QUESTIONMar 02, 2019In your Fraud Examination Casebook with Documents textbook, read Case 1: Fraudulent Financial Statements (pp. 5-19). Perform Exercise 1 – Fraudulent Financial Statements (Larsen Co

1-1 LARSEN CONVENIENCE STORE: USING ANALYTICAL PROCEDURES IN DETECTING FINANCIAL STATEMENT FRAUD

Learning Objective

After completing and discussing this case, you should be able to:

Review and analyze financial statement information relating to a company's balance sheet and income statement accounts using horizontal and vertical analysis method.

Identify potential fraudulent financial accounts for closer scrutiny.

Understand one method used to estimate the loss from the destruction of the out‐of‐sight (destroyed) inventory (cost of goods sold as a percent of gross receipts).

Be able to use one ratio (days sales of inventory) to detect potentially misstated inventory balances.

HISTORY BEHIND THE FRAUD CASE:

In one of the author's fraud cases, an incendiary device destroyed a franchised grocery store at 3:00 a.m. on December 31. The Special Agent in Charge (SAC) of the investigation wanted the case agent to close the case because the store experienced its best year ever. Why would the owner destroy a profitable business? At the time the request was made, two cause‐and‐origin teams concluded that the torches poured over 30 gallons of gasoline that caused a massive explosion, which blew the front windows several hundred feet into the parking lot, warped huge girders, and propelled a concrete wall into the street almost killing a motorist. The case agent pleaded with the author to give the financial information a second look to avoid closing the criminal investigation.

A quick horizontal and vertical analysis of gross receipts, beginning and ending inventory, cost of goods sold, and gross receipts highlighted a potential material misstatement with the ending inventory. Ending inventory was over $300,000 higher and gross and net profits were substantially higher than in the prior three years. Telephone calls to the primary vendors revealed that the owner was delinquent and they had forced him to sign promissory notes and pay for all future shipments cash‐on‐delivery (COD). Agent interviews documented that the shelves were almost bare at the time of the fire.

A physical inventory taken at night 90 days before the fire was unusual. Instead of being taken during the day by professional inventory takers, it was allegedly taken by the owner and his tax accountant (a felon) late at night on a weekend. A handwriting analysis of the physical inventory tapes indicated that the tapes were not made by the owner or tax accountant. Thinking that the handwriting was that of the head teller, the case agent and author interviewed her. When confronted, she cried and then admitted to making up the ending inventory after the fire (and not 90 days before the fire) in the tax accountant's office a week after the fire. The fraud examination of the bank checking account and loan records revealed over 600 insufficient funds charges involving the owner and tax accountant and a bank loan made before the fire to help stop a constant overdraft of the owner's checking account. It also detected check kiting between the owner and tax accountant. A painstaking roll‐forward of the inventory from the prior accounting period and benchmarks confirmed the material overstatement. The author testified as an expert witness for four days.

The jury convicted both the owner and tax accountant. The judge sentenced both to ten years; however, both were paroled after three years. Because the owner did not pay the $1 million in restitution that started on the day he was released, a probation revocation hearing was held. During his incarceration, the owner's wife and daughter liquidated and spent his assets. The judge sent the owner back to prison for the remainder of his sentence.

Introduction

Analytical procedures are powerful forensic accounting tools in conducting a fraud examination. When financial statements (balance sheet, income statement, and statement of changes) are available in whole or in part, analytical procedures can be useful as a starting point in a Fraud Examination. In an ideal world, the fraud examiner has a full set of financial statements (audited statements, reviewed statements, or compiled statements that are neither audited nor reviewed). In some cases, the fraud examiner has to work with only partial financial statements, for example, income statements (e.g., IRS Schedules C, proprietorship income tax returns) or balance sheets (e.g., personal financial statements given to a financial institution).

Analysis of these documents can provide leads and/or corroborative evidence that support other types of evidence (e.g., interviews and supporting financial documentation).

This case teaches the use of horizontal and vertical analysis of an income statement and personal financial statement. It also teaches the calculation of selected financial ratios to augment the horizontal and vertical analysis. In addition, it teaches one method for estimating out‐of‐sight inventories (e.g., inventories destroyed by fire, flood, or other catastrophe) using the cost of goods sold to gross revenues method. For extra credit (25 points), you may research and roll‐forward the October 31, 2016, physical inventory to the date of destruction; adding purchases (which are at cost) and subtracting sales (which must be reduced from retail price at cost).

Normally, income statements prepared for tax purposes and personal financial statements are prepared separately and at different times of year and cannot be used together. In some cases, you can use both. Therefore, when conducting a fraud examination, you need to step back and determine what financial documents can be connected.

From experience with arson‐for‐profit cases, many proprietorship arsons take place at or near the end of the year. According to IRS regulations, ending inventory should be at or near yearend. Financial institutions often require its commercial loan customers to provide them with Small Business Administration (SBA) (or similar) personal financial statements at the beginning of the year. Since both documents are prepared around the same time, you may be able to use one (IRS Schedule C) as an income statement and the other personal financial statement) as the related balance sheet for ratio purposes. Note: Bank personal financial statements may not be a true balance sheet—the personal financial statement when a proprietorship is involved often includes both personal and business assets and liabilities as well as personal sources of income (e.g., a spouse's salary). Accordingly, you may have to separate the personal and business assets and liabilities, as you will do in this case.

Net profit and loss and assets and liabilities may not be accurate. Through the following analyses, you will detect material abnormal balances from the facts of the case as well as by vouching1 the totals listed on the statements back to original accounting documents (e.g., vendor bills, invoices, and summary statements, bank/mortgage loan statements, etc.) and determine what additional fraud examination steps, if any, should be taken.

Background

Three months before Tonya Larsen walked out of Anderson Internal Medicine, a suspicious incendiary fire took place at her husband's convenience store in Canton, Georgia. As with most casualty claims, the examination of the claim takes months to complete as the company files a proof of loss and provides requested documentation, fraud examiners prepare business interruption calculations, and the attorney prepares for and then takes the insured's examination under oath (EUO). Under the standard insurance contract, the insured (Greg Larsen) must (1) provide requested financial documents and (2) submit to a EUO by an attorney hired by the insurance company. If the insured does not, he/she will not be paid for their loss.

The fire started at Larsen Convenience Store in Canton, Georgia, around midnight on December 31, 2015, and completely burned all of the structure and contents to the ground. Agents from the State Fire Marshal's office and independent cause and origin experts hired by the insurance company conducted a cause and origin investigation of the fire scene and determined that the fire was incendiary (i.e., intentionally set as opposed to being caused by natural, mechanical, or electrical causes). The deputy fire marshals and experts found four sources of ignition. Georgia Bureau of Investigation chemists analyzed carpet and wood samples identified by arson dogs at the fire scene and found the samples to contain hydrocarbons in the same category as gasoline. Insurance company special agents also asked Greg Larsen the following questions:

Who discovered the fire?

How was he notified of the fire?

Who was the last person in the building?

Who has keys to the building?

Did he notice any unusual activity before the fire?

Is he the owner or the tenant?

What is the location of flammables, utilities, etc.?

Did he know of any fire hazards and flammable liquid storage?

How were the business and his personal finances at the time of the fire?

Among his answers, Greg Larsen said that he (his business) had just completed its best year ever, sales and net profits were significantly higher than prior years. Larsen also stated that he rented the building from J. L. Jensen LLC for $1,000 a month and had 24 months left on his lease. Larsen told the agents that surely a pyromaniac or someone with a grudge lit the fire.

Because the cause was an incendiary fire, Southern Appalachian Insurance assigned the follow‐up civil investigation to its Special Investigative Unit (SIU) and expanded the services of Alexander Z. Boone to include the casualty loss claim. On March 18, 2016, Greg Larsen filed the proof of loss with Southern Appalachian Insurance for the loss of his inventory, shelving, and leasehold improvements and business interruption (lost net profits and continuing expenses). As requested by the attorney, Greg Larsen also provided financial records, including the 2013, 2014, and 2015 federal income tax returns and January 7, 2014, 2015, and 2016 SBA personal financial statements filed with Sharptop Bank, and a physical inventory he took on October 31, 2015. The 2015 federal income tax return shows that Greg Larsen had his best year ever, having net income totaling $130,458. With such a great net income, Attorney Boone thought that Greg Larsen had no financial motive to burn his store.

Thus far, the SIU special agents found:

Greg Larsen primary suppliers, Georgia‐Tennessee Fuel Partners, Shamrock Groceries, Discount Tobacco Supply, Marietta Beverage Company, and Jenkins Media Services had required Greg Larsen in early November 2015 to sign promissory notes for their respective unpaid balances. Instead of cutting him off, each made future deliveries subject to cash on delivery. The special agents had Greg Larsen sign an Authorization to Release Financial Records and obtained records from the vendors and Georgia Department of Revenue.

Regular customers of Larsen Convenience stated that in the days leading up to the fire, Larsen did not carry their brand of beer, snacks, and tobacco. In fact, the beer and tobacco inventory looked low (i.e., half the tobacco bins behind the counter were empty).

Larsen had a sale on paper towels, which sat on a pallet in the center of the store.

Several years ago, Greg Larsen had a heated argument with his nephew, an employee of the store, in the parking lot. Greg Larsen jumped into his truck, backed it up in anger, and accidently ran over and killed his nephew. His sister and brother‐in‐law sued him in state court for wrongful death and won a $500,000 judgment. The state court judge handed down his decision in mid‐October 2013. The appellate court affirmed the lower court decision in September 2014, and the Georgia Supreme Court denied certiorari in May 2015. The denial of certiorari had the direct effect of upholding the appellate court's decision and making the $500,000 judgment a collectible debt. In July 2015, Southern Appalachian Insurance paid his sister and brother‐in‐law $75,000, the limit of the business liability insurance policy. In September 2015, his sister and brother‐in‐law obtained a court order and subsequently seized the funds in his business bank account and put a lien on his business assets.

Greg and Tonya Larsen were in arrears on their mortgage at the end of December and potentially facing foreclosure unless they came up with several thousand dollars.

Summary Requirements

Your role in the examination of the Greg Larsen has been expanded by Alexander Z. Boone to perform the following under attorney‐client privilege:

A financial condition (solvency) analysis of Greg Larsen's business (Larsen Convenience Store) at the time of the fire

Review the claimed casualty loss and determine the estimated inventory loss on the fire date

Before proceeding, read the documents in Chapter 7, section 7‐1, “Larsen Convenience Store.” As you work the case, you will have to read and reread the documents to fully understand the evidence.

Study section 1-2 on How to Perform a Vertical and Horizontal Analysis that follows this case before conducting the specific requirements relating to this analysis.

The results of your assignment will be used by the attorney during the EUO. Your assignment (in general) is, as follows:

Perform a financial condition analysis of Larsen Convenience as of the fire date, using the tax returns, SBA personal financial statements, October 31, 2015, physical inventory, and all information at your disposal. Among other procedures,

Perform two separate vertical and horizontal analyses of the 2013–2015 Schedules C and January 7, 2014, 2015, and 2016 SBA personal financial statements. Highlight material differences.

Calculate the 2015 estimated ending inventory using the cost of goods sold/gross revenues method using the tax returns:

Calculate the average cost of each product line (e.g., beverages, groceries, tobacco) and associated average gross revenue (e.g., revenue groceries/food) for 2013 and 2014 by adding the totals for both years and dividing result by 2.

Divide the average cost of each product line by the average gross revenue.

Multiply the result by the associated 2015 gross revenue to derive the estimated 2015 cost of product line (e.g., cost of beverages, groceries, and tobacco).

Back into the estimated 2015 ending inventory by adding beginning inventory and purchases and then subtracting the estimated 2015 cost of product.

Recalculate the gross profit and net profit.

Repeat for each of the ending inventories that appear to be overstated.

Calculate the Days Sales of Inventory ratio for December 31, 2013, 2014, and 2015 for total, groceries, beverages, and tobacco sales.

Determine the types of alleged frauds perpetrated by Greg Larsen related to reporting the financial data for Larsen Convenience. DO NOT allege arson!

Prepare a report and associated schedules using the sample report and schedules.

Prepare audiovisuals (e.g., charts, summary schedules, and/or graphs of your choice) to simplify these complex accounting issues. Hint: Comparison of balance sheet and income statement assertions (e.g., inventory at the end of the years 2013, 2014, and 2015) make easy to understand audiovisuals.

The initial steps (see exercises) are to be completed individually. You may confer online on strategy, but do your own work. In particular, each student is to schedule and analyze the tax returns and SBA personal financial statements using Excel, calculate the days sales of inventory ratio, and submit their Excel working papers for grades. These steps will be performed as a series of graded exercises designed to walk you through the process.

The final exercise is a team project. Each team will submit a final examination report addressed to the attorney for Southern Appalachian Insurance, accompanying set of schedules, and audiovisuals for a grade. Each team is to select a team leader, who assigns various tasks to each member of the team, emails a list of each student's assignment, and emails the final deliverables. The team leader is responsible for quality control and should not take on any additional tasks.

Accuracy Certifications and Potential False Statements

When examining financial statements, be aware that most common financial documents have certifications as to the accuracy of the submitted information above or below the signature line. Whoever knowingly prepares and/or submits MATERIALLY untrue, inaccurate, incomplete, or misleading information can be prosecuted for making MATERIAL misstatements.

In this case, you will examine IRS Forms

1040, SBA Personal Financial Statements, and a Sworn Statement in

Proof of Loss. All three have accuracy certifications.

IRS Form 1040

Under penalties of perjury, I declare that I have examined this return and accompanying schedules and statements, and to the best of my knowledge and belief, they are true, correct, and complete. Declaration of preparer (other than taxpayers) is based on all information of which preparer has any knowledge.

Small Business Administration (SBA) Personal Financial Statement

CERTIFICATION: (to be completed by each person submitting the information requested on this form)

By signing this form, I certify under penalty of criminal prosecution that all information on this form and any additional supporting information submitted with this form is true and complete to the best of my knowledge. I understand that SBA or its participating Lenders or Certified Development Companies or Surety Companies will rely on this information when making decisions regarding an application for a loan or a surety bond. I further certify that I have read the attached statements required by law and executive order.

Sworn Statement in Proof of Loss

Any person who knowingly and with intent to injure, defraud or deceive any insurance company files a statement of claim containing any false, incomplete or misleading information is guilty of a felony of the third degree.

When Contacting Law Enforcement, Do Not Forget the IRS Criminal Investigation Division (CID)

When you have completed your fraud examination, your client, employer, or insurance may want to refer your findings to local law enforcement. Often, alleged fraud cases prosecuted at the local level result in probation and no prison due to overcrowding. Fraudsters are not violent criminals. IRS regulations require that ill‐gotten gains be reported on the fraudster's income tax return. However, when fraudsters steal money, they often do not report it on their income tax returns. If IRS CID takes the tax evasion case and it goes to trial, fraudsters often receive sentences of 44 to 48 months incarceration. In one fraud examination, the fraudster stole an average of $12,000 a month for three years. The local detective said he had never seen more than probation given. IRS CID took the case, and two years later the fraudster was convicted and sent to jail for 44 months.

1-2 HOW TO PERFORM A HORIZONTAL, VERTICAL, AND RATIO ANALYSIS

Learning Objective

After reading this synopsis, you should be able to:

Horizontally spread fraudulent data (e.g., from balance sheets, income statements, monthly inventory summaries).

Where applicable, add common‐sized ratios.

Identify horizontal and vertical anomalies (e.g., an account where the balance materially increased or decreased in comparison with prior periods) and/or trends (e.g., seasonality in the revenue account).

Estimate the actual amount of a material anomaly (e.g., ending inventory).

Introduction

Horizontal and vertical analysis is a tool to compare common financial information that is recorded monthly, quarterly, and/or annually. The more data points available (36 monthly versus three annual financial statements) the better the analysis of trends (e.g., seasonality, steadily increasing or decreasing revenues, steadily increasing or decreasing expenses) and abrupt changes (e.g., huge quarterly decreases in certain expenses like salaries and wages). By itself, or combined with ratio analysis between financial statements (e.g., days sales in inventory and days sales in receivables), the fraud examiner can use this tool to pinpoint accounts that require further examination (e.g., obtaining and examining documents and/or conducting interviews).

Below is a discussion of horizontal, vertical, and ratio analysis using only three annual income statements (IRS Schedules C, Profit or Loss for a Proprietorship). Similar analysis can be performed for 12 quarterly or 36 monthly unaudited financial statements (balance sheet, income statement, and statement of cash flow) as well as other financial information like comparative physical inventories.

Steps in Performing a Horizontal and Vertical Analysis

Performing a horizontal and vertical analysis on a spreadsheet is a multistep process.

STEP 1: Schedule the Data

Schedule the financial information. Below is an IRS Schedule C (Proprietorship Profit & Loss Statement) from an individual's tax return. You can schedule other sets of financial information like balance sheets, specific account totals by month, quarter, or year (e.g., customer accounts receivable totals, accounts payable totals, inventory totals, monthly purchases by type).

From Schedules C

2013

2014

2015

Gross receipts

$320,000

$350,000

$300,000

Beginning inventory

90,000

95,000

99,000

Purchases

250,000

275,000

235,000

Ending inventory

95,000

99,000

145,000

Cost of goods sold

$245,000

$271,000

$189,000

Gross profit

$75,000

$79,000

$111,000

Advertising

700

900

1,000

Car & truck expenses

6,000

Insurance

3,000

4,000

Interest—other

100

1,600

1,800

Legal & professional

750

15,000

Office

395

950

550

Rent

10,800

10,975

Repairs

900

1,200

1,655

Supplies

1,500

1,668

3,000

Taxes & licenses

1,800

1,200

1,500

Utilities

4,000

5,900

Wages

4,000

1,666

Total expenses

$33,945

$36,068

$53,046

Net profit/loss

$41,055

$42,932

$57,954

STEP 2: Add Common‐sized Ratios

Add common‐sized percentages (e.g., use gross receipts as the base for income statements, total assets as the base for balance sheets, total inventory for inventory summaries). Do not clutter the percent column with unneeded decimals (like 28.1% or 28.15%). Round up unless specificity is needed.

From Schedules C

2013

2014

2015

Gross receipts

$320,000

100%

$350,000

100%

$300,000

100%

Beginning inventory

90,000

28%

95,000

27%

99,000

33%

Purchases

250,000

78%

275,000

79%

235,000

78%

Ending inventory

95,000

30%

99,000

28%

145,000

48%

Cost of goods sold

$245,000

77%

$271,000

77%

$189,000

63%

Gross profit

$75,000

23%

$79,000

23%

$111,000

37%

Advertising

700

900

1,000

Car & truck expenses

6,000

Insurance

3,000

4,000

Interest—other

100

1,600

1,800

Legal & professional

750

15,000

Office

395

950

550

Rent

10,800

10,975

Repairs

900

1,200

1,655

Supplies

1,500

1,668

3,000

Taxes & licenses

1,800

1,200

1,500

Utilities

4,000

5,900

Wages

4,000

1,666

Total expenses

$33,945

11%

$36,068

10%

$53,046

18%

Net profit/loss

$41,055

13%

$42,932

12%

$57,954

19%

STEP 3: Analyze Dollars and Percentages Horizontally and Vertically

Analyze vertically and horizontally for anomalies in dollars and by percentages (e.g., trends up or down, abnormal common‐sized ratios, abrupt changes in account totals). In the following example, the 2015 ending inventory is significantly higher than the prior two years in both dollars and as a percent of gross receipts. Similarly, interest is up slightly, but legal and professional expenses increased significantly, while wages are materially lower.

From Schedules C

2013

2014

2015

Gross receipts

$320,000

100%

$350,000

100%

$300,000

100%

Beginning inventory

90,000

28%

95,000

27%

99,000

33%

Purchases

250,000

78%

275,000

79%

235,000

78%

Ending inventory

95,000

30%

99,000

28%

145,000

48%

Cost of goods sold

$245,000

77%

$271,000

77%

$189,000

63%

Gross profit

$75,000

23%

$79,000

23%

$111,000

37%

Advertising

700

900

1,000

Car & truck expenses

6,000

Insurance

3,000

4,000

Interest—other

100

1,600

1,800

Legal & professional

750

15,000

Office

395

950

550

Rent

10,800

10,975

Repairs

900

1,200

1,655

Supplies

1,500

1,668

3,000

Taxes & licenses

1,800

1,200

1,500

Utilities

4,000

5,900

Wages

4,000

1,666

Total expenses

$33,945

11%

$36,068

10%

$53,046

18%

Net profit/loss

$41,055

13%

$42,932

12%

$57,954

19%

STEP 4: (Optional) Estimate the Impact of the Anomaly

The previous analysis detects some material differences. In the example above, ending inventory is a material anomaly (45% of gross receipts versus 28–30% of gross receipts in prior years). This anomaly overstates assets on the balance sheet (ending inventory) and understates gross and net profit on the income statement. In such circumstances you may want to estimate the impact of the anomalies. One method for estimating the ending inventory is the cost of goods sold/gross receipts method, which is demonstrated as follows.

Using the Periodic Inventory Formula

NOTE: Below is an example of the periodic inventory method where the company takes a physical inventory. The physical inventory is subtracted from the goods available for sale.

Take a Physical Inventory

Example

Beginning inventory

$100,000

Plus: Purchases

300,000

Equals: Goods available for sale

400,000

Minus: Ending inventory (B/S)

(75,000)

Equals: Cost of goods sold (I/S)

$325,000

NOTE: The periodic inventory method is reversed when the company cannot take an ending inventory (e.g., inventory is destroyed). The example takes numbers for the comparative schedules above.

First, estimate the cost of goods sold by dividing the average cost of goods sold by the average gross receipts from prior periods (using the previous example).

2013

2014

Average

Cost of goods sold

$245,000

$271,000

$258,000

Gross receipts

$320,000

$350,000

$335,000

Percentage (CGS/Gross receipts)

77%

2015 Gross receipts

$300,000

2015 Estimated cost of goods sold

$231,000

Second, plug the estimated cost of goods sold into the formula to get the estimated ending inventory.

Inventory Destroyed

Example

Beginning inventory

$99,000

Plus: Purchases

235,000

Minus: Est. Cost of goods sold

(231,000)

Estimate using prior COGS/Gross Revenue

Equals: Est. Ending inventory

$103,000