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14
Financial Statement Fraud
McGraw-Hill/Irwin
Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.
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Financial Statement Fraud:
Overview
 Financial
statement fraud (FSF) is any undisclosed
intentional or grossly negligent violation of generally
accepted accounting principles (GAAP) that materially
affects the information in any financial statement.
 COSO reported various general areas for FSF schemes:
 Improper
revenue recognition.
 Overstatement of assets (other than accounts receivable
related to revenue fraud).
 Understatement of expenses/liabilities.
 Misappropriation of assets.
 Inappropriate disclosure.
 Other miscellaneous techniques.
 About
half of all FSFs involve overstating revenues/assets
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Revenue Schemes
 Sham
sales
 Premature revenue recognition
 Recognition of conditional sales
 Abuse of cutoff date of sales
 Misstatement of the percentage of completion
 Unauthorized shipments or channel stuffing
 Consignment sales
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Schemes Involving
Overstating Assets
 Inventories
The most common inventory fraud involves
the overstatement of assets.
 Accounts receivable Accounts receivable are overstated
by understating allowances for bad debts or falsifying
accounts balances.
 Property, plant, and equipment In this scheme,
depreciation is not taken when it should be or property,
plant, and equipment is simply overstated. A corresponding
overstatement is made to the revenues.
 Other overstatements These involve other accounts such
as loans/notes receivables, cash, investments, etc.
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Schemes Involving Improper
Accounting Treatment
 Recording
an asset at market value or some other incorrect
value rather than cost.
 Failing to charge proper depreciation or amortization
against income.
 Capitalizing an asset when it should be expensed.
 Improperly recording transfers of goods from related
companies as sales.
 Not recording liabilities to keep them off the balance sheet.
 Omitting contingent liabilities (e.g., pending product liability
lawsuits, pending government fines, and so on) from the
financial statements.
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Characteristics of Financial
Statement Fraud
 The
median amount of the fraud is approximately 25
percent of the median total assets.
 Most frauds span multiple fiscal periods with the average
fraud time being approximately two years.
 The majority of fraud involves overstating revenues by
recording them fictitiously or prematurely.
 FSF is much more likely to occur in companies whose
assets are less than $100 million.
 FSF is much more likely to occur in companies with
decreased earnings, earnings problems, or a downward
trend in earnings.
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Characteristics of Financial
Statement Fraud
 In
a large majority of cases, either the CFO or CEO is
involved in the fraud.
 In many cases, the board of directors has no audit
committee or one that seldom meets, or none of the audit
committee members has the required skills to perform as
intended.
 The members of the board are frequently dominated by
insiders (even related to managers) or by those with
financial ties to the company.
 Auditor changes occurred about one-fourth of the time in
and around the time of the fraud.
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Characteristics of Financial
Statement Fraud
 Nearly
half of audit reports indicate some type of anomaly,
such as a change of auditors, doubts about the company’s
ability to continue as a going concern, a change in
accounting principle, or a litigation issue. Problems with
departures from GAAP seldom occur, however.
 The size of the audit firm does not seem to matter. FSF
occurs frequently in companies audited by both large and
small audit firms.
 Nearly one-third of the enforcement action cases that name
individuals allege wrongdoing on the part of the external
auditor. About half the time, the auditor is accused of
participating in a fraud; the other half the time the auditor is
accused of negligence.
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Prevention of Financial
Statement Fraud
The general philosophy behind SOX is to minimize FSF by
promoting strong corporate governance and
organizational oversight through the oversight of the
following six organizational groups.
 Board of directors
 Audit committee
 Management
 Internal auditor
 External auditor
 Public Oversight Bodies
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Prevention of Financial
Statement Fraud
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Red Flags: Indications of Possible
Financial Statement Fraud
 Lack
of Independence, Competence, Oversight, or
Diligence
 Weak Internal Control Processes
 Management Style
 Personnel-Related Practices
 Accounting Practices
 Company’s Financial Condition
 Industry Environment and Conditions
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Management Discretion, Earnings
Management, And Earnings Manipulation
 Management
Discretion. With respect to accounting
discretion, its legitimate use does not violate any ethics
guidelines although some individuals complain about its use and
would like it eliminated. Managers also make use of economic
discretion.
 The
term earnings management is used frequently confused
with earnings manipulation. The term earnings management
refers to management’s routine use of nonfraudulent accounting
and economic discretion.
 Earnings
manipulation has a more nebulous meaning. It can
refer either to the legitimate or aggressive use, or fraudulent
abuse, of discretion. By definition, then, earnings management is
legitimate, and earnings manipulation can be legitimate,
marginally ethical, unethical, or illegal, depending on its extent.
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Cookie Jar and Big Bath
Accounting
 Cookie
Jar Accounting One type of earnings
management and earnings manipulation. The practice
treats the balance sheet as a cookie jar: In good years, the
company stores cookies (reserves) in the cookie jar (the
balance sheet) so that it can take them out and eat them
(place them on the income statement) when management
is hungry (needs extra income to look good).
 Big-Bath
Accounting When a company makes a large
one-time write off, it is said to take a big bath to improve
future earnings. Many companies take a big bath (often in
the form of restructuring or inventory write-downs) when
earnings performance is already poor.