Fraudulent Financial Statement Schemes

1. Fraudulent Financial Statement Schemes

2. Pop Quiz Name at least three of the five principle financial statement fraud schemes.

3. Financial Statement Fraud Defined • Deliberate • misstatements or omissions • deceive users

4. Specifically • Falsification, alteration, or manipulation • Material intentional omissions or misrepresentations • Deliberate misapplication of accounting principles, policies, and procedures • Intentional omissions of or inadequate disclosures or presentation

5. Costs I • More than 50% of U.S. corporations are victims of fraud with losses of more than $500,000 • Investors, employees, pensioners • Enron, WorldCom, Quest,Global Crossing, and Tyco’s • What might some other fraud costs be?

6. Costs II • Financial reporting process undermined • Integrity of auditing profession • Capital markets lose confidence • Capital markets less efficient

7. Costs III • Economic growth and prosperity • Litigation costs • Destroys careers • Bankruptcy or substantial economic losses

8. Costs IV • intervention • Inefficiency • Doubts re: audits • Public confidence and trust

9. Types • Fictitious revenues • Timing differences • Improper asset valuations • Concealed liabilities and expenses • Improper disclosures

10. Fictitious Revenues • Fake sales, customers • Legitimate customers • Conditional sales

11. Red Flags – Fictitious Revenues • Rapid growth • unusual profitability • Negative CFO with positive NI • Related party/SPE transactions

12. Red Flags – Fictitious Revenues • Complex transactions • ↑ number of days’ sales in receivables • Sales to unknown entities • An unusual surge in sales

13. Timing Differences • Improper periods • Shifting revenues or expenses • Matching revenues with expenses • Premature revenue recognition • Long-term contracts • Channel stuffing

14. Red Flags – Timing Differences • Rapid growth or unusual profitability • Negative CFO with positive NI • Complex transactions • ↑ number of days’ sales in receivables • ↓ number of days’ purchases in accounts payable

15. Concealed Liabilities • Liability/expense omissions • Capitalized expenses • Warranties • Contingencies

16. Red Flags – Concealed Liabilities • Negative CFO with positive NI • Significant estimates • CEO obsession with GAAP selections • Unusual ↑ in gross margin • Unusual SRA, warranty claims • ↓ the number of days’ purchases in accounts payable • Out of line with competitors

17. Improper Disclosures • Liability omissions • Subsequent events • Management fraud • Related-party transactions • Accounting changes

18. Red Flags – Improper Disclosures • Domination of management • Ineffective board of directors • Tone at the top • Rapid growth or unusual profitability

19. Red Flags – Improper Disclosures • Significant, unusual, or highly complex transactions, • Significant related-party transactions • tax haven bank accounts • Overly complex organizational structure

20. Red Flags – Improper Disclosures • Known history of violations • Materiality justifications • Limitation of auditor access

21. Improper Asset Valuation • Inventory valuation • Accounts receivable • Business combinations • Fixed assets

22. Red Flags – Improper Asset Valuation • negative cash flows with positive earnings. • Declining business/economy • Lots of assets based on estimates • CEO obsession on GAAP choices • Gross margin ↑ compared to industry

23. Red Flags – Improper Asset Valuation • ↑ the number of days’ sales in receivables • ↑ number of days’ purchases in inventory • ↓Allowances for bad debts, inventory • Unusual change in the relationships • Increasing assets when competitors are reducing

24. Detection of Fraudulent Financial Statement Schemes • SAS 99 – Consideration of Fraud in a Financial Statement Audit • “The auditor has a responsibility to plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether caused by error or fraud.”

25. SAS 99 • Two major types of fraud • Professional skepticism • Discussion of risk

26. SAS 99 • Obtaining information needed to identify risks of material misstatement due to fraud • Inquiries of management • Unusual or unexpected relationships • Fraud risk factors exist. • Other information

27. SAS 99 • Identifying risks that may result in material misstatement due to fraud • Type • Significance • Likelihood • Pervasiveness • Assessing the identified risks after taking into account an evaluation of the entity’s programs and controls • Specific controls • Broader programs

28. SAS 99 • Responding to the results of the assessment • Overall responses • nature, timing, and extent of procedures • risk of management override of controls • Examining journal entries and other adjustments • Reviewing accounting estimates • Evaluating the business rationale

29. SAS 99 • Evaluating audit evidence • Assessing risks of material misstatement • Evaluating analytical procedures • at or near the completion of fieldwork • misstatements that may be the result of fraud

30. SAS 99 • Communicating about fraud to management, the audit committee, and others • even if considered inconsequential • Internal controls  management • Disclosing possible fraud to outside parties

31. SAS 96 – Audit Documentation • list of factors • new requirements • Retains much of the ownership/record retention guidance of SAS 41 • Contains amendments adding specific documentation requirements to other SASs

32. Financial Statement Analysis • Vertical analysis • Horizontal analysis • Ratio analysis

33. Deterrence of Financial Statement Fraud • Reduce pressures • Reduce the opportunity • Reduce rationalization

34. Reduce Pressures to Commit Financial Statement Fraud • “tone at the top”. • Unachievable goals. • excessive pressure. • Recognize changing market • Fair compensation systems • excessive external expectations • Remove operational obstacles blocking effective performance.

35. Reduce the Opportunity to Commit Financial Statement Fraud • internal accounting records. • monitor the business transactions and interpersonal relationships • physical security system. • Accurate personnel records. • Strong supervisory and leadership relationships. • Clear and uniform accounting procedures

36. Reduce Rationalization of Financial Statement Fraud • Tone @ the top. • Strong policies. • Training • Anonymous tip procedure • Communications • Walk the talk