Trade receivables that are reported on a statement of financial position should reflect the amount that is expected to be realized when collecting from customers. As indicated in Chapter 6, accounting information is useful if it is both relevant to a decision context and has representational faithfulness. But what if the trade receivables are deliberately misstated? This was the case for a Florida company called E. S. Bankest Capital Corp. (ESB) ESB was a factoring company, which means it bought trade receivables from other companies at a discount, undertook cash collection from the companies’ customers, and profited from the difference. The factoring process permits the seller of trade receivables to collect cash immediately and shift the credit risk to the purchaser or factor. Banco Espirito Santo of Lisbon, which controls ESB, lent $ 140 million to ESB along with a line of credit for $ 30 million based on the value of ESB’s trade receivables. Banco Espirito Santo is the second- largest bank in Portugal.
ESB’s management had inflated the value of the trade receivables reported on its statement of financial position in order to obtain the loan. The reported value was $ 225 million when the actual value was only $ 5 million. The troublesome part of this fraudulent activity is that ESB’s auditor, BDO Seidman, did not suspect any wrongdoing by the company and signed off on ESB’s financial statements.
When the ESB fraud was disclosed in 2004, the ex- chairman of the company’s board of directors, Eduardo Orlansky, was convicted of fraud, money laundering, and conspiracy and sentenced to 20 years in prison after a trial. An investigation indicated that the money borrowed from Banco Espirito Santo was deposited in various umbrella companies controlled by ESB. Mr. Orlansky was not the only executive convicted. He was ordered to pay $ 165 million in restitution to Banco Espirito Santo, but the question was whether the bank would ever collect. ESB declared bankruptcy. Then Banco Espirito Santo sued BDO Seidman USA for failing to detect the fraud. The bank sued for actual losses of $ 170 million plus punitive damages of $ 351 million, and won the case in August 2007 for a total cash award of $ 521 million. During the course of the trial, it was revealed that BDO Seidman was a strategic partner of one of ESB’s factoring clients. BDO claimed it was fooled by ESB and that there was no conflict of interest. Although Banco Espirito Santo won the case, BDO Seidman launched and won an appeal. Ultimately, in May 2011, the two parties entered into a confidential settlement agreement. Many articles were written about the ESB fraud in the news media. Access some of these articles to answer the following questions.
Required:
1. Preparers and auditors of financial statements are expected to exercise prudence in their valuation of assets and liabilities that are reported on the statement of financial position. Explain how the concept of prudence applies to the valuation of the trade receivables reported by ESB.
2. In your opinion, is a confidential settlement between Banco Espirito Santo and BDO Seidman a positive event for the profession of accounting?