Fraud Examination, 4E

1. Chapter 11: Financial Statement Fraud Fraud Examination, 4E

2. Learning Objectives © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Discuss the role that financial statements play in capital markets. Understand the nature of financial statement fraud. Become familiar with financial statement fraud statistics. See how financial statement frauds occur and are concealed. Outline the framework for detecting financial statement fraud.

3. Learning Objectives © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Identify financial statement fraud exposures. Explain how information regarding a company’s management and directors, nature of organization, operating characteristics, relationship with others, and financial results can help assess the likelihood of financial statement fraud.

4. Financial statements play a very important role in keeping capital markets efficient. Financial statements are based on generally accepted accounting principles (GAAP), which guide the accounting for transactions. Role of Financial Statements © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

5. Financial Statement Fraud • Financial statements are sometimes prepared in ways that intentionally misstate the financial position and performance of an organization. • Misstatement of financial statements can result from manipulating, falsifying, or altering accounting records. • Misleading financial statements cause serious problems in the market and the economy. © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

6. Misleading financial statements cause serious problems: large losses by investors lack of trust in the market and accounting systems litigation and embarrassment for individuals and organizations associated with financial statement fraud Financial Statement Fraud © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

7. Misstated financial statements and “cooking the books.” Examples: Qwest Enron Global Crossing WorldCom Xerox Examples of Financial Statement Fraud © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

8. Examples of Financial Statement Fraud • Inappropriate executive loans and corporate looting. • Examples: • John Rigas (Adelphia) • Dennis Kozlowski (Tyco) • Bernie Ebbers (WorldCom) © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

9. Insider trading scandals Example: Martha Stewart and Sam Waksal, both used insider information to profit from trading ImClone stock Examples of Financial Statement Fraud © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

10. Why These Frauds Occurred © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

11. Elements of the Perfect Fraud Storm • A Booming Economy • Decay of Moral Values • Misplaced Incentives • High Analysts’ Expectations • High Debt Levels • Focus on Accounting Rules Rather Than Principles • Lack of Auditor Independence • Greed • Educator Failures © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

12. Nature of Financial Statement Fraud © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Involves intentional deceit Involves attempted concealment Rarely seen Many false red flags Conviction is very difficult Because of the difficulty of detecting and proving fraud , investigators must exercise extreme care when performing fraud examinations, quantifying fraud, or performing other types of fraud-related engagements.

13. Fraud Statistics (Between 1987 – 1997) © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The average fraud last about two years Improper revenue recognition, overstatement of assets, and understatement of expenses were the most common frauds Cumulative average magnitude of fraud was $25 million ($4.1 million median) CEO perpetrated the fraud in 72 percent of the cases

14. Fraud Statistics (Between 1987 – 1997) © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Fraudulent companies’ size: Average assets were $532 million ($16 million median) and $232 million average revenues ($13 million median) Severe consequences were usually associated with companies having fraudulent financial statements Most of these firms had no audit committee, or one that met only once per year

15. Fraud Statistics (Between 1987 – 1997) © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Boards of directors were dominated by insiders and “grey” directors Some companies were experiencing net losses or were close to break-even positions 25% of the companies changed auditors during the fraud period

16. Detecting Financial Statement Fraud Strategic Reasoning The ability to anticipate a fraud perpetrator’s likely method of concealing a fraud © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

17. Detecting Financial Statement Fraud © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Strategic Reasoning Questions to ask: • What types of fraud schemes is management likely to use to commit financial statement fraud? • What typical tests are used to detect these schemes? • How could management conceal the scheme of interest from the typical test? • How could the typical test be modified so as to detect the concealed scheme?

18. Detecting Financial Statement Fraud Financial Statement Analysis Focus on the changes in reported assets, liabilities, revenues, and expenses from period to period or by comparing company performance to industry norms. © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Not just general financial statement analysis – think outside the box……

19. Detecting Financial Statement Fraud • Nonfinancial Performance Measures • Look for a discrepancy between the company’s financial and nonfinancial performance • Example: • Former HealthSouth CEO Richard Scrushy’s • The company’s revenues and assets were increasing while the number of HealthSouth facilities decreased © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

20. Detecting Financial Statement Fraud © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

21. Management and Directors • Investigate three aspects of management: • Managements’ backgrounds • Managements’ motivations • Managements’ influence in making decisions for the organization © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

22. Relationship with Others • Relationships should be examined to determine if they present management fraud opportunities or exposures. • Carefully consider relationships with: • related organizations and individuals • external auditors • lawyers • Investors • regulators • bondholders © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

23. Organization and Industry • Some industries are more risky than others. • Attributes of fraud-prone organizations: • unduly complex organizational structure • without an internal audit department • board of directors with no or few outsiders on the board or audit committee • one person or a small group of individuals controls related entities • has offshore affiliates with no apparent business purpose © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

24. Financial Results and Operations • Critical questions that must be asked: • Are unrealistic changes or increases present in financial statement account balances? • Are account balances are not realistic given the nature, age, and size of the company? • Do actual physical assets do not exist in the amounts and values indicated on the financial statements? • Have there been significant changes in the nature of the organization’s revenues or expenses? © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.