avoiding fraudulent dealings cooking the books cooking the books 10% of all frauds are financial...
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Avoiding Fraudulent DealingsCooking the books
Cooking the Books
10% of all frauds are financial statement frauds
Average cost of about 2 million per scheme
Collusion and Power are the main contributors
Frequency of Fraud
2000
2005
2010
0% 20% 40% 60% 80% 100%
Fraudulent StatementsCorruptionAsset Misap-propriation
Cost in Value
$80,000 $93,000
$530,000
$250,000 $4,250,000
$1,000,000
$- $500,000 $1,000,000 $1,500,000 $2,000,000 $2,500,000 $3,000,000 $3,500,000 $4,000,000 $4,500,000
AssetMisappropriation
Corruption
FraudulentStatements
2002 2004
Who Commits Financial Statement Fraud?
Senior management
Mid- and lower-level employees
Organized criminals
Why Do People Commit Financial Statement Fraud
To conceal true business performance
To preserve personal status/control
To maintain personal income/wealth
Why Senior Management Will Overstate Business Performance
To meet or exceed the earnings or revenue growth expectations of stock market analysts
To comply with loan covenants
To increase the amount of financing available from asset-based loans
To meet a lender’s criteria for granting/extending loan facilities
To meet corporate performance criteria set by the parent company
Why Senior Management Will Overstate Business Performance
To meet personal performance criteria
To trigger performance-related compensation or earn-out payments
To support the stock price in anticipation of a merger, acquisition, or sale of personal stockholding
To show a pattern of growth to support a planned securities offering or sale of the business
Why Senior Management Will Understate Business Performance
To defer “surplus” earnings to the next accounting period.
To take all possible write-offs in one “big bath” now so future earnings will be consistently higher.
To reduce expectations now so future growth will be better perceived and rewarded.
To preserve a trend of consistent growth, avoiding volatile results.
To reduce the value of an owner-managed business for purposes of a divorce settlement.
To reduce the value of a corporate unit whose management is planning a buyout
Types of Fraud
Overstatement of Income Understatement of Income Improper Use of Resources Mischaracterization of one-time
expenses Misapplication of the accounting
rules Omission or misrepresented
information
Anti-Fraud Methods
Financial Statement Audits
Code of Conduct
Internal Audit
Independent Audit
Bottom of the List
Fraud Training
Anti-Fraud Policy
Most Effective
Surprise Audit
Mandatory Vacation - Job Rotation
Hotline
Employee Support
Executive Training
Why is it Easy to Commit Fraud? Companies trust employees Employees with authority Autonomy with lack of over-
sight Poor controls Mergers, acquisitions, spinoffs Discontinued services Relationship between auditing
firm and clients
Users of Financial Statements
TransactionActivity
TransactionActivity
InformationUsers
InformationUsers
FinancialStatementsFinancial
StatementsAccounting
SystemAccounting
System
BankersInvestorsVendorsGovernmentManagement
BankersInvestorsVendorsGovernmentManagement
Balance SheetIncome StatementStatement of Owner EquityStatement of Cash Flows
Balance SheetIncome StatementStatement of Owner EquityStatement of Cash Flows
DecisionsDecisions
Loan ApprovalFinancial InvestmentCredit ApprovalOperational & Financial Decisions
Loan ApprovalFinancial InvestmentCredit ApprovalOperational & Financial Decisions
Audit Design Flaws
Not designed to prevent fraud
Primarily check math and accounting rules
Look only for material misstatements
Relies on internal controls
Tests only a percentage
How They Do It!
Hide Fraud in Key Accounts High volume accounts – write-
offs, bad debt, supplies
Accounts auditors don’t understand
Predictable accounts that will be tested, inventory, accounts receivable
Use Account that Require Judgment and Estimates
Warranty Reserve
Allowance of Bad Debt
Sales Allowances and Returns
Restructuring / Discontinued Services
Grey Area
Abuse Reserve
Cookie Jar Accounting
Large Companies Require Large Reserve
Easy to Manipulate
Audit looks at Risk of Understating Reserve
Plan around Auditors Scope and Announced Procedures Exploit Scope and Materiality
Move Inventory locations
Falsify Documents
Force Auditors to choose alternate items to test
Follow the Basic Accounting Principals
Pretend to be Conservative Give auditors the answers they
want to hear Make numbers fall within
acceptable historic lines Make sure there are adjustments
for auditors to book Being stupid is not a crime Simple mistake
Cooking the Books
Income Statement Recording sales before all
conditions are met Order has been received Product has been shipped Little risk the shipment will not be
accepted No other reactions are required Title ownership has changed
payments due
Puff Up the Income Statement Improperly increased revenue
Sales recorded before completed Goods are shipped before sale is
final Revenue recorded while future
services are still due Bogus Revenue Supplier refunds recorded as
income Revenue recorded from self
dealings Revenue recorded from asset
exchanges
Puff Up the Income Statement Improper lowered costs or
expenses Current expenses shifted into
later period Expenses capitalized on Balance
Sheet Assets depreciated slower than
normal Liabilities not accrued Operating losses masked in
discontinued services
Sweeten the Balance Sheet Improperly increased income
Expenses shifted to different periods
Capitalize costs as inventory Assets depreciate or amortized
too slowly Worthless asset not written off
immediately Shift revenue and income into
later periods with reserves
Sweeten the Balance Sheet Improperly increased assets
and equity Increased equity through one
time gains Report gains on exchange of
similar assets Report gains by selling
undervalued assets Retire debt Report revenue rather than
liability on receipt of cash
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