11/11/2018 Print Preview Chapter : Knapp Cases LocatePlus Holdings Corporation Book Title: Fraud Examination Printed By: HAMMAD ALAZMI (alazmih1@montclair.edu) © 2019 Cengage Learning, Inc. LocatePlus Holdings Corporation In August 2004, an Internet-based investment advisory service included the common stock of LocatePlus Holdings Corporation in its “Stocks to Watch” alert. The advisory service touted the New Age business model of LocatePlus, a company whose headquarters were in a Boston suburb. That business model included providing government agencies, business entities, and individuals access to a massive online database that LocatePlus had collected and organized, a database that included information profiles on 98 percent of all U.S. citizens. Customers of LocatePlus purchased access to the company’s database for a wide array of investigative uses, including antiterrorism initiatives by law enforcement agencies, criminal background checks by prospective employers, and identity theft investigations by private individuals. Ironically, LocatePlus, a company that developed an important tool to combat fraud and other criminal activities in the Internet Age, found itself the focus of a fraud investigation in late 2010. That investigation, which involved the Federal Bureau of Investigation (FBI), the Internal Revenue Service (IRS), and the Securities and Exchange Commission (SEC), resulted in the downfall of the company, criminal prosecutions of its top executives, and harsh regulatory sanctions for the company’s independent audit firm. Channeling Fraud LocatePlus had two principal revenue streams. Slightly more than one-half of the company’s annual revenue was generated by selling direct, one-time access to its large database. The company’s other major revenue source involved so-called “channel partner” arrangements. A channel partner paid LocatePlus a fixed monthly royalty in exchange for unlimited access to its database. Channel partners were typically large government agencies or corporations. To enhance their company’s disappointing operating results, two LocatePlus executives created a bogus channel partner in 2005. Those two executives were James Fields, the company’s chief financial officer (CFO), and Jon Latorella, the company’s chief executive officer (CEO). The fictitious company, Omni Data Services, allegedly paid several hundred thousand dollars in monthly royalties to LocatePlus. These royalties accounted for $3.6 million of LocatePlus’s 2005 revenues of $11.6 million and $2.7 million of the company’s 2006 revenues of $12.2 million. Despite these bogus revenues, LocatePlus continued to post large losses each year. In 2004, the company had reported a net loss of $7.5 million. In 2005 and 2006, the company reported net losses of $5.6 million and $5.9 million, respectively. LocatePlus used a series of sham transactions, including fraudulent cash transfers, to make it appear that the Omni Data revenues were genuine. The principal purpose of these sham https://ng.cengage.com/static/nb/ui/evo/index.html?dockAppUid=101&eISBN=9781337619738&id=332634086&nbId=862016&snapshotId=862016& 1/8 11/11/2018 Print Preview transactions and the corresponding fraudulent journal entries was to deceive LocatePlus’s independent auditors. Because LocatePlus was a public company, it had to file audited financial statements annually with the SEC. Predecessor–Successor Auditor Communications In early 2005, LocatePlus contacted Livingston & Haynes (L & H), a Massachusetts-based accounting firm. LocatePlus needed a new independent auditor because its previous one had abruptly resigned. The Form 8-K that LocatePlus filed with the SEC to disclose that resignation included the resignation letter. In that letter, the former audit firm noted that it had “concerns about the timeliness of information we received and about the reliability of certain representations of your company’s management.” Before making a decision to accept or reject LocatePlus as an audit client, two L & H audit partners met with the individual who had served as the company’s previous audit engagement partner. These two L & H partners were William Wood and Kevin Howley. Wood was the senior technical partner on L & H’s audit staff. In his meeting with Wood and Howley, LocatePlus’s former audit engagement partner identified several factors that had contributed to his firm’s decision to resign as the company’s independent auditor: “difficulty getting information from management, management providing contradictory information, management providing unsigned contracts as audit evidence, and difficulty getting management to accept its proposed audit adjustments.” The former audit engagement partner also provided Wood and Howley access to his firm’s audit workpapers for LocatePlus. Included in these workpapers was a letter that the former audit firm had received from an individual who had previously served as a member of LocatePlus’s management team. This letter alleged that a LocatePlus business partner with whom it had engaged in a multimillion-dollar transaction was “not a legitimate entity.” Despite the information obtained from LocatePlus’s former audit engagement partner, L & H accepted LocatePlus as an audit client. After accepting LocatePlus as an audit client, L & H designated the company a “high-risk audit client.” The planning workpapers for the engagement required the audit team to “use extensive care” in auditing the company. Howley was appointed to serve as the audit engagement partner, while Wood served as the concurring partner on the engagement. Red Flags Discovered During 2005 During their 2005 reviews of LocatePlus’s quarterly financial statements, L & H auditors “became aware of multiple red flags concerning the revenue recognized from Omni Data and the resulting receivable on LocatePlus’s balance sheet.” In June 2005, Howley noted in an email he sent to James Fields that Omni Data was not included on a government website that supposedly listed all corporations domiciled in its home state. More troubling was the fact that the L & H auditors could not find a website for that company “despite the fact that Omni Data was purportedly a business doing data sales over the Internet.” Fields https://ng.cengage.com/static/nb/ui/evo/index.html?dockAppUid=101&eISBN=9781337619738&id=332634086&nbId=862016&snapshotId=862016& 2/8 11/11/2018 Print Preview subsequently told Howley that Omni Data did not have a website because the company was “trying to keep a low profile.” In August 2005, a former member of LocatePlus’s board of directors contacted Howley and made disturbing allegations regarding the reliability of the company’s accounting records. Over the next several months, this individual contacted Howley on “numerous occasions” and made similar statements to him. The individual’s most serious allegation was that Omni Data did not exist. Among other evidence to support this claim, he pointed out that the alleged President of Omni Data knew “nothing” about the company and that she was a ballet teacher who had previously been Latorella’s girlfriend. Howley informed Wood of each of the successive messages he received from the former board member and forwarded that individual’s allegations to the chairman of LocatePlus’s audit committee. Howley then recommended that the audit committee chairman arrange a meeting of the audit committee with the former board member and himself (Howley) to address the allegations. Such a meeting never took place. During the fraud “brainstorming session” for the 2005 LocatePlus audit, the L & H audit team identified “overstated and/or fictitious revenues/accounts receivable” related to Omni Data as a fraud risk factor. For the revenues LocatePlus received from its channel partners other than Omni Data, the L & H auditors compared the “amounts billed and recognized as revenue to LocatePlus’s data usage logs to ensure that the customer had agreed to purchase the product and had actually used it.” This critical audit test was not applied to the Omni Data revenues despite those revenues accounting for nearly one-third of LocatePlus’s 2005 revenues. If the auditors had applied this test to the Omni Data revenues, they would have discovered that Omni Data never accessed the company’s online database in 2005. In auditing the Omni Data revenues, L & H “relied on the executed agreement between LocatePlus and Omni Data and a confirmation received from Omni Data regarding the monies earned and owed.” In fact, both the executed agreement (contract) between the two parties as well as the confirmation received from Omni Data were fraudulent. As of December 31, 2005, LocatePlus’s accounting records included a $3.3 million receivable from Omni Data that accounted for 75 percent of the company’s net receivables and represented nearly 40 percent of its total assets. The confirmation for this large receivable was sent to the alleged president of Omni Data. That initial confirmation was returned as “undeliverable” by the U.S. Postal Service. After being provided with a new address for Omni Data’s president, L & H mailed a second confirmation that was signed and returned without any exceptions being noted. The L & H auditors documented in their 2005 workpapers the allegations made by the former LocatePlus board member—the principal one being that Omni Data did not exist— but failed to rigorously investigate those allegations. For example, the SEC discovered that the “Fraud Risk Assessment Form” included in the 2005 LocatePlus workpapers was left blank by the L & H auditors. In fact, according to the SEC, the auditors failed to reach “any conclusion about the merits” of the former board member’s disturbing allegations. https://ng.cengage.com/static/nb/ui/evo/index.html?dockAppUid=101&eISBN=9781337619738&id=332634086&nbId=862016&snapshotId=862016& 3/8 11/11/2018 Print Preview Lingering concern about the validity of the Omni Data revenues and receivable prompted the L & H auditors to include specific statements regarding those items in the 2005 letter of representations that was signed by Fields and Latorella. In the letter of representations, Fields and Latorella maintained that they had “no knowledge of any fraud or suspected fraud” and that they were unaware of any “allegations of fraud or suspected fraud” related to the Omni Data transactions. 2006 Audit By December 31, 2006, the receivable from Omni Data totaled $5.1 million. In late 2006, LocatePlus had supposedly amended Omni Data’s payment terms. These amended terms resulted in most of the large receivable being reclassified from current assets to long-term assets on LocatePlus’s December 31, 2006, balance sheet. The company also reduced the gross amount of the long-term portion of the receivable to its net present value and recorded an allowance of nearly $600,000 against the receivable. After these adjustments, the net reported value of the Omni Data receivable was approximately $3 million, an amount that represented slightly more than one-half of LocatePlus’s total assets as of December 31, 2006. The principal evidence collected by L & H to support the Omni Data receivable during the 2006 audit was once again a confirmation. As in the prior year, the initial mailing of the confirmation resulted in it being returned as “undeliverable.” After informing LocatePlus that the original confirmation had not been delivered, Howley was told that Omni Data was operating under a new name and had a new president. L & H mailed the confirmation a second time with the corrected address information, which resulted in the confirmation being returned signed without any reported exceptions. While investigating the 2006 LocatePlus audit, the SEC obtained a document from Howley that was entitled “LocatePlus Memorandum—Gallagher Allegations.” This memo summarized the fraud allegations made by the former LocatePlus board member. In the memo, Howley reported that he had discussed the allegations with the chairman of LocatePlus’s audit committee who had “indicated that he did not believe there was any basis” for them. The memo also noted that Howley had discussed the allegations with LocatePlus’s outside legal counsel who also “found no basis for them.” The outside legal counsel suggested that the former board member had made the allegations out of vengeance because he and Latorella were no longer on good terms. Although the memo included evidence pertinent to the Omni Data receivable, it was not included in the LocatePlus workpapers, nor was it dated. The 2006 workpapers did include a document that briefly referenced an investigation carried out in September 2006 by the Massachusetts Securities Division, an investigation that involved LocatePlus. The state agency’s report on that investigation indicated that “even the most cursory review of LocatePlus’s business would reveal that many aspects of its business were either highly exaggerated or fictitious.” This report was readily available on the state agency’s website, however, Howley apparently never accessed the report. https://ng.cengage.com/static/nb/ui/evo/index.html?dockAppUid=101&eISBN=9781337619738&id=332634086&nbId=862016&snapshotId=862016& 4/8 11/11/2018 Print Preview In the 2006 letter of representations, Fields and Latorella once again indicated that they were unaware of any suspected fraud or fraudulent allegations involving Omni Data. Near the conclusion of the 2006 audit, William Wood approved Kevin Howley’s decision to issue an unqualified opinion on LocatePlus’s 2006 financial statements. Wood, who had been involved in the planning for both the 2005 and 2006 audits, had also approved the unqualified opinion issued on the company’s 2005 financial statements. Both the 2005 and 2006 audit opinions on LocatePlus’s financial statements included a fourth explanatory paragraph. In that paragraph, L & H reported that there was substantial doubt that LocatePlus would remain a going concern. Exhibit 1 includes the 2006 audit opinion. “Highly Unreasonable Conduct” In June 2011, the SEC issued an Accounting and Auditing Enforcement Release summarizing its investigation of L & H’s 2005 and 2006 audits of LocatePlus. The SEC accused Howley and Wood of engaging in “highly unreasonable conduct.” In light of the specific allegations that the [Omni Data revenue and receivable] … were fictitious…. The failure of L & H and Howley to properly plan the audits, adequately test the Omni Data revenue, obtain sufficient competent evidence to serve as a basis for L & H’s audit reports, exercise due professional care, apply skepticism, and properly assess the risks of material misstatement due to fraud, and the failure of Wood to address these deficiencies … constituted highly unreasonable conduct that resulted in a violation of applicable professional standards in circumstances in which each knew, or should have known, that heightened scrutiny was warranted. Exhibit 1 Audit Opinion Issued by L & H on LocatePlus’s 2006 Financial Statements INDEPENDENT AUDITORS’ REPORT To the Stockholders and Board of Directors of LocatePlus Holdings Corporation Beverly, Massachusetts We have audited the accompanying consolidated balance sheet of LocatePlus Holdings Corporation as of December 31, 2006, and the related consolidated statements of operations, stockholders’ equity (deficit) and cash flows for the year ended December 31, 2006, and December 31, 2005. These financial statements are https://ng.cengage.com/static/nb/ui/evo/index.html?dockAppUid=101&eISBN=9781337619738&id=332634086&nbId=862016&snapshotId=862016& 5/8 11/11/2018 Print Preview the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audit. We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of LocatePlus Holdings Corporation and its subsidiaries as of December 31, 2006, and the results of its consolidated operations and its consolidated cash flows for the years ended December 31, 2006, and December 31, 2005, in conformity with accounting principles generally accepted in the United States of America. The accompanying financial statements have been prepared assuming that the Company will continue as a going concern. As disclosed in the financial statements, the Company has an accumulated deficit at December 31, 2006, and has suffered substantial net losses in each of the last two years, which raise substantial doubt about the Company’s ability to continue as a going concern. Management’s plans in regard to these matters are disclosed in Note 1. The consolidated financial statements do not include any adjustments that might result from the outcome of this uncertainty. /s/LIVINGSTON & HAYNES, P.C. Livingston & Haynes, P.C. Wellesley, Massachusetts May 1, 2007 Source: LocatePlus’s 2006 Form 10-K. Both Howley and Wood were suspended from practicing before the SEC for three years. L & H was fined $130,000, prohibited from accepting any new SEC clients for one year, and required to undergo an extensive quality control review. Each professional staff member of L & H who served public clients was also required to undergo 24 hours of training involving audit documentation standards, fraud detection, assessing the risk of material misstatements, and obtaining and evaluating audit evidence. https://ng.cengage.com/static/nb/ui/evo/index.html?dockAppUid=101&eISBN=9781337619738&id=332634086&nbId=862016&snapshotId=862016& 6/8 11/11/2018 Print Preview Epilogue In November 2010, the SEC announced that James Fields and Jon Latorella were being charged with criminal violations of the federal securities laws. In March 2012, Latorella pleaded guilty to conspiring to commit securities fraud and related charges, including making false statements to his former company’s independent auditors. Three months later, Latorella was sentenced to five years in prison. In November 2012, a federal jury found James Fields guilty of 29 criminal charges, including securities fraud, money laundering, and making false statements to his former company’s independent auditors. A federal judge sentenced Fields to five years in prison in February 2013. LocatePlus filed for bankruptcy in June 2011. The company’s assets, including its name and website, were sold to a private investment firm in November 2011. Questions 1. The PCAOB’s auditing standards identify auditors’ responsibilities when addressing the possibility that fraud has materially impacted a public company’s financial statements. Which of those responsibilities did the L&H auditors fail to comply with during the 2005 and 2006 LocatePlus audits? For each item that you listed, explain how the L&H auditors failed to fulfill that responsibility. 2. What is the purpose of predecessor–successor auditor communications? Which party, the predecessor or successor auditor, has the responsibility for initiating those communications? Briefly summarize the information that a successor auditor should obtain from the predecessor auditor. 3. What are the primary responsibilities of a “concurring partner” under current U.S. auditing standards? 4. What is the nature and purpose of a “letter of representations”? Comment on the quality or strength of the audit evidence yielded by a letter of representations. Chapter : Knapp Cases LocatePlus Holdings Corporation Book Title: Fraud Examination Printed By: HAMMAD ALAZMI (alazmih1@montclair.edu) © 2019 Cengage Learning, Inc. https://ng.cengage.com/static/nb/ui/evo/index.html?dockAppUid=101&eISBN=9781337619738&id=332634086&nbId=862016&snapshotId=862016& 7/8 11/11/2018 Print Preview © 2018 Cengage Learning Inc. All rights reserved. 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