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FRAUD EXAMINATION ALBRECHT, ALBRECHT, & ALBRECHT. Financial Statement Fraud. CHAPTER 11. Learning Objectives. Understand the role that financial statements play in U.S. businesses. Describe the nature of financial statement fraud. Become familiar with financial statement fraud statistics
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FRAUD EXAMINATIONALBRECHT, ALBRECHT, & ALBRECHT Financial Statement Fraud CHAPTER 11
Learning Objectives • Understand the role that financial statements play in U.S. businesses. • Describe the nature of financial statement fraud. • Become familiar with financial statement fraud statistics • See how financial statement frauds occur and are concealed.
Learning Objectives • Understand the framework for detecting financial statement fraud. • Identify financial statement fraud exposures. • Explain how information regarding a company’s management and directors, nature of organization, characteristics, relationship with others, and financial results can help assess the likelihood of financial statement fraud.
What Are Some Problems with Financial Statements? • Misstated “Cooked” • Inappropriate executive loans and corporate looting • IPO favoritism, spinning & laddering • Excessive retirement perks • Exorbitant compensation • Loans for trading fees • Massive employee fraud
What Are the Elements of the Perfect Fraud Storm? • Management lacked understanding of the causes for success of their companies • Moral decay occurring in the United States and around the world • Misplaced executive incentives • Wall Street’s unachievable expectations that targeted only short-term performance • The large amount of debt and leverage each of the fraudulent companies had placing tremendous pressure on executives
What Are the Elements of the Perfect Fraud Storm? • The nature of U.S. accounting rules • The opportunistic behavior of some CPA firms • The greed by executives, investment banks, commercial banks, and investors • Three types of failure by educators • Failure to provide sufficient ethical training • Failure to teach students about fraud • Failure to teach less about content as an end in itself and to focus more content in the context of helping them develop analytical skills
Financial Statement Fraud Statistics. • Infrequent • 300 over 10 years • Costly • Last 23.7 months • Mean $25 million • CEO in 72%, CFO, COO • Computer hardware/software • 78% of firms on NASDAQ
Financial Statement Fraud Statistics. • Most had no audit committee • Most directors were insiders • Family relationships between directors • 56% audited by Big Eight or Big Six • 25% changed auditors during fraud • Significant number of class action suits • Many resignations-few served jail time
What Are the Motives for Financial Statement Fraud? High Stock Prices Competition Increase Personal Wealth Bond or Stock Offerings To Meet Expectations
Discuss Detecting Financial Statement Fraud. Difficult Competition Understand Operations Understand What Motivates Management Period to Period Changes
Complete the Fraud Exposure Rectangle. Fraud Exposure Rectangle Company’s Relationship with Other Entities Management & Directors 1 2 The Organization & Its Industry Financial Results & Operating Characteristics 4 3
Discuss Management & Directors. Financial Statements Requires Management’s Participation Work “ON” Behalf of the Organization Backgrounds Motivations Influence on Decision Making
Comment On & Explain Relationships with Others. • Related Party Transactions • With Financial Institutions & Bond Holders • Improper or Unrealistic Transactions • Auditors • Attorneys • Investors • Regulators
Describe Questionable Organizations & Industries. • Structures designed to hide fraud • Unduly complex organizations • Legitimate purpose for each business segment • Active or passive board of directors • Active or passive independent audit committee • Active, independent internal audit • Board of directors with few outsiders • Offshore activities without an apparent business purposes
List What to Ask About Organization & Industry. • Is it a new business without a proven business history? • Have recent significant changes occurred in the nature of the organization? • Is monitoring of significant controls adequate? • Are accounting and IT staff organized and effective? • Is it a declining industry with increasing business failures and declining demand?
What Approach is Taken to Examine Financial Statements? Non-Traditional Examine Footnotes Comparisons of Financial Statement Balances with Similar Organizations
What Approach is Taken to Examine Financial Statements? Large Volumes Of Inventory Requires Large Volumes of Space See if Activities Match Between Organization & Standard Operations Comparisons of Financial Statement Balances with Similar Organizations
Define the Acronyms. • COSO is • SEC is • GAAP is Committee of Sponsoring Organizations Securities and Exchange Commission Generally Accepted Accounting Principles
Match Terms & Definitions. 10-K Quarterly report publicly traded companies file with SEC Government Agency responsible for regulating stock trading & financial Statements of Public companies 10-Q Annual report publicly traded companies file with SEC AAER Document released by SEC when a company commits financial statement fraud SEC
Match Terms & Definitions. Financial Statement Fraud It recommended changes in financial statements Intentionally misstating financial statements Financial Statements Reports summarizing cash & profits of an organization Treadway Commission