Fraud Examination, 4E
Chapter 11: Financial Statement Fraud
Albrecht, Albrecht, Albrecht, Zimbelman
Learning Objectives
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.
Albrecht, Albrecht, Albrecht, Zimbelman
© 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
Learning Objectives
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.
Albrecht, Albrecht, Albrecht, Zimbelman
© 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
Role of Financial Statements
 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.
Albrecht, Albrecht, Albrecht, Zimbelman
© 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
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.
Albrecht, Albrecht, Albrecht, Zimbelman
© 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
Financial Statement Fraud
 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
Albrecht, Albrecht, Albrecht, Zimbelman
© 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
Examples of Financial
Statement Fraud
 Misstated financial
statements and
“cooking the books.”
 Examples:
 Qwest
 Enron
 Global Crossing
 WorldCom
 Xerox
Albrecht, Albrecht, Albrecht, Zimbelman
© 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
Examples of Financial
Statement Fraud
Inappropriate executive loans and corporate
looting.
 Examples:
 John Rigas (Adelphia)
 Dennis Kozlowski (Tyco)
 Bernie Ebbers (WorldCom)
Albrecht, Albrecht, Albrecht, Zimbelman
© 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
Examples of Financial
Statement Fraud
 Insider trading
scandals
 Example:
 Martha Stewart and
Sam Waksal, both
used insider
information to profit
from trading
ImClone stock
Albrecht, Albrecht, Albrecht, Zimbelman
© 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
Why These Frauds Occurred
Albrecht, Albrecht, Albrecht, Zimbelman
© 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
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
Albrecht, Albrecht, Albrecht, Zimbelman
© 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
Nature of Financial
Statement Fraud
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.
Albrecht, Albrecht, Albrecht, Zimbelman
© 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
Fraud Statistics (Between
1987 – 1997)
 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
Albrecht, Albrecht, Albrecht, Zimbelman
© 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
Fraud Statistics (Between
1987 – 1997)
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
Albrecht, Albrecht, Albrecht, Zimbelman
© 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
Fraud Statistics (Between
1987 – 1997)
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
Albrecht, Albrecht, Albrecht, Zimbelman
© 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
Detecting Financial
Statement Fraud
 Strategic Reasoning
 The ability to anticipate a fraud perpetrator’s likely method
of concealing a fraud
Albrecht, Albrecht, Albrecht, Zimbelman
© 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
Detecting Financial
Statement Fraud
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?
Albrecht, Albrecht, Albrecht, Zimbelman
© 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
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.
Not just general financial
statement analysis –
think outside the box……
Albrecht, Albrecht, Albrecht, Zimbelman
© 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
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
Albrecht, Albrecht, Albrecht, Zimbelman
© 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
Detecting Financial
Statement Fraud
Albrecht, Albrecht, Albrecht, Zimbelman
© 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
Management and Directors
Investigate three aspects of management:
 Managements’ backgrounds
 Managements’ motivations
 Managements’ influence in making decisions for the
organization
Albrecht, Albrecht, Albrecht, Zimbelman
© 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
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
Albrecht, Albrecht, Albrecht, Zimbelman
© 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
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
Albrecht, Albrecht, Albrecht, Zimbelman
© 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
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?
Albrecht, Albrecht, Albrecht, Zimbelman
© 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