Reference no: EM133198040

Company Overview:

The Equity Funding Life Insurance Company (EFLIC) was in the co-insurance business and had 4,000 full-time sales representatives. EFLIC would sell life insurance policies to individuals and then sell the policies to other insurance companies that assumed the related risk. The policies would be transferred to the other insurance companies but EFLIC would continue to service the policies for a fee. The premiums were collected by EFLIC and forwarded to the other insurance companies that held the policies. EFLIC would be paid 180% of the first year's premiums as a fee for the sale and service of the policy. (See Figure 2) This provided EFLIC with needed immediate cash flow to raise share value for acquisitions. EFLIC would retain 10% of future premium payments as a service fee.

The Scheme:

As a growing organization, Equity Funding was desperate to meet cash demand for expenses and to grow the organization. A scheme was concocted to create fictitious people that would purchase life insurance policies that could be sold to other insurance companies. EFLIC created a committee, "The Maple Street Gang", to create the fictitious policyholders. The paperwork to create a person required detailed information: name (used a baby naming book), address (used maps), sex, birth date, and numerous other pieces of information required on the insurance forms. The Maple Street Gang ultimately created 64,000 fictitious people. This was close to two-thirds of EFLIC's business. As reflected in the following flowchart (Figure 2), the revenue from the policyholders created in the first year was used to inflate the financial statements and meet the cash flow needs. The inflated financial statements kept the share value high to generate more cash from the sale of 6 stocks and also, in shares-to-shares acquisitions. The high share value minimized dilution. These acquisitions were of profitable companies that made Equity Funding appear profitable. Unfortunately, part of the premiums (180%) from the second-year fictitious policyholders had to be used to pay the premiums for the first-year fictitious policyholders. Note, the fictitious policyholders are unable to pay premiums. You can see that this was in essence a great big pyramid scheme, that functioned similarly to a Ponzi Scheme. The all-pervading concern of executive management was the share price. This is often the downfall of management. The insurance companies holding the policies were never suspicious since they always received their policyholder premiums through EFLIC and the lapse rate and claims rates were consistent with expectations.

Figure 2: EFLIC Business Cash Flow:

A humorous aspect of the EFLIC case is that the actuarial staff was used to determine how often to "kill" off the fictious policyholders and file a claim with the other insurance companies holding the policies. This created an additional cash flow. Another benefit of having fictitious policies is that EFLIC did not have to pay commissions to their salesforce on the policies. To emphasize that the tone at the top filters down through the organization, middle management was involved in personal corruption. They knew about the fictitious policies and would file fictitious claims and pocket the proceeds. EFLIC management ultimately realized that they needed to slow the process to become clear of the fraud and created "Project Z" which was a cost-cutting effort. Unfortunately, they terminated Ronnie Secrist who was knowledgeable of the fraud. Mr. Secrist notified Raymond Dirks, a securities analyst, who in turn reported the fraud to the insurance regulators of Illinois and California. In April of 1973, the story was the front-page article of the Wall Street Journal. Equity Funding dissolved in literally one day and banks refused to cash any Equity Funding checks.

The Assigned Auditors: Wolfson, Weinert, Ratoff, and Lapin (WWRL):  

The external auditors on site at the client did not fully understand the business nor the computer operations used in the fraud. Two of the external audit partners were aware of the fraud and were indicted. The on-site auditors allowed the client to generate random numbers on their computer for testing of policies. Even EFLIC management could not determine the difference between the valid policies and the fake policies. The prefix of 99 was added to the policy number of all fake policies for identification. It would not have been difficult to run a sample list for the auditors that just eliminated all 99 policies. As a side note, the use of Benford's Law would have discovered this fraud. In a database of natural numbers, if you select the first digit of each number, the number "1" will appear about 30% of the time and the number "9" would appear only about 4% of the time. In the database of EFLIC policies, the 8 number "9" would have appeared first in about 70% of the policies. Remember, that about 2/3 of the policies were fictitious and started with a "9". The auditors gave the client's administrative assistant a list of claims to confirm. The auditors asked the individual to make the calls and patch the number through to the conference room where they were working when the policyholder was on the phone. The calls were actually all made to an EFLIC manager down the hall who pretended to be a policyholder. Additionally, the EFLIC managers gained access to the auditors' plans and used this information to help conceal the fraud.

The Audit Standards Board (ASB) has issued many Statements to improve the detection of fraud in financial statements. SAS #99 which was issued in October 2002 is an example of one of those statements and reflects the continuing quest by the ASB to improve fraud detection by an attest audit.  An outline of #99 is presented below:

• Description and Characteristics of Fraud:
  • Fraud is an intentional act that results in a material misstatement in financial statements that are subject of an audit.
  • There are two types of misstatements that are relevant to the auditor's consideration of fraud.
    • Misstatements arising from fraudulent financial reporting are intentional misstatements or omissions.
    • Misstatements arising from misappropriation of assets.
  • Overview of the elements of the Fraud Risk Triangle.
  • Management has a unique ability to perpetrate fraud.
  • Fraud is often concealed through collusion.
  • Analytics may assist in revealing fraud.
• The importance of exercising professional skepticism.
  • Questioning mind.
  • Critical assessment of audit evidence.
• Discussion among engagement personnel regarding the risks of material misstatement due to fraud. (Brainstorming)
• Obtaining the information needed to identify the risks of material misstatement due to fraud.
• Identifying risks that may result in a material misstatement due to fraud.
• Assessing the identified risks after taking into account an evaluation of the entity's programs and controls that address the risk.
• Responding to the results of the assessment.
• Evaluating audit evidence.

NOTE: SAS #99 is presented to reflect the progress that has been made in improving the quality of audits relative to fraud.  You should reflect on SAS #99 and put it in the context of Equity Funding.  An interesting coincidence is that the prefix 99 also represented the coding of the fraudulent policies at EFLIC. 

Select one aspect of SAS #99 and discuss why it would have assisted auditors with the audit of Equity Funding.