Fraudulent Financial Reporting

1. Fraudulent Financial Reporting C. Delano Gray

2. Accounting Concepts Fraudulent acts are usually of a financial nature. The fraud examiner must understand the essential nature of financial transactions and how they affect records. The fraud examiner should have a grasp of financial terminology as well as accounting theory.

3. Accounting can be defined as the identification, accumulation, measurement, and communication of economic data about an enterprise for decision-makers and other interested parties. The measurement and recording of this data are accomplished through keeping a balance of the accounting equation. The accounting model or accounting equation is the basis for all double-entry accounting Accounting Basics 1

4. Accounting Basics 2 By Definition: TheAssets side of the equation consists of the net resources owned by an entity. Examples of assets include cash, receivables, inventory, property, and equipment as well as intangible items of value such as patents, licenses, and trademarks. To qualify as an asset, an item must be • owned by the entity and (2) provide future benefit. The Liabilities are the obligations of an entity or an outsider’s claim against a company’s assets. Liabilities are generally incurred through the acquisition of assets or by operational expenses.

5. Accounting Basics 3 Owners’ Equity represents the investment of the owners in the company plus accumulated profits (revenues less expenses). Owner’s equity is equal to assets minus liabilities.

6. Accounts and the Accounting Cycle The major items of the accounting equation are made up of numerous detail accounts. An account is nothing more than a specific accounting record that provides an efficient way to categorize similar transactions. All transactions are recorded in accounts that are categorized under assets accounts, liability accounts, owners’ equity accounts, revenue accounts, and expense accounts. Account format occurs in a number of ways. The simplest, most fundamental format is to use a large letter T, often referred to as a T account. Examples of T accounts are cash, inventory, notes payable, and common stock.

7. Accounts in the Salesand Collection Cycle Sales Cash sales Sales on account Cash in Bank Cash Discounts Taken Accounts Receivable Beginning Cash receipts balance Sales returns Sales on and allowances account Charge-off of Ending uncollectible balance accounts Sales Returns and Allowances Bad Debt Expense

8. Accounts and Transactions in thePayroll and Personnel Cycle Accrued Wages, Salaries, Bonuses, and Commissions Payment Beginning balance Earned wages, salaries, etc. Ending balance Cash in Bank Payment for salaries Payment for payroll taxes Direct Labor Withheld Income Taxes and Other Deductions Payment Beginning balance Payroll withholding Ending balance

9. Accounts in the Acquisitionand Payment Cycle Raw Material Purchases Cash in Bank Accounts Payable Cash Acquisitions disbursements of goods and services Purchase returns and allowances Purchase discounts Purchase Returns and Allowances Property, Plant, and Equipment Purchase Discounts Prepaid Expenses

10. Inventory and Warehousing Cycle 1 Raw Materials Work in Process Beginning inventory Raw materials used Purchases Ending inventory Manufacturing Direct Labor Manufacturing Overhead Actual Applied Actual Applied

11. Inventory and Warehousing Cycle 2 Work in Process Finished Goods Beginning inventory Ending inventory Beginning inventory Ending inventory Cost of goods sold Cost of goods manufactured Cost of Goods Sold

12. Capital Acquisition andRepayment Cycle

13. Notes Payable and the Related Interest Accounts Notes Payable Interest Expense Payments of principal Beginning balance Interest expense Issue of new notes Interest Payable Ending balance Payments of interest Beginning balance Cash in Bank Interest expense Issue of new notes Payments of principal Ending balance Payments of interest

14. Financial Statements and Fraud Schemes

15. The results of accounting are reports or financial statements concerning the assets, liabilities, and operating results of an entity. The balance sheet of a company is an expansion of the accounting equation. That is, it lists all assets on one side of the page and all liabilities and owners; equity on the other side. While assets and liabilities are easy to understand, owners’ equity requires more explanation. Financial Statements 1

16. Financial Statements 2 • The owner's equity in a firm usually represents amounts from two sources-from undistributed earnings (usually referred to as retained earnings) and from owner contributions (usually referred to as common or capital stock). • The balances in the capital stock account increase only when the owners invest in a company. The retained earnings balance increases when a company has earnings and decreases when a company has losses or when distributed earnings go to the owners in the form of dividends. Thus, the basic accounting equation expands.

17. Transaction Flow 1 Transaction Occurs 2 Purchase Orders, Receipts and other Documents 3 Transaction Recorded Posted to Individual Accounts 4 Generate Financial Statements

18. Accounting Users and Rules • Generally Accepted Accounting Principles (GAAP) FASB (Financial Accounting Standards Board 1973-….) FASB Interpretations APB (Accounting Principles Board 1962-1973) ARB Bulletins (Accounting Research Bulletins 1939-1959) GAAS (Generally Accepted Auditing Standards) SAS (Statements of Auditing Standards)

19. Accounting Terms (Some) • Historical Cost • Revenue Recognition • Matching • Consistency • Full Disclosure • Going Concern • Materiality • Industry Practice

20. Fraud Investigation Fraud investigation often requires an understanding of the debit-and-credit process. For example: • A fraud examiner who is searching for a mysterious $5,000 disappearance of cash finds a debit in the legal expense account and corresponding credit in the cash account for $5,000 and cannot find genuine documentation for the charge. • He can then reasonable suspect that a perpetrator may have attempted to conceal the theft by labeling the stolen $5,000 as legal expense

21. Financial Schemes • Corruption: Conflict of Interest Kickbacks Bid Rigging Illegal Gratuities Economic Extortion

22. Financial Schemes • Asset Misappropriation Cash Larceny Fraudulent Disbursements Skimming Inventory Misuse

23. Financial Schemes • Fraudulent Statements: Financial: Asset /Revenue Overstatement Asset/Revenue Understatement Timing Differences Fictitious Revenues Concealed Liabilities & expenses

24. Financial Schemes • Non Financial: Employment Credentials Internal Documents External Documents

25. Financial Statement Fraud Deliberate Misrepresentation Of the Financial Condition an Organization by intentional misstatement or omission of amounts or disclosures to Deceive Users

26. Cost RESTATEMENTS COST 100 B IN MARKET CAPITALIZATION (GAO 2002)

27. Why Frauds are Committed • Encourage investment in Stock Sales • Increase earnings per share • To cover cash flow • Obtain financing • Meet Company Goals

28. Opportunities • Absence of or weak controls • Absence of or weak oversight • Unusual or complex transactions • Subjective financial estimates by Management

29. Methods • Improper Revenue Recognition • Misstatement of Assets Primarily receivables and inventory. • Absence of an Audit Committee • “Friendly” Directors

30. Most Prevalent • Fictitious Revenues • Timing Differences • Improper Asset Valuation • Concealed Liabilities • Improper Disclosure

31. Fictitious Revenue • Recording of goods and services that did not occur • Fictitious Sales • Sales with conditions

32. Indicators • Rapid growth • Unusual Profitability • Recurring negative cash flow • Sale of Assets • Related Party Transactions • Significant or high volume of complex transactions • Increase in days sales to receivables • Increase in sale to unknown parties.

33. Situational Pressures • Sudden decreases in market share • Sudden decreases in revenues • Unrealistic budget demands, especially short term • Financial pressures form incentive plans, usually related to short term performance.

34. Revenue Recognition Revenue should recognized when: • An arrangement exists • Delivery has occurred • Price fixed or determinable • Assurance of collectibility Particularly difficult for long term contracts where payments are dependent on partial completion over time.

35. Timing Differences • Transactions not recorded in their proper time period. Usually done to shift revenues or expenses between time periods

36. Improper Asset Valuation • Valuation method • “Lower of cost or Market” • “Mark to Market” Assets held for Sale. • Accounts Receivable-Impairment of Long Lived Assets (SFAS 144) • Capitalization of Expenses. • Misclassification of Assets

37. Indicators (Some) • Recurring negative cash flow accompanied by earnings or earnings growth • Subjective valuation methods • Bad debt allowances out of line with pass performance or peers • Change in relationship between depreciation and fixed assets

38. Liabilities/Expenses Omissions • Capitalizing Expenses • Expensing Capital Expenditure • Return Allowances and Warranties

39. Disclosures • Liability Omissions-Loan Covenants and Contingent Liabilities • Subsequent Events • Management Fraud • Accounting Changes

40. Indicators (Some) • Domination of Management • Ineffective Board of Directors, Audit Committee or Internal Controls • Complex Organization Structure • Significant Transactions with Off_Shore Tax Sheltered Subsidiaries

41. Financial Statement Analysis • Ratio Analysis • Percentage Analysis. Note: Analysis are not evidence but provide trends from time period to time period. Further investigation must be conducted to support any possible abnormal of irregular trends.

42. Asset Misappropriation

43. Asset Misappropriation Asset Misappropriation is the most common of occupational fraud. • Cash Theft-Including theft of incoming checks and lapping • Cash Disbursement Fraud • Inventory Theft • Receivables Manipulation

44. Cash Theft • Ring “no sale” on register • Manipulate register tape • No receipt issued • Destroy store copy of receipt • Substitute check for cash

45. Result of Cash Theft • Understated sales • False discounts Note: Contributory factor to aid theft: • Poor Collection Procedures • Poor Supervision • Absence of or lack of proper control procedures

46. Cash Disbursement • False refunds • Fictitious refunds • Overstated refunds • Credit Card refund • False voids

47. Cash Disbursement Concealment: • Destroy detail tapes • Refund below review limits • Conceal shortages of inventory • Force Totals • Write as obsolete

48. Prevention • Proper segregation of duties • Enforce control over reimbursements • Follow up on inquiries from bank and customers. • Proper review of refund expense accounts

49. Indicators (Some. More??) • Improper segregation of duties • Cashiers with access to supervisory override • Employee with authority to void own transactions • Personal Checks in cashiers register • Inordinate number of refunds, voids and no-sale transactions

50. Fraud In Financial Institutions