11

Fraudulent Financial Fraudulent Financial Statement SchemesStatement Schemes

22

Name at least three of Name at least three of the five principle the five principle

financial statement financial statement fraud schemesfraud schemes..

  

Pop QuizPop Quiz

33

Financial Statement Fraud Financial Statement Fraud DefinedDefined

DeliberateDeliberate misstatements or omissions misstatements or omissions deceive usersdeceive users

44

SpecificallySpecifically

Falsification, alteration, or manipulationFalsification, alteration, or manipulation Material intentional omissions or Material intentional omissions or

misrepresentations misrepresentations Deliberate misapplication of accounting Deliberate misapplication of accounting

principles, policies, and procedures principles, policies, and procedures Intentional omissions of or inadequate Intentional omissions of or inadequate

disclosures or presentationdisclosures or presentation

55

Costs ICosts I

More than 50% of U.S. corporations are More than 50% of U.S. corporations are victims of fraud with losses of more than victims of fraud with losses of more than $500,000 $500,000

Investors, employees, pensionersInvestors, employees, pensioners Enron, WorldCom, Quest,Global Enron, WorldCom, Quest,Global

Crossing, and Tyco’sCrossing, and Tyco’s What might some other fraud costs be? What might some other fraud costs be?

66

Costs IICosts II

Financial reporting process underminedFinancial reporting process undermined Integrity of auditing professionIntegrity of auditing profession Capital markets lose confidenceCapital markets lose confidence Capital markets less efficient Capital markets less efficient

77

Costs IIICosts III

Economic growth and prosperityEconomic growth and prosperity Litigation costsLitigation costs Destroys careers Destroys careers Bankruptcy or substantial economic lossesBankruptcy or substantial economic losses

88

Costs IVCosts IV

interventionintervention InefficiencyInefficiency Doubts re: auditsDoubts re: audits Public confidence and trustPublic confidence and trust

99

TypesTypes

Fictitious revenuesFictitious revenues Timing differencesTiming differences Improper asset valuationsImproper asset valuations Concealed liabilities and expensesConcealed liabilities and expenses Improper disclosuresImproper disclosures

1010

Fictitious RevenuesFictitious Revenues

Fake sales, customersFake sales, customers Legitimate customersLegitimate customers Conditional salesConditional sales

1111

Red Flags Red Flags – Fictitious Revenues– Fictitious Revenues

Rapid growthRapid growth unusual profitabilityunusual profitability Negative CFO with positive NINegative CFO with positive NI Related party/SPE transactionsRelated party/SPE transactions

1212

Red Flags Red Flags – Fictitious Revenues– Fictitious Revenues

Complex transactionsComplex transactions ↑ ↑ number of days’ sales in receivablesnumber of days’ sales in receivables Sales to unknown entitiesSales to unknown entities An unusual surge in sales An unusual surge in sales

1313

Timing DifferencesTiming Differences

Improper periodsImproper periods Shifting revenues or expensesShifting revenues or expenses Matching revenues with expensesMatching revenues with expenses Premature revenue recognitionPremature revenue recognition

– Long-term contractsLong-term contracts– Channel stuffingChannel stuffing

1414

Red Flags – Timing Red Flags – Timing DifferencesDifferences

Rapid growth or unusual profitabilityRapid growth or unusual profitability Negative CFO with positive NINegative CFO with positive NI Complex transactionsComplex transactions ↑ ↑ number of days’ sales in receivablesnumber of days’ sales in receivables ↓ ↓ number of days’ purchases in accounts number of days’ purchases in accounts

payablepayable

1515

Concealed LiabilitiesConcealed Liabilities

Liability/expense omissionsLiability/expense omissions Capitalized expensesCapitalized expenses WarrantiesWarranties ContingenciesContingencies

1616

Red Flags – Concealed LiabilitiesRed Flags – Concealed Liabilities

Negative CFO with positive NINegative CFO with positive NI

Significant estimatesSignificant estimates CEO obsession with GAAP selectionsCEO obsession with GAAP selections Unusual ↑ in gross marginUnusual ↑ in gross margin Unusual SRA, warranty claimsUnusual SRA, warranty claims ↓ ↓ the number of days’ purchases in the number of days’ purchases in

accounts payableaccounts payable Out of line with competitorsOut of line with competitors

1717

Improper DisclosuresImproper Disclosures

Liability omissionsLiability omissions Subsequent eventsSubsequent events Management fraudManagement fraud Related-party transactionsRelated-party transactions Accounting changesAccounting changes

1818

Red Flags – Improper Red Flags – Improper DisclosuresDisclosures

Domination of management Domination of management Ineffective board of directors Ineffective board of directors Tone at the topTone at the top Rapid growth or unusual profitabilityRapid growth or unusual profitability

1919

Red Flags – Improper Red Flags – Improper DisclosuresDisclosures

Significant, unusual, or highly complex Significant, unusual, or highly complex transactions, transactions,

Significant related-party transactions Significant related-party transactions tax haven bank accountstax haven bank accounts Overly complex organizational structureOverly complex organizational structure

2020

Red Flags – Improper Red Flags – Improper DisclosuresDisclosures

Known history of violations Known history of violations Materiality justificationsMateriality justifications Limitation of auditor accessLimitation of auditor access

2121

Improper Asset ValuationImproper Asset Valuation

Inventory valuationInventory valuation Accounts receivableAccounts receivable Business combinationsBusiness combinations Fixed assetsFixed assets

2222

Red Flags – Red Flags – Improper Asset ValuationImproper Asset Valuation

negative cash flows with positive earnings.negative cash flows with positive earnings. Declining business/economyDeclining business/economy Lots of assets based on estimatesLots of assets based on estimates CEO obsession on GAAP choicesCEO obsession on GAAP choices Gross margin ↑ compared to industryGross margin ↑ compared to industry

2323

Red Flags – Red Flags – Improper Asset ValuationImproper Asset Valuation

↑ ↑ the number of days’ sales in receivablesthe number of days’ sales in receivables ↑ ↑ number of days’ purchases in inventorynumber of days’ purchases in inventory ↓↓Allowances for bad debts, inventoryAllowances for bad debts, inventory Unusual change in the relationships Unusual change in the relationships Increasing assets when competitors are Increasing assets when competitors are

reducingreducing

2424

Detection of Fraudulent Financial Detection of Fraudulent Financial Statement SchemesStatement Schemes

SAS 99 – Consideration of Fraud in a SAS 99 – Consideration of Fraud in a Financial Statement AuditFinancial Statement Audit

““The auditor has a responsibility to plan The auditor has a responsibility to plan and perform the audit to obtain and perform the audit to obtain reasonable assurance about whether the reasonable assurance about whether the financial statements are free of material financial statements are free of material misstatement, whether caused by error or misstatement, whether caused by error or fraudfraud.”.”

2525

SAS 99SAS 99 Two major types of fraudTwo major types of fraud Professional skepticismProfessional skepticism Discussion of riskDiscussion of risk

2626

SAS 99SAS 99 Obtaining information needed to Obtaining information needed to

identify risks of material identify risks of material misstatement due to fraudmisstatement due to fraud– Inquiries of management Inquiries of management – Unusual or unexpected relationshipsUnusual or unexpected relationships– Fraud risk factors exist.Fraud risk factors exist.– Other informationOther information

2727

SAS 99SAS 99 Identifying risks that may result in material Identifying risks that may result in material

misstatement due to fraudmisstatement due to fraud– TypeType– SSignificanceignificance– LLikelihoodikelihood– PPervasivenesservasiveness

Assessing the identified risks after taking into Assessing the identified risks after taking into account an evaluation of the entity’s programs and account an evaluation of the entity’s programs and controlscontrols– Specific controls Specific controls – Broader programsBroader programs

2828

SAS 99SAS 99 Responding to the results of the Responding to the results of the

assessmentassessment– Overall responses Overall responses – nature, timing, and extent of procedures nature, timing, and extent of procedures – risk of management override of controlsrisk of management override of controls– Examining journal entries and other Examining journal entries and other

adjustments adjustments – Reviewing accounting estimates Reviewing accounting estimates – Evaluating the business rationaleEvaluating the business rationale

2929

SAS 99SAS 99

Evaluating audit evidenceEvaluating audit evidence– Assessing risks of material Assessing risks of material

misstatement misstatement – Evaluating analytical proceduresEvaluating analytical procedures– at or near the completion of fieldworkat or near the completion of fieldwork– misstatements that may be the result of misstatements that may be the result of

fraudfraud

3030

SAS 99SAS 99 Communicating about fraud to Communicating about fraud to

management, the audit committee, and management, the audit committee, and othersothers– even if considered inconsequentialeven if considered inconsequential– Internal controls Internal controls management management– Disclosing possible fraud to outside partiesDisclosing possible fraud to outside parties

3131

SAS 96 – Audit SAS 96 – Audit DocumentationDocumentation

list of factors list of factors new requirementsnew requirements Retains much of the ownership/record Retains much of the ownership/record

retention guidance of SAS 41retention guidance of SAS 41 Contains amendments adding specific Contains amendments adding specific

documentation requirements to other documentation requirements to other SASsSASs

3232

Financial Statement AnalysisFinancial Statement Analysis Vertical analysisVertical analysis Horizontal analysisHorizontal analysis Ratio analysisRatio analysis

3333

Deterrence of Financial Deterrence of Financial Statement FraudStatement Fraud

Reduce pressures Reduce pressures Reduce the opportunity Reduce the opportunity Reduce rationalizationReduce rationalization

3434

Reduce Reduce PressuresPressures to Commit to Commit Financial Statement FraudFinancial Statement Fraud

““tone at the top”.tone at the top”. Unachievable goals.Unachievable goals. excessive pressure.excessive pressure. Recognize changing marketRecognize changing market Fair compensation systems Fair compensation systems excessive external expectationsexcessive external expectations Remove operational obstacles blocking Remove operational obstacles blocking

effective performance.effective performance.

3535

Reduce the Reduce the OpportunityOpportunity to Commit to Commit Financial Statement FraudFinancial Statement Fraud

internal accounting records.internal accounting records. monitor the business transactions and monitor the business transactions and

interpersonal relationshipsinterpersonal relationships physical security system. physical security system. Accurate personnel records.Accurate personnel records. Strong supervisory and leadership Strong supervisory and leadership

relationships.relationships. Clear and uniform accounting proceduresClear and uniform accounting procedures

3636

Reduce Reduce RationalizationRationalization of of Financial Statement FraudFinancial Statement Fraud

Tone @ the top.Tone @ the top. Strong policies.Strong policies. TrainingTraining Anonymous tip procedureAnonymous tip procedure CommunicationsCommunications Walk the talkWalk the talk