How the experts expose financial statement fraud

Garreth Hanley:
This is INTHEBLACK, a leadership, strategy and business podcast, brought to you by CPA Australia. Welcome to INTHEBLACK, In this special ‘Crime by Numbers’ episode we’re talking about cooking the books. From Wirecard to HIH and Big Un, do you know the tell-tale signs of the fraud triangle? Here is Jackie Blondell and ‘Crime by Numbers’.

Jacqueline Blondell:
Financial statement fraud involves various degrees of ‘cooking the books’ – falsifying numbers with the deliberate aim to misrepresent a company’s financial position. Some of the most high-profile cases of financial misstatement in include US energy giant Enron, UK construction firm Carillion and Australian insurance giant HIH. One of the most elaborate recent examples of financial fraud is German payments processor Wirecard. The company collapsed into insolvency in June 2020, shortly after revealing that 1.9 billion euro in cash balances on trust accounts – about a quarter of its balance sheet – did not, in fact, exist. Dan McCrum is an investigative reporter from the Financial Times in London. His interest in corporate misbehaviour helped expose Wirecard. He remembers the pivotal moment he realised Wirecard was a “smoke and mirrors” organisation.

Dan McCrum:
“The one which sticks in my mind is when my colleague, Stefania, goes to the Philippines, and she finds where there's supposed to be an international payment processing company, but it's a fisherman's house where a couple of guys are giving a poodle a haircut and, in that moment, we thought to ourselves, ‘This is it. This is the smoking gun’.

Jacqueline Blondell:
The story of Wirecard unfolds like a classic Hollywood blockbuster. The company was founded in Munich in 1999 as an online payment processor. Its clients at the time were mainly pornography and gambling websites. Fast forward two decades later, Wirecard was reporting revenues of more than 2 billion euros. In 2018, the company joined the DAX blue-chip market index with a market capitalisation of more than 24 billion euros. This made it one of the 30 most valuable German companies listed on the Frankfurt Stock Exchange – up there with Volkswagen, Siemens and Deutsche Bank. At its peak, Wirecard employed more than 5,000 people in 26 countries, and was one the largest digital payment processing companies for major global financial players, including MasterCard and Visa. But something didn’t quite add up. Dan McCrum began looking into Wirecard following a tip off a few years prior to its 2018 debut on the DAX.

Dan McCrum:
The first time I heard the name ‘Wirecard’ was actually from an Australian hedge fund manager, John Hempton. We were chatting, and he knew the sort of thing I was interested in, so he says to me, ‘Hey, Dan. Would you be interested in some German gangsters?’ ‘Yeah, that sounds really interesting.’ When I took a look, he was talking about Wirecard, and it was this funny little company worth about 4 billion euros, and it did something to do with payments, moving money around from credit cards to businesses. It called itself the ‘European PayPal.’ “But when I read its annual report, it was full of gobbledygook. It didn't make sense, and it was really hard to get a grip on how its business actually worked and how it made its money. Then, a month or two later, this English hedge fund manager gets in touch as well. Complete coincidence – he's also taken a look at Wirecard – a guy called Leo Perry of Ennismore Capital. And he sits down and lays out in front of me this whole theory about how Wirecard is faking its profits, and it's hiding that fraud by buying up a whole load of businesses all across Asia and doing some funny accounting tricks with them.

Jacqueline Blondell:
These “funny accounting tricks” are more commonly known as financial misstatement. In fact, the specific type of fraud that brought down Wirecard was “round tripping”, which involves sending money on a bit of a journey. Here’s how Dan McCrum explains the concept.

Dan McCrum:
You send it out of the company, off to a friend who looks after it for a while, and then sends it back. And you can do this in and out, and in and out, and what's happening is the money is going on this journey, but there's no real business happening.

Jacqueline Blondell:
This is a journey that even the most experienced auditors can find hard to follow. Dan McCrum frames the process through this example: Say, $2 million is sent to a business in one country which then pays out an invoice for $2 million to an outside company.

Dan McCrum:
Then, that outside company becomes a customer in India, and it buys 2 million dollars of software from Wirecard over in India. So, if you're just looking at each transaction individually, it kinda looks legitimate, but in aggregate, nothing has really happened. They've just created some paperwork and moved money in and out, and that's a really simple fraud. You're creating costs in one place, and you're creating sales in another. What Wirecard was doing was finding rubbish businesses in Asia, and it would spend its fake cash on this business at fake valuations. So, there you go. You swap money the auditors will look for, for some assets on the balance sheet, and Wirecard's were stuffed full of intangible assets. What happened was, when you looked through the documents on the ground in Asia, local corporate filings in Singapore, press releases to do with the businesses published locally, the numbers there didn't match up with what Wirecard was saying back in Germany. Now, there's this American short seller called Marc Cohodes who has a phrase I love, which is, ‘There is never just one cockroach in the kitchen.’ So, what really stood out to me was the company is lying about what it is doing in Asia, and that was the starting point, but the thing is it wasn't completely clear-cut, because there were two theories about Wirecard.

Jacqueline Blondell:
One theory was fraud due to misstatement. The other was money laundering.

Dan McCrum:
You have this company, which is growing really quickly, genuinely by operating in grey areas and occasionally stepping over the line and processing illegal payments – so for things like online gambling, particularly in the United States after it was made illegal.

Jacqueline Blondell:
What ultimately drew the attention of Wirecard’s auditor was a 1.9 billion euro cash anomaly in the company’s 2019 financial statements. The funds couldn’t be located in any of Wirecard’s trust accounts and the auditor refused to provide its report on the company’s financial results. In June 2020, Wirecard was forced to admit that those 1.9 billion euros did not exist. Shortly after the admission, Wirecard became the first-ever DAX member to file for insolvency, owing close to 3.5 billion euros to creditors.

Jacqueline Blondell:
Accounting fraud is about much more than fudging a few numbers in financial reports. When large corporations such as Wirecard implode, they leave a trail of destruction. Behind the high-profile scandals, there are innocent employees who have lost their jobs. There are investors who have lost money. There’s the loss of public trust that ripples throughout the corporate sector, and a shadow can be cast on the accounting profession in general. Jeffrey Luckins FCPA, a director in audit and assurance services at Melbourne accounting firm William Buck, says fortunately, Wirecard-style fraud – at least on that scale – simply doesn’t happen that often.

Jeffrey Luckins:
My initial observation about financial reporting fraud is that it rarely happens, so that when an Enron or a WorldCom in the US, a Wirecard in Germany, or a Big Un in Australia comes along, it does strike you as a big surprise.

Jacqueline Blondell:
Big Un was a listed video play company that collapsed in 2018 after an investigation into its earnings, which later revealed elaborate and extensive accounting fraud. When large-scale fraud does happen, the logical question is, why? Forensic accountant Glen Unicomb CPA can shed some light on this. He worked as an investigator at Australian corporate regulator ASIC, and investigated some of the country’s most high-profile corporate collapses, including the $5.3 billion implosion of insurance giant HIH back in March 2001. His experience shows that the motivations behind cooking the books generally fall into two baskets: flat-out personal greed or a desperate attempt to keep up appearances.

Glen Unicomb:
I've lived and breathed the history of fraud in Australia. The characteristics of the frauds committed in the late '80s and early '90s was more what I'll call, crudely, as ‘fingers in the till’. It was basically straight-out fraud for personal benefit. Whereas in 2001, when HIH collapsed, the hallmarks of the fraud – or, when I say ‘fraud,’ the ‘misconduct’ – in that particular instance, was motivated by the window dressing of HIH’s accounts, basically to cover up its deteriorating financial position.

Jacqueline Blondell:
This ‘window dressing’ aimed to cover up reinsurance arrangements between HIH and global reinsurance group Hannover Re. The deals were accounted for as conventional reinsurance contracts, but were actually financial reinsurance contracts, and by accounting for them incorrectly, HIH could report a far greater operating profit for the 1999 financial year.

Glen Unicomb:
At the time when this arrangement was entered into, HIH had been suffering reputationally in the market, because there were rumours spreading that HIH was not achieving the results it had in prior years, and that its profits were on the decline. In fact, it was deteriorating into a loss situation. So, in actual fact, for the 30th of June 1999 accounts, HIH should have declared a loss of approximately 114 million dollars, which obviously would not have been a good look in the market and would significantly impact the share price. So this reinsurance arrangement was put into place, so that HIH could record an additional 92.8 million dollar profit, based on the timing between the payment of the premium to Hannover Re, and the transfer of claims off HIH's books. Because of the timing of the transfer of the claims, it enabled HIH to record an additional 92.8 million dollars in profits. Instead of recording a loss of 114 million, HIH recorded a loss of 21 million dollars.

Jacqueline Blondell:
To understand why people commit this kind of fraud, Glen Unicomb draws on a framework commonly used by auditors – the so-called “fraud triangle”. The first side of the triangle is opportunity.

Glen Unicomb:
A fraud will only occur where a person has the opportunity to commit the fraud. So, if you've got weak internal controls in your organisation, people who want to extract money out of the company will be able to see gaps in those controls and exploit them. Also, under this tag of ‘opportunity’ is the actual cultural compliance circumstances of the group of companies. If you have a compliance culture which is weak, where people draw to management's attention that there may be gaps in the control framework or that people are not following the protocols, and management chooses to ignore that for whatever reason, that will, again, give momentum for an opportunity to commit fraud.

Jacqueline Blondell:
Corporate culture certainly came into place at Wirecard. Dan McCrum says that, when an employee in Wirecard’s Singapore office uncovered some dodgy dealings within the company, he was promptly shown the door.

Dan McCrum:
A lawyer launched a whole internal investigation, and they found out, yeah, this is what's going on. There's a whole bunch of weird little frauds for 2 million dollars there, 2 million dollars here. Fake contracts, fake invoices. And what happened was, the lawyer did the right thing, reported this back to head office in Germany, ‘Guys, there's 2 million dollars about to go out the door, and doesn't seem there's any real reason for it.’ And what happened was, his whole investigation was squashed. Germany says, ‘It's all right. We'll take it from here.’ And the lawyer is the one who is forced out.

Jacqueline Blondell:
The lawyer’s name was Pav Gill and, according to Dan McCrum, firing him was the beginning of the end for Wirecard.

Dan McCrum:
They allowed him to stay till the end of the week. They didn't walk him out the door there and then. So, the next morning, he comes in with a hard drive and takes a copy of the entire internal investigation and all the documents, and he gets in touch with me. Well, actually, it was his mother who got in touch with me, this incredible character who... she was not going to let the company do that to her son. And so she gets in touch and says, ‘You need to talk to my son. Let him tell you what's happened.’ And when he finds out, he says, ‘Oh my God, mum. What have you done?’ But he does the right thing, he talks to me, and more importantly, he hands over this trove of documents.

Jacqueline Blondell:
So, opportunity is one side of the “fraud triangle”. The second side is motivation. Here’s Glen Unicomb again.

Glen Unicomb:
In my career, I've seen all sorts of situations. I've seen people commit fraud to pay for their mother or father's medical costs. I've seen people commit fraud because they have a gambling problem.

Jacqueline Blondell:
The third side of the fraud triangle is rationalisation.

Glen Unicomb:
Most people don't like to acknowledge that they've done something dishonest, or, if they have, they need to justify in their own mind why it had to happen. And I'm sure in HIH that would've loomed large, because HIH had been built from the ground up by Ray Williams. And I'm sure anything that would put the existence of something that he'd spent his whole life building under threat would be a very good incentive for him to rationalise the window dressing of the accounts.

Jacqueline Blondell:
Now, remember that poodle from the start of this episode? The one that was getting a haircut in a fisherman’s house in the Philippines? For Dan McCrum, that poodle was the ‘smoking gun’ – the final piece of evidence he needed to prove that all wasn’t as it seemed with Wirecard. McCrum and his colleague, Stefania Palma, had been investigating Wirecard’s international payment partners. One of them was based in Manila – and, when the investigators arrived at the address in question, they quickly discovered that they weren’t a payment partner at all. Poodles aside, there are many other tell-tale signs of accounting fraud. High on Glen Unicomb’s list of fraud red flags is the presence of a dominant CEO.

Glen Unicomb:
Often the power from the CEOs, apart from their personality, arose because they had substantial shareholding in the companies. That is one of the most powerful indicators – a dominant CEO. Sometimes it could be just as much a dominant chairman.

Jacqueline Blondell:
Another factor to watch is a recent change of CFO.

Glen Unicomb:
Corporate accountants, in my experience, seem to have a conscience, so when they see that the company is not travelling as well as it should, or as well as it's represented in the marketplace, they will get to a point where they will leave.

Jacqueline Blondell:
Jeffrey Luckins is another CPA adept at spotting corporate fraud. One of his favourite red flags to look out for is when cash flow from operations is much lower than operating income. Another is when rapidly growing revenue isn’t matched by a boost in cashflow. And then, there’s the vibe.

Jeffrey Luckins:
The vibe is so important, and you can't teach it necessarily. As an audit partner, I view culture, communications with the board and management and their implementation of accounting policies as the first line of consideration as to whether fraud or error may be a key concern for the engagement. You generally get a vibe with that, and you may, for instance, focus more time on issues like revenue recognition, capitalisation of expenses, the global and or complex group operations.

Jacqueline Blondell:
When the dodgy dealings at Wirecard were exposed, questions were raised about why they were not detected earlier. Luckins agrees that procedural and sceptical scrutiny has an important role to play in detecting fraud, but he says there is often an expectation gap when it comes to audit.

Jeffrey Luckins:
It's a worldwide problem, and it hurts the auditing profession, because every time that there's a high-profile company failure, stakeholders including shareholders, media, customers, unions and employees, politicians – they want to blame someone. And they ask, ‘How could the auditor have not realised that there was a going concern problem or a major fraud, mismanagement, things like that, given our privileged access to all the information of the company’. For instance, in the recent case of Wirecard and the missing 1.9 billion euros in cash, which was, according to the company, with banks in Singapore – which they themselves then deny having any relationships with Wirecard – you can understand why, prima facie, stakeholders are angry.

Jacqueline Blondell:
To help close the expectations gap and improve outcomes, diversity is key.

Jeffrey Luckins:
Audit business is really no different to any other business, in that having a dependence on key customers, on key suppliers, on key financiers, is never a good thing. So, I would strongly encourage audit firms in particular to have a really good selection of clients, around a number of different industries and for instance, with work that needs to be done at different times of the year. When you end up with that sort of a mix, then you don't become reliant on any one particular client. When you also have that greater vision of, we talk about protecting the ship – and protecting the ship means making sure that our audit firm is protected, that all of our people will continue to have jobs. That we'll be able to produce the work as we say we will, to be true to our own vision and principles, to have the sort of audit firm that we want to have, right. If you end up having clients which are disruptive to all of that, that is not worth it, that is very bad for your own vibe.

Jacqueline Blondell:
Paying attention to perceived or actual conflicts of interest is also important.

Jeffrey Luckins:
I am constantly astounded by how frequently people do not understand the importance of independence and potential conflicts of interest. Whether in business, government and politics, not-for-profit organisations and the like, we are consistently seeing bad decisions made to satisfy someone's conflict of interest, which is not declared, recognised and/or allowed to prevail.”

Jacqueline Blondell:
The fallout of Wirecard’s collapse in 2020 has been dramatic, including arrests, prosecutions and a full parliamentary inquiry. The scandal also resulted in the resignations of the head of Germany’s financial regulator and the country’s top accounting watchdog, the Financial Reporting Enforcement Panel. When Dan McCrum got the opportunity to interview Wirecard’s disgraced CEO, Markus Braun, in 2014, he asked him bluntly, “Are you a crook?”

Dan McCrum:
“I found his answer really fascinating, because he answered with a question, classic way liars lie – ‘Why would I do these things?’ “And he did another thing – he used social proof…But what always stays with me is his tone. Just very matter of fact about it, whereas I think most people, normally, if you ask them outright if they're a crook, well, they get a bit angry, and Markus just didn't.”

Garreth Hanley:
If you enjoyed this special ‘Crime by Numbers’ episode, subscribe to the INTEBLACK podcast, leave us a review and tell your colleagues and friends about us. To find out more about our other podcasts, check out the show notes for this episode. And we hope you can join us again next time for another episode of INTHEBLACK.