LINSO, HAZRAPHINE S March 22, 2021

Audit in Specialized Industry BSA 3

Case Article: SEC Charges Oil and Gas Company and Top Finance Executives with
Accounting Fraud

On June 28, 2017, the Securities and Exchange Commission charged a Canadian-based
oil and gas company and three of its former top finance executives for their roles in an extensive,
multi-year accounting fraud. The SEC's complaint alleged that Penn West Petroleum Ltd., which
has since been renamed Obsidian Energy Ltd., fraudulently moved hundreds of millions of
dollars in expenses from operating expense accounts to capital expenditure accounts. This
alleged fraudulent movement caused Penn West to artificially reduce its operating costs by as
much as 20 percent in certain periods, which falsely improved reported metrics for oil extraction
efficiency and profitability. Penn West was one of Canada's largest oil producers at the time.
According to the SEC's complaint, the fraud was orchestrated by the company's former CFO
Todd Takeyasu, former vice president of accounting and reporting Jeffery Curran, and former
operations controller Waldemar Grab. The SEC alleges that they manipulated the company's
operating expenses in order to lower a key publicly reported metric concerning the cost of oil
extraction and processing needed to sell a barrel of oil. Penn West allegedly created an internal
budget target representing the amount it would improperly move in its publicly-reported
financial statements and gave the illusion that it was spending less money to get oil of out the
ground. In fact, the SEC alleges, the company historically struggled to keep its operating costs
under control, and Takeyasu, Curran, and Grab managed operating expenses to meet the budget
target. According to the SEC's complaint, they frequently met this target to the dollar by having
the company record large, round number, and unsupported adjusting journal entries. Within the
company, this practice was referred to as "reclass to capital."
As mentioned above, the three former top finance executives orchestrated an accounting
fraud where they fraudulently moved hundreds of millions of dollars in expenses from operating
expenses accounts to capital expenditure account. This act caused the company to falsely
decrease its operating costs by as much as 20 percent in certain periods which improved the
reported metrics for oil extraction efficiency and profitability. The SEC said the three executives
manipulated operating expenses to lower a key metric related to the cost of oil extraction. It was
also alleged that Penn West has an internal budget target which represents the amount it would
inappropriately move in its publicly-reported financial statements. Consequently, it made an
illusion that the company was spending less money to extract the oil out of the ground.
The first step in financial statement fraud prevention is strong internal accounting
controls. Internal control is expected to identify possibilities of better prevention which is more
desirable than detection. Generally, responsibility for internal control system functioning must be
attached to the highest hierarchical level in the company. Companies should develop an internal
control system able to fully protect both owners and resources. It includes procedures designed
to lower the risk of criminal activities and obtain reliable and objective financial reports. Internal
control should develop and describe techniques for dealing with criminal activities. It is very
important in fraud prevention because all participating subjects are informed about how to
handle fraud. Documenting will support the supervision of preventive controls or suggest that
such controls are ineffective. Testing of the procedures which ensure adequate operations of
preventive controls and their results have to be documented in detail. The most important is that
documentation contains a detailed description of elements used to prevent financial statement
fraud, emphasizing the roles and responsibilities of all participating parties. When companies
evaluate management programs to fight fraud, or try to improve such programs, they should also
evaluate techniques for fraud prevention. Therefore, a company should, with the help of internal
and external auditors, periodically evaluate preventive techniques in order to make sure that none
of the preventive control elements has been warped.
One of the best ways for prevention of financial statement fraud is in providing a control
environment which encompasses: 1) a code of behavior, an ethical policy in order to establish a
proper attitude towards fraud prevention at the highest level of organizational structure, 2) ethical
and warning programs of communication for alerting and reporting the noted deviations, 3)
instructions, practice and rewards for employees, 4) supervision by audit committee and
managing board, 5) investigation of reported cases and elimination of any confirmed fraud.
Companies should test their financial information for accuracy by having an audit of their
financial statements. This helps management understand where weaknesses are in their
accounting department and allows them to take corrective measures quickly. Audit procedures to
discover the error and uncover the fraud should include:
1. Fraud brainstorming sessions - Under generally accepted auditing standards, audit
engagement teams must hold a fraud brainstorming session at the beginning of the
audit. This session is designed to provide a time for the audit team to consider how
the company could commit fraud and is used to set a tone of professional skepticism
in the audit.
2. Journal Entry Testing - Because committing material financial statement fraud
often requires adjustments to the company's financial records, auditors will test the
company's journal entries for any signs of manipulation. To perform this test, after
gaining an understanding of the company's controls and procedures, the auditor will
make a selection from the company's journal entries.
3. Accounting Estimates - Another place for fraud to occur is in accounting estimates.
Accounting estimates are subjective in nature and management may be able to
influence accounting estimates to manipulate the financial statements. Auditors look
for fraud in accounting estimates in two ways. First, auditors complete a "lookback"
procedure to determine if the methodology for completing accounting estimates has
changed from the prior year. Changes in methodology could be a sign of
manipulation. Second, auditors examine the directionality of estimates as a whole.
For instance, if nearly all estimates in the prior year were of decreasing income and
nearly all estimates in the current year were of increasing income, auditors may be
concerned that the company is shifting income from one period to another.
4. Significant Unusual Transactions - Recent revisions in generally accepted auditing
principles require that auditors closely examine significant unusual transactions
 outside of a company's normal business operations. This requires companies to
explain the purpose and business rationale for the transaction. Once the auditor
obtains management's explanation, the engagement team should corroborate
management's response with other information received during the audit.
Increased competition driven by the dynamic market growth forced companies to adapt to
forever changing demands. In doing so, companies are exposed to numerous internal and
external influences, some of which may cause significant damage. In order to avoid this,
companies are inclined to establish effective internal control system. Many companies do have
internal controls but its role in fraud prevention is marginalized, especially when managers are
personally involved in fraud.
References:
SEC Charges Oil and Gas Company and Top Finance Executives with Accounting Fraud. (2017,
June 28). Https://Www.Sec.Gov/. https://www.sec.gov/news/press-release/2017-120
Financial Statement Fraud Prevention. (n.d.). Https://Www.Grahamcpa.Com/. Retrieved March
19, 2021, from https://www.grahamcpa.com/media/Financial%20Statement%20Fraud
%20Prevention.pdf
University of Information Technology and Management, Rzeszów. (n.d.). The role of a
company’s internal control system in fraud prevention. Https://Www.Econstor.Eu/. Retrieved
March 19, 2021, from https://www.econstor.eu/bitstream/10419/147130/1/857500287.pdf