Brilliance v. Ethics – Which One Wins?

Originally published by ACFE Insights.

Smart people commit fraud every day. A recent case gives us a prime example.

A federal judge asked Donald Watkins, Sr. to step away from the jury box as Watkins, Sr. made an impassioned plea in his closing argument. Watkins, Sr. was in the personal space of front-row jurors, who were clearly agitated and restless as they leaned, twisted back and forth and from side to side to move away from the attorney. Watkins, Sr. was pointing his finger at the jurors and leaning directly into them.

In their March 2019 fraud trial, Donald Watkins, Sr. and Donald Watkins, Jr. were both convicted of defrauding investors of more than $10 million. An FBI agent described both as “financial predators who truly represent pure greed.”

Condoleezza Rice, the Rev. Martin Luther King III and former Birmingham mayor Richard Arrington, Jr. testified for the prosecution at the trial. Former NBA star Charles Barkley also testified, as he is a former friend of Watkins. In over a decade, Barkley invested more than $6.1 million and “never got a dime back.” Other professional athletes also invested with Watkins and have not been repaid. According to prosecutors the investors were given “materially false and fraudulent pretenses, representations, and promises.”

The guilty verdict was delivered in the same Birmingham, Alabama, courthouse with the same federal judge as the infamous Richard Scrushy case. On June 29, 2005, Scrushy, founder and CEO of the $2.7 billion fraud-ridden HealthSouth Corporation, walked out of Federal Judge Karen Bowdre’s courtroom a free man — represented by Waktins, Sr. Scrushy was the first CEO indicted and tried under Sarbanes Oxley.

How did Scrushy make it out of the courtroom unscathed? Prior to the trial, Scrushy bought a local public television station, from which he and his wife produced a religious evangelism program. Soon, Scrushy became a lay minister, preaching at local churches and reportedly making large contributions to the congregations. This trial strategy, a strategy of positive image and strong community outreach, worked in securing an acquittal.

Unfortunately, Scrushy did not fare as well when, four months after his acquittal, he was indicted in a political corruption scandal with the governor of Alabama. Both Scrushy and former governor Don Siegelman were convicted of a political conspiracy in a federal criminal court in Montgomery, Alabama. Both were sentenced to over five years in federal prison.

Scrushy also received a bitter defeat in a later civil case. While incarcerated in 2009, a state court judge ruled “Scrushy was the C.E.O. of the fraud” at HealthSouth. The judge awarded a $2.8 billion judgement to the stockholders of HealthSouth against Scrushy.

By all accounts, Richard Scrushy was regarded as brilliant. He built a Fortune 500 company from scratch (albeit, by fraudulent means) and grew his self-proclaimed net worth to more than $600 million. But, after his criminal conviction and civil judgment, he lost his wealth and his freedom. Clearly, in this battle of flawed ethics vs. brilliance, Scrushy’s flawed personal ethics emerged victorious.

Donald Watkins, Sr. orchestrated his own defense in his fraud trial. The indicted 70-year-old attorney represented himself and testified as a defense witness. He would ask himself questions, then answer those questions. Unsurprisingly, this proceeding was exceedingly strange — the prosecutor even objected that Watkins was asking leading questions!

Watkins, Sr., who had developed a national reputation by representing Scrushy and the City of Birmingham’s then-mayor, Richard Arrington, Jr., was reported by several news sources to be a billionaire. According to Watkins, Sr., he was “certified by Goldman Saks” as being qualified to make a bid for the St. Louis Rams football team. Like Scrushy, however, Watkins’ alleged wealth and intellect met a test of brilliance v. flawed ethics.

The November 2018 indictment against Watkins and his son was filed after a 2016 SEC civil suit claiming Watkins duped investors into paying millions of dollars to a bank account controlled by Watkins, Sr. Rather than being used to finance the growth of two international companies, the funds were used to finance an elaborate personal lifestyle, paying for personal expenses such as American Express bills, private jet expenses, taxes, alimony, clothing and personal loans.

On March 8, 2019, the federal jury in Birmingham, Alabama returned a verdict of guilty on all 10 counts of the indictment against Watkins, Sr., along with a guilty verdict on two counts against Watkins, Jr. Sentencing for both men is set for July 16, 2019. In this battle between personal ethics and brilliance, flawed personal ethics again emerged the winner.

At FSS, we are a team of certified fraud examiners, certified public accountants, investigators and forensic technology experts – learn more about our work here.

Auditors Who Stole the Exam Are Convicted of Fraud

This failure of duty matters – it violates public trust and costs innocent people their jobs, their pensions and above all – faith in a system.

The Wall Street Journal reported on March 11, 2019 that David Middendorf, the former national managing partner for audit quality and professional practice at KPMG, and co-defendant, Jeffrey Wada, former employee of the Public Company Accounting Oversight Board (PCAOB), were convicted in a Manhattan federal court. The federal prosecutors termed their actions a “Steal the Exam” conspiracy.

In a previous blog about the trial, I described why this violation of trust matters, and why auditors must design audits to detect fraud.

We’ve all heard stories about students stealing exams. Years ago, when I was a young auditor, a student who had passed the CPA exam was discovered taking the exam for other candidates. In response, the controls to monitor the exam were changed.

That CPA was expelled by the state board, but on appeal, was surprisingly allowed to keep his CPA certificate. He then got a degree to practice law. Perhaps I was naïve in thinking this was an anomaly and would not happen again. Now, we have the case of the auditor and the regulator who oversees the auditor both being convicted of fraud.

Auditors have received a lot of publicity about their failures to detect fraud. Just a year ago in March 2018, Federal judge Barbara Rothstein ruled that Big 4 accounting firm PwC failed to design their audit to detect fraud at Colonial Bank, resulting in the bank’s failure. She entered a judgment of $625 million against the firm.

When auditors don’t design an audit to detect fraud, unfortunate circumstances may result – the failure at Colonial Bank cost thousands of employees their jobs; stakeholders lost their entire investment; all lost their retirement savings, and some lost a fortune in Colonial stock.

When the KPMG auditors stole the exam and knew which audits would be reviewed by the regulator, they took actions to cover their failures. KPMG wanted to improve their performance on inspections because they had performed poorly in past reviews.  For example, they were under close scrutiny by the SEC for their failure to detect problems at GE and Wells Fargo.

Rather than focus efforts on improvements such as performing their work at an acceptable level of care and committing to higher-quality work, the defendant at KPMG took an easier approach – he illegally obtained knowledge of which audits the inspectors would review, and made poor work appear better than it actually was.

We now see a fraud scheme where we didn’t expect to ever see one – among the group whose duty it is to detect it. And this is a question of ethics – both personal ethics and business ethics. I don’t see how you separate the two. How does this happen? As a fraud examiner, I was taught the Fraud Triangle. One of the three legs of the triangle is rationalization – the mindset of a person who rationalizes their fraudulent action. However, I will never understand how fraudsters rationalize these actions!

Auditors must be taught how to recognize fraud – and we have a mandate to teach them. Unlike a cat who attempts to cover its tracks, cover-ups and stealing the exam are unacceptable. It is simply fraud.

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Cash Flow and Fraud Go Hand-in-Hand

Imagine working at a company for a period of time, checking your bank account and realizing that no paycheck had been deposited in exchange for your work. This scenario would undoubtedly raise red flags. Similarly, cash flow analysis performed by lenders and auditors that reveals stagnant or negative cash flow can also serve as a warning sign that something is awry – and it could be fraud.

Cash flow is a significant indicator of a company’s overall health and operations. It allows investors, lenders and auditors to gauge the relative stability of a company by assessing its ability to avoid excessive borrowing, grow its business and endure hard times. Merger and acquisition professionals, business appraisers and lenders are keenly interested in the free cash flow of an organization. Auditors should be particularly aware of free cash flow and its ramifications, especially in designing an audit to look for fraud.

It is imperative to note how cash flow increases as sales increase, since both should be moving at a relatively consistent rate. This analysis can be conducted using a ratio of net operating cash flow to net sales, which shows how many dollars of cash are produced by each dollar of sales. Remember: the higher the percentage, the better.

2010 2011 2012 2013
Operating Activities:
Net Income (loss) (76,604) (64,815) 4,385 52
Adjustments to reconcile net income (loss) to net cash from operating activities:
Depreciation of property & equipment 41,501 37,235 36,535 38,085
Loss on Sales of Equipment 10,895
Decrease (Increase)
Inventories (107,265) (2,809) (88,442) (97,986)
Accounts receivable, net and other 164,231 (810,465) 376,837 (198,482)
Deferred Income Tax Benefit 202,360 (15,666) 48,710 10,620
Other Assets 16,502 (13,333) (22,318) 13,860
(Decrease) Increase in:
Accounts payable 207,525 523,501 (367,398) 42,004
Accrued expenses and other (62,082) 33,047 (22,746) (5,185)
Deferred Income Taxes Payable (8,673)
Franchise Tax Payable 3,277
Deposits on Hand (205,000)
Prepaid Deposits (16,255) 174,005
Net cash provided by (used in) operating activities 172,495 (310,028) (39,797) (23,027)
Total Net Sales 1,106,112  1,156,410  1,299,210  1,946,820
Operating Cash to Sales Ratio 16% -27% -3% -1%

 

In the table above, the operating cash to sales ratio is low, and cash is decreasing despite sales increasing. Cash that is stagnant or decreasing when sales are increasing should set off alarm bells for anyone, especially an auditor. Fraud and cash go hand in hand. When there is a cash flow pattern such as this, it is probable that there may be fraud lurking under the surface.

Companies often have an asset-based revolving line of credit in which the company receives loan advances based on a set percentage of asset balances such as accounts receivable. The gross receivables are typically reduced by receivables 90 days and over to calculate the eligible receivables balance as the borrowing base. This balance is then multiplied by the agreed advance rate (usually between 75 and 85 percent) to arrive at the available loan advance amount.

A common fraud scheme related to this type of lending arrangement occurs when a company inflates accounts receivable to increase their borrowing capacity. While this can be executed in a variety of ways, the cash flow analysis shown above would reveal that something is amiss. For example, assume a company generates fake receivables to increase its borrowing base. After the fake receivable goes over 90 days old, the receivable is written off and the borrowing base is decreased – the company now must pay down its loan. Typically, to continue the fraud scheme, the company will then create a new receivable to replace the old fake receivable in order to maintain a level borrowing base. Once the company finds that this scheme works, it will then create more false receivables and begin a cycle which generates cash flow through fraudulent bank loans. Thus, a negative or lower cash balance will exist because receivables should have generated cash, but did not.

Auditors should always follow the cash when evaluating a company. External auditors are required to plan an audit to detect fraud. Internal auditors and regulators should also include this procedure cash flow analysis in their audits as a “best practice.” Cash decreasing despite an increase in sales could be an indication that fraudulent activity is occurring – and prudent auditors will find this procedure invaluable on their path to determine the source of the cash flow problem.

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