Chapter 14
Financial Statement
Fraud
Critical Thinking Exercise
A woman shoots her husband. Then she holds
him under water for over 5 minutes. Finally,
she hangs him. But 5 minutes later they both
go out together and enjoy a wonderful dinner
together. How can this be?
Fraud in Financial Statements
• Pressure on upper management to show
earnings
• Subjective nature of the way books and
records are kept
• Three general questions that go to the heart
of these crimes
– Who commits financial statement fraud?
– Why do people commit financial statement fraud?
– How do people commit financial statement fraud?
Who Commits Financial Statement Fraud?
Three main groups of people commit financial
statement fraud
– Senior management
– Mid and lower-level employees
– Organized criminals
Why Do People Commit Financial
Statement Fraud
Senior managers and business owners may
“cook the books” for several reasons
– To conceal true business performance
– To preserve personal status/control
– To maintain personal income/wealth
How Do People Commit Financial
Statement Fraud?
Three general ways in which fraudulent
financial statements can be produced:
1. Playing the accounting system
2. Beating the accounting system
3. Going outside the accounting system
NOTE: Commonly starts with the first method and
progressively incorporates the other two methods
Conceptual Framework
for Financial Reporting
I. Recognition and Measurement Concepts
A. Assumptions
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i. Economic entity
ii. Going concern
iii. Monetary unit
iv. Periodicity
B. Principles
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i. Historical cost (Fair value)
ii. Revenue recognition
iii. Matching Expenses to Revenues
iv. Full disclosure
C. Constraints
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i. Cost-benefit
ii. Materiality
iii. Industry practice
iv. Conservatism
II. Qualitative Characteristics
A. Relevance and Reliability
B. Comparability and Consistency
Responsibility for Financial Statements
• Company management is responsible
• Board of directors and senior management set
the organization’s “culture”
– “Tone at the Top”
– High integrity leads to more honest employees
Users of Financial Statements
• Potential users of financial statements
– Company’s owners
– Lending organizations
– Vendors / Customers
– Investors
• Uses of financial statements
– Increase the apparent prosperity of the
organization
– Dispel negative perceptions
– Judge employee or management performance
Types of Financial Statements
• Statement on Auditing Standards (SAS) No. 62
• Types of financial statements
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Balance sheet
Statement of income or statement of operations
Statement of retained earnings
Statement of cash flows
Statement of changes in owners’ equity
Statement of assets and liabilities that does not
include owners’ equity accounts
Statement of revenue and expenses
Summary of operations
Statement of operations by product lines
Statement of cash receipts and disbursements
Types of Financial Statements
• Other financial data presentation
– Prospective financial information
– Pro forma financial statements
– Proxy statements
– Interim financial information
– Current value financial representations
• Other comprehensive bases of accounting
– Government or regulatory agency accounting
– Tax basis accounting
* The term financial statement includes almost
any financial data presentation
Case Study:
That Way Lies Madness
Eddie Antar’s 7-Point Plan
1. Listed smuggled money from foreign banks as sales
2. Made false entries to accounts payable
3. Overstated Crazy Eddie, Inc.’s inventory by breaking
into and altering audit records
4. Took credit for “returning” merchandise while
continuing to count it as inventory
5. “Shared inventory” from one store to another to
boost stores’ audit counts
6. Arranged for vendors to ship merchandise and defer
the billing
7. Sold large lots of merchandise to wholesalers, then
spread the money to individual stores as retail
receipts
Fraudster’s Perspective
• Hide your dirty laundry in the footnotes
– Prior to 1987: Purchase discounts and trade
allowances are recognized when received
– In fiscal year 1987: Purchase discounts and trade
allowances are recognized when earned
– No disclosure was made as auditors ignored the
effects of the accounting change
– Obstruction by distraction
• Lessons from the Crazy Eddie accounts payable
fraud
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Even sophisticated investors don’t read footnotes
Audit was poorly planned, executed, and supervised
Crazy Eddie had weak internal controls
Auditors were too trusting
Types of Fraudulent Financial Statement
Schemes
Five distinct categories:
– Fictitious revenues
– Timing differences
– Concealed liabilities and expenses
– Improper disclosures
– Improper asset valuation
Defining Financial Statement Fraud
• Deliberate misstatements or omissions of
amounts or disclosures of financial statements
to deceive financial statement users,
particularly investors and creditors
• Statement on Auditing Standards (SAS) No.99
“Consideration of Fraud in a Financial
Statement Audit”
– Misstatements arising from fraudulent financial
reporting
– Misstatements arising from misappropriation of
assets
Defining Financial Statement Fraud
• Financial statement fraud may involve the
following schemes
– Falsification, alteration, or manipulation of material
financial records, supporting documents, or business
transactions
– Material intentional omissions or misrepresentations
of events, transactions, accounts, or other significant
information from which financial statements are
prepared
– Deliberate misapplication of accounting principles,
policies, and procedures used to measure, recognize,
report, and disclose economic events and business
transactions
– Intentional omissions of disclosures or presentation of
inadequate disclosures regarding accounting
principles and polices and related financial amounts
Costs of Financial
Statement Fraud
1. Undermines the reliability, quality, transparency,
and integrity of the financial reporting process
2. Jeopardizes the integrity and objectivity of the
auditing profession
3. Diminishes the confidence of the capital markets
in reliability of financial information
4. Makes the capital markets less efficient
5. Adversely affects the nation’s economic growth
and prosperity
6. Results in huge litigation costs
Costs of Financial
Statement Fraud
7. Destroys careers of individuals involved in financial
statement fraud
8. Causes bankruptcy or substantial economic losses
by the company engaged in financial statement
fraud
9. Encourages regulatory intervention
10. Causes devastation in the normal operations and
performance of alleged companies
11. Raises serious doubt about the efficacy of financial
statement audits
12. Erodes public confidence and trust in the
accounting and auditing profession
Fictitious Revenues
• Recording of sales of goods or services that did
not occur
• Artificially inflate or alter invoices of legitimate
customers
• Revenue is recognized when
1. Realized or realizable
2. Earned
• All the following criteria must be met
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Persuasive evidence of an arrangement exists
Delivery has occurred or services have been
rendered
The seller’s price to the buyer is fixed or
determinable
Collectability is reasonably assured
Fictitious Revenues
• Current conceptual guidelines for revenue
recognition
– FASB Concepts Statement No. 5
“Recognition and Measurement in Financial
Statements of Business Enterprises”
– FASB Concepts Statement No. 6
“Elements of Financial Statements”
• FASB and IASB have partnered to tackle issue
of revenue recognition
Sales with Conditions
• Sale is booked even though
– Some terms have not been completed
– The rights and risks of ownership have not passed
to the purchaser
• Recorded in an effort to fraudulently boost a
company’s revenue
• Do not qualify for recording as revenue until
conditions are satisfied
Pressures to Boost Revenues
• External pressures to succeed often provide
motivation to commit fraud
– Loan requirements by banks
• Pressures to commit financial fraud may also
be internal
– Departmental budget requirements
Red Flags Associated with Fictitious
Revenues
• Rapid growth or unusual profitability
• Inability to generate cash flows from operations while
reporting earnings
• Significant transactions with related parties or specialpurpose entities not in the ordinary course of business
• Significant, unusual, or highly complex transactions
• Unusual growth in the number of days’ sales in
receivables
• A significant volume of sales to entities whose
substance and ownership is not known
• Unusual surge in sales by a minority of units within a
company
Timing Differences
• Recording of revenues and/or expenses in
improper periods
• Shift revenues or expenses between one
period and the next
– Increase or decrease earnings as desired
Matching Revenues
with Expenses
• Revenues and corresponding expenses should
be matched in the same accounting period
– Failure to do so violates GAAP’s matching principle
• Record revenue in December and expense in
January to overstate net income at year end
Premature Revenue Recognition
• Early recognition of revenue can serve as a
catalyst to further fraud
• One or more of the criteria set forth in SEC
Staff Bulletin No. 104 are typically not met
– Persuasive evidence of an arrangement does not
exist
– Delivery has not occurred or services have not
been rendered
– The seller’s price to the buyer is not fixed or
determinable
– Collectability is not reasonably assured
Long-Term Contracts
• Completed contract method
– Does not record revenue until completion of the
project is 100% complete
– Construction costs are held in an inventory
account until completion of the project
• Percentage of completion method
– Recognizes revenues and expenses as measurable
progress on a project is made
– Vulnerable to manipulation
– Used to prematurely recognize revenues and
conceal contract overruns
Channel Stuffing
• “Trade loading”
• Sale of unusually large quantity of a product
to distributors
– Encouraged to overbuy through the use of deep
discounts and/or extended payment terms
• Attractive in industries with high gross
margins
• Steals from next period’s sales
• Raises questions about collectability of
accounts receivable
Recording Expenses in the Wrong Period
• Timely recording of
expenses is often
compromised
– Pressures to meet budget
projections and goals
• Not properly matched
against the income that
they help produce
Red Flags Associated with Timing
Differences
• Rapid growth or unusual profitability compared
to other companies in the industry
• Inability to generate cash flows from operations
while reporting earnings
• Significant, unusual, or highly complex
transactions
• Unusual increase in gross margin or margin in
excess of industry peers
• Unusual growth in the number of days’ sales in
receivables
• Unusual decline in the number of days’ purchases
in accounts payable
Concealed Liabilities and Expenses
• Significant impact on reported earnings
• Easier to commit than falsifying sales
transactions
• 3 common methods for concealing liabilities
and expenses
– Liability/expense omissions
– Capitalized expenses
– Failure to disclose warranty costs and liabilities
Liability/Expense Omissions
• Easiest method of concealing
liabilities/expenses
• Among the most difficult financial statement
schemes to uncover
• Perpetrators often believe they can conceal
their fraud in future periods
• Adelphia
Capitalized Expenses
• Costs that provide a benefit to a company
over more than one accounting period
• Overstate income in current period,
understate income in subsequent periods
• WorldCom
• Expensing capital expenditures
– Minimize income in current year for tax
considerations
– Increase income in future periods
Returns and Allowances and Warranties
• Expense associated with sales returns and
customer allowances
• Record expense as contra-sales account
– Reduce amount of net sales
• Estimated warranty expense should be
accrued as liability
Red Flags Associated with Concealed
Liabilities and Expenses
• Inability to generate cash flows from operations while
earnings growth
• Assets, liabilities, revenues, or expenses that involve
subjective judgments that are difficult to corroborate
• Nonfinancial management’s excessive participation in
selection of accounting principles or determination of
significant estimates
• Unusual increase in gross margins in excess of industry
peers
• Allowances for sales returns and warranty claims that are
out of line with industry peers
• Unusual reduction in the number of days’ purchases in
accounts payable
• Reducing accounts payable while competitors are
stretching out payments to vendors
Improper Disclosures
• Disclosures are supposed to prevent user of
financial statements from being misled
• Improper disclosures relating to financial
statement fraud
– Liability omissions
– Subsequent events
– Management fraud
– Related-party transactions
– Accounting changes
Liability Omissions
• Failure to disclose loan covenants
– Agreements that borrower has promised to keep
as long as financing is in place
– Ratio limits or restrictions on other financial
agreements
• Failure to disclose contingent liabilities
– Potential liabilities that will materialize only if
certain events occur in the future
Subsequent Events
• Events occurring or becoming known that may
have significant effect on financial statements
• Should be disclosed
• Fraudsters often avoid disclosing court
judgments
• Public record searches often reveal this
information
Management Fraud
• Must disclose fraud committed by officers,
executives, and others in position of trust
• Withholding such information likely involves
lying to auditors, an illegal act
Related-Party Transactions
• Business with entity that is significantly
influenced by company
• “Self-dealing”
• Legal as long as they are fully disclosed
• Arm’s length
• Tyco
Accounting Changes
• Statement of Financial Accounting Standards
No. 154 (SFAS 154) “Accounting Changes and
Error Corrections”
– Accounting principles
– Estimates
– Reporting entities
• Fraudster may not restate if change causes
financial statements to appear weaker
Red Flags Associated
with Improper Disclosures
• Domination of management by a single person
without compensating controls
• Ineffective board of directors or audit committee
oversight
• Significant related-party transactions not in
ordinary course of business
• Overly complex organizational structure
• Recurring attempts by management to justify
marginal or inappropriate accounting
• Restrictions on the auditor that limit access to
people or information
Improper Asset Valuation
• Misclassification of long-term assets as
current assets
– “Window dressing”
• Improper asset valuation categories
– Inventory valuation
– Accounts receivable
– Business combinations
– Fixed assets
Inventory Valuation
• “Lower of cost or market value”
• Manipulation of physical inventory count
• Inflation of unit costs used to price out
inventory
• Failing to relieve inventory for costs of goods
sold
• Phantom inventory
Accounts Receivable
• Should be reported as net realizable value
• Fictitious accounts receivable
– Common at end of accounting period
– False confirmations of balances to auditors
• Failure to write down
– Required to accrue losses on uncollectable
receivables
• Financial Accounting Standards Board Statement No. 5
– Record impairment of long-lived assets and
goodwill
• Statement of Financial Accounting Standards No. 144
• Statement of Financial Accounting Standards No. 142
Business Combinations
• Required to allocate purchase price to tangible
and intangible assets
• Changes in goodwill accounting
• Companies still may be tempted to
– over-allocate purchase price to in-process R&D
assets
– Establish excessive reserves for various expenses
to release at a future date
Fixed Assets
Common fixed asset schemes
– Booking fictitious assets
– Misrepresenting asset valuation
– Understating assets
– Capitalizing non-asset cost
– Misclassifying assets
Red Flags Associated
with Improper Asset Valuation
• Inability to generate cash flows from operations earnings
growth
• Significant declines in customer demand and increasing
business failures
• Unusual change in the relationship between fixed assets and
depreciation
• Adding to assets while competitors are reducing capital tied
up in assets
• Allowances for bad debts, excess and obsolete inventory that
are out of line with industry
Detection of Fraudulent Financial
Statement Schemes
• Financial statement analysis
– Vertical analysis (percentage analysis)
• Analyze relationships between items on income
statement, balance sheet, or statement of cash flows
– Horizontal analysis (percentage analysis)
• Analyze percentage change in individual financial
statement items from one year to the next
– Ratio analysis
• Measure relationship between 2 different financial
statement amounts
Deterrence of Financial Statement Fraud
• More complex than deterring asset
misappropriation and other frauds
• 83% of financial statement frauds involved
CEO or CFO
• Executives use their authority to override
most internal controls
Reduce Pressure to Commit
Financial Statement Fraud
• Establish effective board oversight of the “tone at
the top” created by management
• Avoid setting unachievable or unreasonable goals
• Avoid applying excessive pressure on employees
to achieve goals
• Change goals if changed market conditions
require it
• Ensure compensation systems are fair and do not
create too much incentive to commit fraud
• Discourage excessive external expectations of
future corporate performance
• Remove operational obstacles blocking effective
performance
Reduce the Opportunity to Commit
Financial Statement Fraud
• Maintain accurate and complete internal accounting
records
• Carefully monitor business transactions and
interpersonal relationships between financial units
• Establish a physical security system to secure
company assets
• Divide important functions among employees
• Encourage strong supervisory and leadership
relationships to enforce accounting procedures
• Establish clear and uniform accounting procedures
with no exception clauses
Reduce Rationalization of
Financial Statement Fraud
• Promote strong values throughout the organization
• Clearly define prohibited behavior
• Provide regular training to all employees
communicating prohibited behavior
• Have confidential advice and reporting mechanisms
• Communicate that integrity takes priority over goals
• Ensure management practices what it preaches
• The consequences of violating the rules and
punishment of violators should be clearly
communicated