”
• “Insta-Enterprise”: http://tinyurl.com/olmo7qm

9
Get a grip: The 10s
Primary financial and operational disclosures for established
public companies. http://tinyurl.com/4px4l
10-K
•Annual
•Audited
•Comprehensive
10-Q
•Quarterly (3x a year)
•Unaudited
•More incremental
Image: Heather, http://flic.kr/p/9rpM2p

10
Get a grip: What to look for
• Frequent reshuffling
• Strategies
• Core products & services
• Restructuring
• Poor acknowledgement of costs or risks
• Repeated stock issuance (dilution)
• Unexplained & poorly explained capital raises

11
Get a grip: What’s core?
Everyone knows General Electric
•Power turbines
•Jet engines
•Medical imaging
•Dishwashers
•Subprime debt?!
(http://tinyurl.com/opgcn3b)
•Today: $46B = 31%

12
Get a grip: Go Wayback
InternetArchive.org
•(Almost) Nothing on the Internet ever dies
•Why no cure for AIDS & the common cold?
• http://tinyurl.com/mevqfww

13
Measuring up: The filings
10-K
•Audited
•More comprehensive
•More history
10-Q
•Unaudited
•Narrower in focus
•Less history
Earnings release
•Heavy on the PR
•Compare to 10-K or 10-Q
S-1
•New companies
Other options
•Google Finance
•Yahoo! Finance
•Etc.

14
Measuring up: Financials
The basics:
•Income statement
• Profit & loss
• Revenue (sales)
• Net income (earnings)
•Balance sheet
• Assets & liabilities
•Cash-flow
• Circulatory system
Other resources:
•Reynolds Center 10-Q financial basics: http://bit.ly/1jskFFp
•Mark Tatge’s “Funny Money: How companies play games with numbers”:
http://slidesha.re/1jsjG8c

Measuring up: Receivables
Accounts receivable
Money owed to the company, generally by customers
•Big swings
• in dollar terms
• as a percent of revenue
•Collectibility
•Concentration of risk
• Risk factors
•Footnotes
• Rising A/R should mean rising delinquencies, amounts
past due for 90+ days
• Or company may be hiding uncollectible sales
• Overstatement of revenues

Measuring up: Inventories
Inventory:
Raw materials, work-in-process goods and completely finished goods
held for sale
•Big swings
• in dollar terms
• as a percent of cost of goods sold
•Risk of write-down in valuation due to obsolescence
•Footnotes
• Rising inventories could mean increased risk of unsaleable
goods and eventual write-down or inflation of inventory to
overstate profits

Measuring up: Payables
Accounts payable
Money the company owes, generally to
suppliers
•Profitable company with rapidly increasing
A/P
• Implies the company may not be
paying its bills
• The opposite can imply that a
company is understating liabilities
Photo by Flickr user 401(k) 2012

Measuring up: Arthrocare
• ArthroCare Spine segment revenues (Sept. 30 quarter)
• to $11.4 million from $5.9 million
• to 15.1% of sales from 9.4%
• Extremely competitive market for spinal devices
• Competitors are bigger and well funded
• Johnson & Johnson, Stryker
• Kickback allegations
• Channel stuffing
• Disclosure

Measuring up: Arthrocare
• Accused of “parking” millions of dollars in merchandise with
distributors
• to meet/beat forecasts
• booked $37 million in sales to one distributor
• but only $50,000 in net sales
History:
• Investors raised questions.
• Arthrocare bought the distributor.
• Over time, $400 million in stock losses
• Two former SVPs pleaded guilty to conspiracy to commit
securities and wire fraud in 2013.
• Executives convicted, await sentencing.

Channel Stuffing
“A deceptive business practice used by a company to inflate its
sales and earnings figures by deliberately sending retailers along
its distribution channel more products than they are able to sell to
the public.” (Source: Investopedia)
Channel stuffing provides an immediate boost to revenues and
earnings. However, it results in a revenue shortfall in the following
period. To maintain the scheme, companies need to increase the
amount of channel stuffing by growing amounts growing amounts in
subsequent periods.

How to you detect channel
stuffing?
The SEC has recognized that, “a growing
DSO figure is often a telltale sign that a
company’s receivables are impaired due to
channel stuffing.” (Source: SEC v Korkuc)

Accounts receivable: If a company is taking longer periods of time to
collect on accounts receivable, it is a red flag for a possible revenue
overstatement
How long does it take a company to collect payments on accounts
receivable?
Days- Sales -Outstanding (DSO):
End of Quarter or Avg. Accounts Receivable X Number of Days in Period
Sales During Period

What is DSO?
Days- Sales-Outstanding (DSO). It measures how long it takes a
company to collect on accounts receivable:
Accounts Receivable X Number of Days in Period
Sales During Period
Note: Can use end of period accounts receivable or average of
beginning and ending accounts receivable

Why a rising DSO is a red flag?
As a company pushes more
unnecessary inventory into the
distribution channels, it becomes
harder and harder to collect revenue,
both because the company is forced
to offer increasingly generous credit
and collection terms to customers to
induce excess sales and because
distributors are themselves unable to
sell to end-customers, limiting their
ability to pay.

Example:
“By allowing distributors to delay payment or
not pay their invoices in full, McAfee
accumulated on its balance sheet millions of
dollars of aging receivables. Consequently,
“days sales outstanding” (“DSO”) – the
average number of days that it takes a
company to collect its accounts receivable –
was directly affected.” – (Source: SEC v
McAfee)

Measuring up: Orthofix International N.V.
•Founded in 1980
•Operationally based in Lewisville, Texas
•Global medical device company with six offices
worldwide and an international distribution presence.
•Publicly traded on the NASDAQ exchange (stock
ticker “OFIX”)
•June 2012: Pleaded guilty to obstructing a federal
audit after it failed to disclose that it routinely falsified
Certificates of Medical Necessity
•July 2012: Agreed to a deferred prosecution
agreement regarding violations of Foreign Corrupt
Practices Act by Mexican subsidiary

SEC Filings Reveal Red Flags - Rising DSO
Quarter
Ended:
Net DSO
Quarter
Ended:
Net DSO
Quarter
Ended:
Net
DSO
Quarter Ended: Net DSO
03/31/13 120.5
12/31/12 122.4 09/30/12 124.0 06/30/12 114.1 03/31/12 99.8
12/31/11 88.2 09/30/11 89.6 06/30/11 88.5 03/31/11 87.8
12/31/10 85.2 09/30/10 87.2 06/30/10 82.7 03/31/10 88.4

“… certain revenues recognized during 2011 and 2012,
upon further evaluation, should not have been recognized
or should not have been recognized during the periods in
which they were recognized.” – (Source: 8-K, 08/06/13)
“The Company has received requests from the SEC
Enforcement Staff for documents and other information
concerning various accounting practices, internal controls
and business practices. Such requests cover the years
ended December 31, 2011 and 2012, and in some
instances, prior periods.” – (Source: 10-K report for 2013)

Measuring up: Inventories
Inventories: If a company is taking longer periods of sell
(turnover its inventory) it is a red flag for possible inventory
inflation or future write-downs due to obsolescence
How long does it take a company turnover its inventory?
Days-Sales-Inventory (DSI):
Average Inventory X Number of Days in Period
Cost of Sales During Period
Note: Average inventory is total of beginning and ending balances divided by 2

Crazy Eddie Inventory Fraud
Crazy Eddie inventory inflation: $3 million in 1985, $13 to $16 million in
1986, and $28.5 to $37 million in 1987
Source: Second set of books maintained by Sam E. Antar

Red Flags, But No One Listened
Then too, while we are at it, inventory
controls seem a wee bit casual, what
with the company not keeping records
based on product groups. The
company “believes” that television and
video products account for the largest
percentage of sales. Oh, by the way,
Crazy’s shopping around for a new
chief financial officer. (Source: Not-So-
Crazy Eddie: Hard-Sell Retailer Going
Public, by Gigi Mohan, Barron's
National Business and Financial Jun 4,
1984)

Red Flags, But No One Listened
And so it was that Mr. O'glove had never met, much less been charmed by, the fast-
talking chief of Crazy Eddie. In fall 1986, he noticed that for the fiscal half ended
Aug. 31, Crazy Eddie's sales had risen 41%, while inventories had mushroomed
147%. Previously, sales and inventories had generally moved in unison.
"It was obvious to me that the company was having big problems despite other
sanguine analyses on Wall Street," he said in a 1987 interview. Mr. O'glove is
generally credited with being the first to sense trouble at Crazy Eddie.
In hindsight, his suspicions seem almost naive. According to allegations in lawsuits
filed by shareholders and by current management, those bloated inventory figures in
fall 1986 were reflections of nothing less than a scheme to defraud Crazy Eddie and its
shareholders. (Source: Calculated Madness: The Rise and Fall of Crazy Eddie Antar,
by Gary Belsky and Phyllis Furman, Crain’s New York Business, June 5, 1989)

Finding fraud: Compare the footnotes
Crazy Eddie changed one word in footnotes to overstate income by $20 million
Annual Report Fiscal year 1986:
"Purchase discounts and trade allowances are recognized when received."
Discounts and trade allowances were not recognized until a credit memo was received from a
vendor even if the discount was earned.
Annual Report Fiscal year 1987:
"Purchase discounts and trade allowances are recognized when earned."
Crazy Eddie immediately recognized discounts and trade allowances when earned.
Change in policy enabled Crazy Eddie to recognize discounts and trade allowances faster and
inflate income by booking $20 million in fictitious charges to vendors.

Finding fraud: Compare the numbers
Sharp drop in accounts payable to inventory ratio resulting from
phony discounts and trade allowances booked by Crazy Eddie

Measuring Up: Overstock.com
Always check what they say against what they disclose
BYRNE: We're profitable.
BUTTNER: Your real, honest-to-goodness profit, not pro
forma?
BYRNE: None of that stuff.
(Source: Your World with Neil Cavuto, December 11, 2001)

Overstock was never profitable
We have a history of losses and we may continue to incur operating and net
losses for the foreseeable future. We incurred net losses of $13.8 million in the
fiscal year ended December 31, 2001. As of December 31, 2001, our
accumulated deficit was $44.1 million. We will need to generate significant
revenues to achieve and maintain profitability, and we may not be able to do so.
Even if we do achieve profitability, we may not be able to sustain or increase
profitability on a quarterly or annual basis in the future. If our revenues grow
more slowly than we anticipate, or if our operating expenses exceed our
expectations, our financial results would be severely harmed.
Source: Overstock.com S-1 filed on March 5, 2002

Always check what they do against what they said
"…I think 'EBITDA' is the stupidest thing I ever heard
emanate from Wall Street (no small feat)....“
Source: Email to Tim Mullaney from Business Week,
January 10, 2006
From Q2 2007 to Q2 2008, started reporting EBITBA, but
used the wrong calculation (Source: Various 8-K, 10-Q, and
10-K reports filed with the SEC)

What is EBITDA?
The acronym EBITDA refers specifically to earnings before interest, tax,
depreciation and amortization. (Source: SEC Comment Letter to CGG
Veritas)
"Earnings" means net income as presented in the statement of operations
under GAAP. (Source: SEC Compliance and Disclosure Interpretations)
Overstock.com’s EBITDA calculation
Our measure of “EBITDA” is a non-GAAP financial measure. EBITDA, which
we reconcile to “Operating loss” in our income statement, is earnings before
interest, taxes, depreciation, amortization and stock-based compensation.
(Source: Various Overstock.com 10-Q and 10-K reports)

Result: Overstock.com inflated EBITDA

Always check what they disclose against the rules:
In Q4 2008, Overstock.com reported a $1.014 million net profit.
“After a tough three years, returning to GAAP profitability
is a relief.” ~ CEO Patrick Byrne (Source: Press release
01/30/09)
Earnings call after press release:
“This included a one-time gain of $1.8 million relating to
payments from partners who were under-billed earlier in the
year.” ~ CFO Steve Chesnut (Source: Transcript)

The rules
Under GAAP, we are required to use an accrual basis of
accounting.
Income is recognized when it is earned and not when it is later
billed or when amounts are collected.
The “one-time gain of $1.8 million relating to payments from
partners who were under-billed earlier in the year” was
earned before Q4 2008 and should have been recognized in prior
periods.
Since the accounting error is material under SAB No. 99,
Overstock.com is required to restate prior period financial reports
under SFAS No. 154 and cannot use a “one-time gain” to correct
its error. – (Source: White Collar Fraud, 02/04/09)

Measuring up: Form 4
Always read the explanations very carefully
On 12/21/11, Robert Pedersen, CEO ZAGG, sold 345,200 shares at an average
price of $7.5248 per share:
Explanation of Responses:
1. The shares were sold to meet an immediate financial obligation.
Question: What is an immediate financial obligation?
Source: Form 4 filed on 12/23/11

Stock Pledges are required to be disclosed in proxy reports
Item 403 -- Security Ownership of Certain Beneficial Owners and
Management
(b) (3), indicate, by footnote or otherwise, the amount of shares that are
pledged as security
Source: Securities Lawyer’s Deskbook

August 14, 2012, Robert Pedersen sold 515,500 shares at an average price of
$8.22 per share
Explanation of Responses:
1.The shares were sold to meet margin calls on the Reporting Person's
account.
Source: Form 4 filed 08/17/12
On August 17, 2012, Pedersen “resigned in order to focus on his family, his church
and a family foundation.”
Source: CEO of Utah’s ZAGG quits unexpectedly, Salt Lake Tribune 08/17/12

On August 28, 2012, Zagg held a conference call with investors and admitted:
…departure was entirely related to the margin calls situation that started last
December and unfortunately surfaced again two weeks ago.
Question: If Zagg knew about Pedersen’s stock pledges and margin calls in
December 2011, when didn’t the stock pledge in a proxy report filed on April 27,
2012?

SEC investigating ZAGG and Pedersen:
“In the fourth quarter of 2012, the Company received requests to provide documentation
and information to the staff of the SEC in connection with a non-public investigation
being conducted by the SEC’s Salt Lake City office. The Company believes the
investigation includes a review of the facts and circumstances surrounding some of the
same issues raised by the plaintiffs in the above lawsuits; specifically, whether the
Company failed to disclose Mr. Pedersen's margin account sales or the alleged
existence of a plan to have Mr. Hales succeed Mr. Pedersen as the Company’s CEO. The
Company responded to these requests and is cooperating fully with the staff. The
Company has chosen to disclose this non-public investigation due to the highly public
nature of the lawsuits described above, which the Company intends to defend vigorously.””
Source: Zagg 10-Q report for quarter ended 03/31/14

Measuring Up: Warranty Reserves
A warranty reserve as a liability account is set up to measure expected
warranty claims arising from current sales.
•Beginning Balance
•Provision for Warranty Expense (Increases the Reserve Account and
Reduces Current Period Income)
•Warranty Usage (Reduces Warranty Reserve Account and cash or
accounts receivable – no effect on income)
•Ending Balance
If a company “overestimates” its reserve in one period, it can create illusory
profits in a future period to “correct” the overstatement.

Green Mountain Coffee Q1 2012 10-Q Report

Green Mountain Coffee Q1 2013 10-Q Report

Red flags: Director departures
• Sudden resignations
• http://tinyurl.com/m9stmt7 and http://tinyurl.com/ld3yssk
• Detailed complaint letters
• Accounting problems
• Regulatory inquiries
• Board cliques
• Companies sometimes file
responses

Red flags: Auditor oddities
• Big company, small auditor
• Audit vs. consulting fees
• Sudden departures

Red flags: Next steps
• PCAOB (Public Company Accounting Oversight Board)
• http://pcaobus.org
• Audits the auditors
• Insight into an accounting firm’s quality
• Audit clients usually not named
• Always call departing directors
• Especially if there’s a letter
• Short interest
• If many investors are selling the shares short, why?
• Talk to investors, bullish and bearish.

Do audits really protect investors?
PCAOB Inspection Reports of “Big 4” accounting
firms for 2012
What they say:
• Ernst & Young: 51 audits inspected /deficiencies
(49%)
• Pricewaterhouse Coopers: 52 audits inspected/21
deficiencies (40%)
• KPMG: 48 audits inspected/17 deficiencies (35%)
• Deloitte & Touche: 51 audits inspected/13
deficiencies (25%)
Update: Deloitte & Touche: 51 audits inspected/15
deficiencies (25%) – 2013 Inspection Report

No Transparency
•The audit engagement partner’s name is not identified in audit reports.
The accounting firm signs the audit report.
•The CEO and CFO of a public company signs the financial reports.
•Neither the company in question nor audit engagement partner are
identified in PCAOB Inspection Reports.

Puda Coal
The issue, Judge Katherine B. Forrest of Federal District Court in Manhattan stated
in an opinion filed on Tuesday, was not whether the auditor could have done a
better job, but whether “a reasonable auditor would have” checked the records that
showed a fraud had been committed. “
Could more have been done? Clearly yes,” the judge wrote. “Did more need to be
done, and would auditors conducting a P.C.A.O.B.-compliant audit have done
more? Neither the court nor any reasonable juror at a trial has any way to answer
this question.” (Source: Auditor Moore Stephens Said Not at Fault; Puda Coal
Investor Suit Is Dismissed by Floyd Norris, New York Time, June 19, 2014)

Shabby Audits: Autonomy
History:
•October 2011: HP acquires Autonomy for $11.1 billion
•November 2012: HP announced a non-cash
impairment charge of $8.8 billion related to Autonomy
($5 billion linked to serious accounting improprieties)
HP investigation concluded:
•Autonomy made 80% less profits and 54% less
revenues than originally reported

Blind Reliance on 2 Audit Firms
The technology giant said that an internal investigation had revealed "serious
accounting improprieties" and "outright misrepresentations" in connection with
U.K. software maker Autonomy, which H-P acquired for $11.1 billion in October
2011.
"There appears to have been a willful sustained effort" to inflate Autonomy's
revenue and profitability, said Chief Executive Meg Whitman. "This was
designed to be hidden.“
Ms. Whitman said Tuesday the company relied on Autonomy's regular
auditor Deloitte and had hired KPMG for an additional review before the
deal closed. (Source: H-P Says It Was Duped, Takes $8.8 Billion Charge, by
Ben Worthen, Wall Street Journal, 11/20/12)

How is most fraud discovered?
Source: Association of Certified Fraud Examiners, Report to the Nations

Who are the Whistleblowers?
XXX’s:
1. Ex-lovers: Divorced spouses, former girlfriends and boyfriends.
2. Ex-business associates: Former customers and vendors
3. Ex-employees: Fired employees, laid off employees, and
employees who quit working for the entity.
Beware: Most whistleblowers are not motivated by altruism. They
have axes to grind. They come forward because of their personal
agendas.

Beware: Most White-Collar Criminal Are Invisible
Source: Association of Certified Fraud Examiners, Report to the Nations 2012

Slump in FBI White Collar Crime Prosecutions
Source:
Transactional Records
Access Clearinghouse
(TRAC)

Income Statement Fraud
Falsifying/Misrepresenting Sales or Expenses
• Booking Fake Sales
• Delaying, Not Reporting Expenses
• Paper Gains (“Level III”)

The Most Creative Dumbasses
In The Room
Enron’s 1996 Revenues: $13.2 Billion
Enron’s 1999 Revenues: $40.1 Billion
Enron’s 2000 Revenues: $101 Billion

Worldcom: Buying your way into jail
Multiple Acquisitions Hide No Organic Growth
Free Cash Flow Tells Real Story
Source: Financial Shenanigans, Howard Schilit

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