DRAFT
COMMON FINANCIAL STATEMENT FRAUD SCHEMES
Jamal Ahmad, JD., C.P.A.
David Jansen, C.A.
Jonny J. Frank, J.D., LL.M.
Contents
1 Introduction
2 Categories of Fraud
3 Fraudulent Financial Reporting
3.1 Earnings Management Methods Permissible by GAAP; The “Grey Zone”
3.2 Earnings Management Methods Not Permissible by GAAP
4 Overview of Largest Fraudulent Financial Reporting Cases
(1997 – 2002)
5 Improper Revenue Recognition
5.1 Reviewing for and Investigating Allegations of Improper Revenue
Recognition
5.1.1 Accounting Policies and Customer Contracts
5.1.2 Forensic Auditing Techniques
5.2 Side Agreements
5.3 Liberal Return, Refund Or Exchange Rights
5.4 Channel Stuffing
5.5 Early Delivery Of Products
5.5.1 Partial Shipments
5.5.2 Soft Sales
5.5.3 Contracts With Multiple Deliverables
5.5.4 Up-Front Fees
5.6 Bill and Hold Transactions
5.7 Fictitious Revenue Schemes
5.7.1 Fictitious Sales
5.7.2 Round Tripping
5.8 Other Improper Recognition Schemes
5.8.1 Recognizing Revenue On Disputed Claims Against Customers
5.8.2 Holding The Books Open Past The End Of A Period
5.8.3 Recognizing Income On Consignment Sales Or On Products
Shipped For Trial Or Evaluation Purposes
5.8.4 Construction Accounting Schemes
5.8.5 Sham Related Party Transactions
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Asset Overstatement/Liability Understatement Schemes
6.1 Inventory Schemes
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6.1.1 Inflating Inventory Quantity (Fictitious Inventory)
6.1.2 Inflating Inventory Value
6.1.3 Fraudulent Or Improper Inventory Capitalization
6.2 Accounts Receivable Schemes
6.2.1 Creating Fictitious Receivables
6.2.2 Artificially Inflating The Value Of Receivables
6.3 Investment Schemes
6.3.1 Fictitious Investments
6.3.2 Manipulating The Value Of Investments
 Misclassification of Investments Recording Unrealized
 Declines in Fair Market Value/Overvaluation
6.4 Improper Capitalization of Expenses
6.4.1 Software Development
6.4.2 Research and Development
6.4.3 Start Up Costs
6.4.4 Interest Costs
6.4.5 Advertising Costs
6.5 Recording Fictitious Fixed Assets
6.6 g Depreciation and Amortization Schemes
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Understatement of Liabilities
7.1 General
7.2 Off Balance Sheet Entity Schemes
7.2.1 Off Balance Sheet Treatment versus Consolidation
7.2.2 The Old Rules
7.2.3 The “New” Rules
7.3 Overstatement of Liability Reserves (“Cookie Jar Reserves”)
8. Improper or Inadequate Disclosures
9. Materiality
10 Misappropriation of Assets
10.1 Misappropriation of Cash
10.1.1 Skimming of Cash
 Unrecorded or Understated Sales or Receivables
 Lapping
10.1.2Fraudulent Disbursements
 Billing Schemes - Creation of Fictitious Vendors or Shell
Companies to Convert Monies
 Billing Schemes - False Credits, Rebates, Refunds and
Kickbacks
 Billing Schemes - Over billing
 Billing Schemes - Pay and Return Schemes
 Theft of Company Checks
 Payroll Fraud - Ghost Employees
 Payroll Fraud - Falsified Hours
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10.2 Misappropriation of Inventory Conversion of Inventory
10.2.1Conversion of Inventory
10.2.2False Write-Off’s and Other Debits to Inventory
10.2.3False Sales of Inventory
11. Other Fraudulent Revenue and Expenditures
11.1 Revenue And Assets Obtained By Fraud
11.2 Expenditures and Liabilities For An Improper Purpose
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1. Introduction
Statement on Auditing Standards No. 991 (“SAS 99”) requires auditors to focus
on two broad areas of fraud: (i) fraudulent financial reporting and (ii)
misappropriation of assets. Each of these has a multitude of fraud schemes.
This chapter provides an overview of the most common financial statement fraud
schemes, indicators of their occurrence, and methods of detection.
The focus is to familiarize the reader with certain fraud schemes, the various
indicators which evidence that these schemes may be or are being perpetrated
and how an auditor might detect those schemes. While this chapter discusses
numerous fraud schemes, it does not contain a comprehensive list of all possible
schemes.
Similarly, with respect to the listed schemes, space constraints
prevent discussion of all possible detection procedures the auditor can perform to
determine whether the particular scheme exists.
2. Categories of Fraud
Fraud schemes can be grouped in various categories. For example, from a legal
perspective, frauds can be distinguished between: frauds by the corporation and
frauds against the corporation. Frauds committed by the corporation carry legal
risk, that is, potential civil, regulatory, and criminal liability. Frauds committed
against the corporation carry financial risk, that is, the loss of income or assets.
External and internal misappropriations of assets are by far the most common
fraud against the corporation.
This chapter groups, financial frauds into four broad categories:

Fraudulent Financial Reporting Schemes;

Misappropriation Of Assets;

Revenue And Assets Obtained By Fraud and

Expenditures and Liabilities For An Improper Purpose
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Most auditors would consider only to the first two categories (fraudulent financial
reporting and misappropriation of assets) to be financial statement frauds. The
final two categories although financial in nature, are not generally considered to
be financial statement frauds, as they do not impact upon the balances in the
financial statements.
3. Fraudulent Financial Reporting
Most fraudulent financial reporting schemes involve “earnings management”,
which the Securities and Exchange Commission (“SEC”) has defined as “the use
of various forms of gimmickry to distort a company’s true financial performance in
order to achieve a desired result.”2
Earnings management, however, does not always involve outright violations of
Generally Accepted Accounting Principles (“GAAP”) - - more often than not,
entities manage earnings by choosing accounting policies that bend GAAP to
attain earnings targets. Thus, it is important to distinguish between earnings
management techniques that are aggressive in nature but otherwise permitted by
GAAP, and those that clearly violate GAAP.
Accountants working with public companies, however, take note. The SEC takes
the position that compliance with GAAP will not necessarily protect an entity from
an SEC enforcement action, if financial performance is distorted.3
3.1 Earnings Management Techniques Permissible Under GAAP:
The “Grey Zone”
GAAP frequently allows management alternative ways to record the operations
of an entity. For instance, GAAP allows any depreciation method, so long as it
systemically and rationally allocates the cost of the asset over its useful life. 4
Similar instances in which management is provided wide latitude include:
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Changing depreciation methods from an accelerated method to the more
conservative straight-line method or vice versa;
Changing the useful lives or the estimates of salvage values of assets;
Determining the appropriate allowance required for uncollectible accounts
receivable;
Determining whether/when assets have become impaired and are
required to be reserved against or written off;
Choosing an appropriate method of inventory valuation (LIFO, FIFO,
specific identification etc.);
Determining whether a decline in the market value of an investment is
temporary or permanent; and
Estimating the write-downs required for investments.
Thus, in certain instances, GAAP “allows” a company to manage earnings by
simply altering its accounting policy to select those accounting principles that
benefit it most.
The SEC itself has noted that accounting principles are not
meant to be a straightjacket and that flexibility of accounting is essential to
innovation.5 Abuses occur, however, when this flexibility is exploited to distort
the true picture of the corporation.6
Entities have a host of reasons for selecting those principles that will paint the
rosiest financial picture.
Some would argue that the market demands it, as
reflected by the stock price punishment for companies that differ by as little as
one penny per share from prior estimates. External market pressures to “meet
the numbers” conflicts with market pressure for transparency in financial
reporting.
Often, it is difficult to distinguish between “aggressive”, but allowable accounting
and that which is abusive and prohibited. How, for example, does one determine
whether management’s reserve for uncollectible accounts is or is not
reasonable?
The line between aggressive and fraudulent behavior hinges on management ‘s
intent. Fraud rarely occurs if management’s intent is transparent and clearly
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understandable.
What, however, if management selects a GAAP permissive
policy to conceal a fraud or error? Does the selection of the otherwise allowed
policy demonstrate intent to commit fraud? Consider also whether management
selects a policy that it knows will have both a positive and negative effect on the
financial picture. If management selects the policy but refuses to recognize the
negative effect, does that demonstrate fraud in the selection of the policy?
Whether a fraud has been committed is fact-specific.
For purposes of this
chapter, we have assumed that management has acted with malicious intent.
The case examples cited also involve instances where the company and/or its
management was charged and most often found guilty of wilfully engaging in the
alleged misconduct.
3.2 Earnings Management Methods Not Permissible by GAAP
Some financial frauds have no grey; that is, earnings management that are
clearly not within the parameters of GAAP.
These techniques can inflate
earnings, create an improved financial picture, or conversely, mask a
deteriorating one.
Examples cited by the SEC include:

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“Big Bath” charges;
Creative acquisition accounting;
“Cookie jar” liability reserves;
Use of materiality to record small but intentional misstatements in the
financial statements; and
Revenue recognition irregularities.7
4. Overview of Largest Fraudulent Financial Reporting Fraud Cases
(1997 – 2002)
To demonstrate the breadth of recent fraud cases, the table below outlines some
of the larger and more publicized frauds and accounting scandals detected over
the period 1997 – 2002.
The schemes involved an array of industries and
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included both frauds “by” and “against” the entity as well as corporate
misconduct.
Company
Fraud Scheme
Result
Adelphia
Communications
Misappropriation of firm assets
by executives for personal use.
Concealment of $2.3 billion in
loans to cover losses by founder
and family members.
As a result of its merger of HFC
with CUC International, it was
revealed that CUC overstated
revenue by $500 million between
1995 and 1997 using assorted
techniques such as recording
fictitious
revenues
and
understating liabilities.
Declared
bankruptcy
in
January 2002.
CEO and
family members charged with
fraud.
Cendant Corp.
Enron
Overstated
income
by
intentionally
understating
liabilities and concealing debt
through the creation of off
balance sheet entities.
Inadequately disclosed Co.’s off
balance sheet transactions.
Possible tax evasion.
Global Crossing
Charged with using "swap deals"
with other telecom carriers to
inflate sales.
Inflated revenue by improperly
recognizing entire $42.3 million in
revenue
from
a
multiyear
contract in 2nd quarter of 2001.
Improperly recognized revenue
from sales of software as
agreements were entered into
rather than as services were
K-Mart
MicroStrategy
Restated
1997
earnings
decreased by more than $161
million.
Former CFO, VP, and
controller pled guilty to
numerous other charges.
Company settled $3.2 billion
shareholder suit
Ernst & Young paid $335
million to settle shareholder
lawsuit.
Declared
bankruptcy
in
December 2001.
Lost more than $80 billion in
market capitalization.
Former CFO among others
convicted
of
money
laundering and securities,
wire
and
mail
fraud.
Additional charges brought
against others.
Resulted in dissolution of
company and accountants
Arthur Anderson.
Declared bankruptcy January
2002.
SEC investigations pending.
Declared bankruptcy, January
2002.
Two former VPs charged with
earnings fraud.
Restated earnings for fiscal
years 1998 and 1999, which
caused revenues to be
reduced by almost $66
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Company
Fraud Scheme
Result
provided.
million.
Former CEO, COO, and CFO
each fined $350,000.
Restated 1997 income from
$109 million to $38 million.
CEO charged with violating
federal securities laws by
misrepresenting
material
information
about
the
company. CEO settled by
paying a piece of a $141
million fine.
Former controller and chief
accounting
officer
each
agreed to pay $100,000 in
fines.
Former
Arthur
Anderson
partner also settled for
undisclosed amount.
Three
former
executives
including CEO and general
counsel arrested for fraud.
CEO also charged with
avoiding payment of over $1
million in sales taxes on $13
million of artwork
Sunbeam Corp.
Created
$35
million
in
inappropriate
restructuring
reserves in 1996 that were
reversed in 1997 to inflate
income thus creating the illusion
of a rapid turn around.
In 1997, reported over $70
million of revenue from bill and
hold sales, channel stuffing and
other inappropriate accounting
practices.
Tyco
International
Misappropriation of $600 million
by CEO and CFO for personal
use through theft and the false
sale of securities.
Company also separately sued
former CEO seeking the return of
more than $100 million. Suit
alleges CEO gave himself
unauthorized bonuses totalling
$58 million and unauthorized
loans of more than $43 million,
and of taking personal credit for
more than $43 million in
charitable donations that actually
were made by Tyco.
Intentionally
improperly
capitalized billions of dollars of
expenses
as
capital
expenditures.
Former CEO facing possible
charges for allegedly profiting
improperly from IPOs offered by
brokerages
in
return
for
investment banking business.
Overstated revenue for over 4
years
by
accelerating
the
WorldCom
Xerox
Declared bankruptcy, July
2002. Former finance chief
and finance and accounting
executives
charged
with
securities fraud.
Co. agreed to pay $10 million
in fines and restate its income
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Company
Fraud Scheme
Result
recognition of $3 billion in
revenue and inflating earnings by
about $1.5 billion.
Alleged
scheme included the recognition
of revenue on its office copier
leases too early in their cycles.
for the years 1997-2000.
SEC sued three current
KPMG partners and one
former partner of securities
fraud in the claiming the firm
fraudulently let the Co.
manipulate its accounting
practices to fill a $3 billion gap
and make it appear to be
meeting market expectations.
5. Improper Revenue Recognition
Improper recognition of revenue - either prematurely or of fictitious revenue – is
the most common form of fraudulent earnings management.
Premature
recognition of revenue involves the recording of revenue generated through
legitimate means, at any time prior than would be allowed under GAAP.
Premature recognition should be distinguished from recognition of fictitious
revenue derived from false sales or to false customers.
The Report of the National Commission on Fraudulent Financial Reporting
(hereinafter, “ the COSO Report”)8 found that improper revenue recognition was
alleged in 47% of the cases reviewed by the Commission from 1981 to 1986. A
second COSO Report found that the number of revenue recognition alleged
matters accounted for 50% of all matters enforced by the SEC from 1987-1997.9
According to SEC figures, 32 of the 90 actions bought by the Commission in
1999 involved improper revenue recognition using such techniques as side
letters, rights of return, consignment sales, and the shipping of unfinished
products. Another 12 cases involved the booking of fictitious sales.10
A PricewaterhouseCoopers study revealed that in the year 2000, 66% of the
shareholder actions filed alleged revenue recognition violations.11 In 2001, the
number of revenue recognition actions jumped to 69% of all actions filed. 12
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Finally, of the approximately 140 earnings management/accounting cases
brought by the SEC in 2002, more than half related to revenue recognition.13
With respect to premature recognition, SEC Staff Accounting Bulleting 101,
Revenue Recognition in Financial Statements, (“SAB 101”)
14
spells out four
basic criteria that must be met before a public company may recognize revenue.
Specifically, these criteria require:

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Persuasive evidence that an arrangement exists;
Evidence that delivery has occurred or that services have been rendered;
A showing that the seller's price to the buyer is fixed or determinable; and
Ability to collect payment must be reasonably assured.
SAB 101 echoes the recognition requirements originally listed in AICPA
Statement of Position (“SOP”) 97-2, Software Revenue Recognition15, which
governs the software industry. Accountants should also refer to industry specific
literature depending upon the client and circumstances.16
In fact, SAB 101
explains that where it exists, companies should apply industry specific authority
over SAB 101.
Many of the schemes described in this chapter violate more than one of the SAB
101 recognition criteria. The indicia for each listed scheme are not mutually
exclusive; that is; factors indicating the potential existence of one scheme can
often be used to detect others.
Companies can use numerous methods to engage in premature or fictitious
revenue recognition. Following are the most common techniques:

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Agreements or policies which grant liberal return, refund or
exchange rights;
Side agreements;
Channel stuffing;
Early delivery of product
 Contracts with multiple deliverables;
 Soft sales;
 Partial shipments; and
 Up-front fees;
Bill and hold transactions;
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
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Recording false sales to existing customers and false sales to
fictitious customers;
Round tripping
Other forms of improper recognition:
 Recognizing revenue on disputed claims against customers;
 Holding the books open past the end of a period;
 Recognizing income on consignment sales or on products
shipped for trial or evaluation purposes; and
 Improper accounting for construction contracts ; and
Sham related party transactions.
5.1 Reviewing For and Investigating Allegations of Improper Revenue
Recognition
5.1.1 Accounting Polices and Customer Contracts
Inquiries into alleged improper revenue recognition usually begin with a review of
the entity’s revenue recognition policies and customer contracts. The auditor
considers the reasonableness of the company’s normal recognition practice and
whether the company has done everything necessary to comply. For example, if
the company customarily obtains a written sale agreement, the absence of a
written agreement becomes a red flag.
The review should begin with a detailed reading of the contract terms and
provisions.
Particular attention should be focused upon terms governing (i)
payment and shipment, (ii) delivery and acceptance, (iii) risk of loss, (iv) terms
requiring future performance on the part of the seller before payment, (v)
payment of up-front fees, and (vi) other contingencies. The auditor must consider
timing – particularly as it relates to the company’s quarter and year-end periods.
In which periods were the sales agreements obtained? When was the product or
equipment delivered to the buyer’s site? When did the buyer become obligated
to pay? What additional service(s) was required of the seller?
In the absence of a written agreement, the auditor should consider other
evidence of the transaction, e.g. purchase orders, shipping documents, payment
records, etc. He or she should also consider SAB 101 as well pronouncements
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specific to the particular business, as accounting literature often contains relevant
examples and issues. For example, companies engaged in business over the
internet face unique revenue recognition issues. The Emerging Issues Task
Force Abstract (“EITF”) 99-19, Reporting Revenue Gross as a Principal versus
Net as an Agent,
17
attempts to solve this problem by listing factors which are
considered by the SEC in determining whether revenue should be reported on a
gross or net basis. Similarly EITF 01-9, Accounting for Consideration Given by a
Vendor to a Customer (Including a Reseller of the Vendor’s Products),18
addresses the issue of sales incentives, such as discounts, coupons, rebates,
and "free" products or services offered by manufacturers to customers of retailers
or other distributors. Being aware of the applicable authority governing the facts
and circumstances can assist the auditor in his determination of recognition
violations.
5.1.2 Forensic Auditing Techniques
The auditor should perform the following techniques when investigating revenue
recognition allegations:
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
Inquire of management and other relevant personnel as to the existence
factors causing the auditor to believe the scheme exists19;
Perform substantive analytics designed to detect the fraud being
investigated; and
Perform substantive testing to determine whether there is evidence to
support the existence of a scheme or lack of evidence to support the
validity of a transaction. Such substantive procedures include but are not
limited to:
- Request and review documents such as contracts and support
for invoices and deliveries;
- Confirmation with customers to the existence of accounts
receivable and the amount of consigned goods;
- Possible public records/background research/site visits
conducted on customers/third parties to verify existence of the
entity being billed;
- Analyzing journal entry activity and supporting documentation in
certain accounts, focusing on round dollar entries at the end of
periods;
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-
If entries are accruals, obtaining support for the reversal and
confirming the proper timing of the entries.
The following general indicators can often alert the auditor or auditor as to the
potential existence of premature revenue recognition:
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Unexplained change in recognition policies;
Unexplained improvements in gross margin;
Increasing sales with no corresponding increase in cash from operations;
Reported sales, revenue or accounts receivable balances which appear to
be to high or are increasing too fast;
Reported sales discount, sales returns or bad debts expenses which
appear to be too low;
Large, numerous or unusual sales transactions occurring shortly before
the end of the period;
Large amounts of returns or credits after the close of a period; or
Inconsistent business activity –
- Increased revenues with no corresponding increase in distribution
costs or
- Increased revenues with no offsetting increase in accounts receivable.
The use of analytics should also not be overlooked as a means of detecting
fraud. Analytical procedures and relationships the auditor can perform or review
to determine whether revenue is being recognized prematurely include:
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Comparing current period financial statement line item amounts with
amounts from prior periods and inquiring as to significant changes in
accounts between periods (Horizontal Testing, See Chapter
);
Reviewing balances in revenue related accounts for unusual changes;
Calculating the percent of sales and receivables to the total balance sheet
in the current period, comparing it with prior periods and inquiring of any
unusual changes (Vertical Testing, See Chapter
);
Reviewing the statement of cash flows to determine if cash collected is in
proportion to reported revenues;
Reviewing sales activity for the period and note any unusual trends or
increases such as increases towards the end of the period;
Significant or unusual or unexplained changes in the following particular
ratios (See Chapter XX for a detailed explanation of ratios):
o Increases in Net Profit Margin (Net Income/Total Sales);
o Increases in Gross Profit Margin (Gross Profit/Net Sales);
o Increases in the Current Ratio (Current Assets/Current Liabilities);
o Increases in the Quick ratio (Cash and Receivables and Marketable
Securities/Current Liabilities);
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o Increases in the Accounts Receivable Turnover (Net Sales/A/R);
o Increases to Days Sales Outstanding (A/R Turnover/365);
o Increases in Sales Return Percentages (Sales Returns/Total
Sales);
o Increase in Asset Turnover (Total Sales/Average Total Assets);
o Increases in Working Capital Turnover (Sales/Average Working
Capital);
o Decrease in A/R Allowance as a % of A/R (Allowance/Total A/R);
and
o Decreases in the bad debt expense or allowance accounts.
Of course, good interviewing and sound analytics will not substitute for having a
good understanding of the client’s business. Even seasoned auditors have been
misled and thought revenue to be appropriate because they did not fully
understand the business. Thus, after all the analytics and interviews, the auditor
must ask him or herself whether the information and results obtained make
sense in light of the client’s industry and business. The auditor should also to the
extent applicable, benchmark performance results against other companies in
the same industry.
5.2 Side Agreements
While SAB 101 requires a definitive sales or service agreement, agreements can
and often are legitimately amended. Problems arise however when a company
enters into such an arrangement and subsequently modifies, supplements,
revokes, or otherwise amends the original agreement with a written or oral side
agreement prepared and agreed to outside the normal reporting channels of the
business.
Management often employ side arrangements or letters to boost sales figures.
Sales force members also use them to meet sales targets or to obtain
undeserved commissions. Side agreements created outside of the normal and
proper recording channels are often used to perpetrate many of the schemes
listed in this chapter.
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The existence of numerous side agreements should raise red flags to the auditor
and require further detailed inquiry as to the facts and circumstances surrounding
how, when and why the agreements were entered into. Additional investigation
is warranted if the inquiry points to preparation outside the normal reporting
channels.
Common side agreement fraud schemes involve:
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Liberal or unconditional rights of return granted to customers;
Rights to cancel orders at any time;
Contingencies that nullify the sale, such as:
o Re-sale;
o Receipt of funding;
Rights of continuing negotiations; and
Extension of payment terms.
Case Illustration
The case of Informix Corp illustrates the improper use of side-agreements.20
Informix sold licensed software to companies, which, in turn, would resell the
licenses to third parties.
Consistent with then current GAAP for revenue
recognition with respect to software21, the company’s written policy was to
recognize revenue from the sale of licenses only upon receipt of a signed and
dated license agreement. However, to meet the earnings expectations of the
company and financial analysts, management entered into numerous written and
oral side agreements containing different provisions, which caused them to
violate GAAP revenue recognition principles. These provisions included:
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Allowing resellers to return and to receive a refund or credit for unsold
licenses;
Committing the company to use its own sales force to find customers for
resellers;
Offering to assign future end-user orders to resellers;
Extending payment dates beyond twelve months;
Committing the company to purchase computer hardware or services from
customers under terms that effectively refunded all, or a substantial
portion, of the license fees paid by the customer;
Offering to pay for customer storage costs;
Diverting the company's own future service revenues to customers as a
means of refunding their license fees; and
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
Paying fictitious consulting or other fees to customers to be repaid to the
company as license fees.
Auditors should perform inquiries of management, accounting and sales
personnel as to whether they are made aware of all side agreements entered into
by the other party that modify sales in any one of the methods mentioned or in
any other fashion. The auditor should also inquire of sales people whether they
are allowed or encouraged to use side letters or agreements to complete a sale
and whether these agreements are made using proper reporting channels.
In addition to inquires, the auditor should review the company’s right of return
policy and understand its rationale. The auditor should satisfy him or herself by
reviewing a sample of contracts for side agreements and confirm with a sample
of customers the major contract terms of their contracts, including the existence
or absence of any side agreements.
5.3
Liberal Return, Refund, Or Exchange Rights
Most industries allow customers to return products to sellers for any number of
reasons, and GAAP allows entities to recognize revenue in certain cases even
though the customer may have a right of return.
Specifically, Statement of
Financial Accounting Standard (“SFAS”) No. 48, Revenue Recognition Where
Right of Return Exists22 provides that when customers are given a right of return,
revenue may be recognized at the time of sale if the:
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Sales price is substantially fixed or determinable at the date of sale;
Buyer has paid or is obligated to pay the seller;
Obligation to pay is not contingent on resale of the product;
Buyer's obligation to the seller does not change in the event of theft or
physical destruction or damage of the product;
Buyer acquiring the product for resale is economically separate from the
seller;
Seller does not have significant obligations for future performance or to
bring about resale of the product by the buyer; and
Amount of future returns can be reasonably estimated.23
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Sales revenue not recognizable at the time of sale is recognized either when the
return privilege has substantially expired or if the above conditions are
subsequently met.
Companies can and often do run astray of SFAS 48 by
establishing accounting policies or creating sales agreements which (i) grant
customers vague or liberal rights of returns, refunds or exchanges, (ii) fail to fix
the sales price, (iii) make payment contingent upon resale of the product or some
other future event such as the receipt of funding from a lender.
Payment terms that extend over a substantial portion of the period in which the
customer is expected to use or market the purchased products also create
problems. These terms effectively create consignment arrangements inasmuch
as no economic risk has been transferred to the purchaser. As will be discussed
in Section 5.9.3, sales under consignment arrangements cannot be recorded as
revenue.
Case Illustration
In the case of Midisoft Corporation,
24
the SEC charged the company with
overstating revenue on in the amount of $458,000 on transactions for which
products were shipped, but for which, at the time of shipment, the company had
no reasonable expectation that the customer would accept and pay for the
products. The company eventually accepted back most of the product as sales
returns during the first quarter of the subsequent period.
The SEC noted that Midisoft’s written distribution agreements generally allowed
the distributor wide latitude to return product to Midisoft for credit whenever the
product was, in the distributor's opinion, damaged, obsolete, or otherwise unable
to be sold. In preparing Midisoft's financial statements for fiscal 1994, company
personnel submitted a proposed allowance for future product returns that was
unreasonably low in light of the large levels of returns Midisoft received in the first
several months of 1995. Furthermore, various officers and employees in the
company’s Accounting and Sales Departments knew the exact amount of returns
18
FIRST DRAFT
the company had received prior to the end of March 1995, when the company’s
independent auditors finished their field work on the 1994 audit. Had Midisoft
revised the allowance for sales returns to reflect the returns information, it would
have had to reduce accordingly the amount of net revenue reported for fiscal
1994.
Instead, several Midisoft officers and employees devised schemes to
prevent the auditors from discovering the true amount of the returns including
preventing the auditors from touring that portion of the Midisoft headquarters
where the returned goods were stored.
In addition, Midisoft accounting
personnel altered records contained in the computer accounting system to
reduce falsely the level of returns.
Midisoft teaches that the auditor should carefully review the terms of the
contracts and any side or extension agreements to determine what rights are
afforded the customer with respect to returning and exchanging the delivered
product. Only in those cases where the customer has limited or no right to return
the product should revenue be recognized. The auditor should also inquire into
the company’s refund and exchange policy: how it was derived, whether it is
subject to override, by whom and how often it is overridden. Other relevant
inquiries include sales personnel as to whether the company has offered
customers price concessions, refunds, or new products.
Auditors should also inquire of accounting staff and financial personnel as to the
returns policy and confirm with warehouse personnel who process returns that
the policy is being followed. In addition to the inquiries, the auditor may also
choose to perform the following analytics:


Compare returns in current period to prior periods and inquire as to any
unusual increases;
Determine whether returns are processed timely (this may require a visit
an inquiry with warehouse personnel, an inquiry can also be made of
customers on confirmations)
o Companies may slow down the return processing process to avoid
reducing sales in the current period.
19
FIRST DRAFT


Perform sales return percentage (Sales Returns/Total Sales) and inquire
as to any unusual increase; and
Compare returns subsequent to reporting period to both the return reserve
and the monthly returns for reasonableness.
5.4 Channel Stuffing
Channel stuffing refers to the practice of offering deep discounts, extended
payment terms or other concessions to customers to induce the sale of products
in the current period, when they would not have not been otherwise sold until
later periods, if at all.
Case Illustration
The case against Sunbeam Corporation25 is illustrative.
In December 1997,
Sunbeam established a program offering discounts, favourable payment terms,
guaranteed mark-ups and the right of return or exchange on unsold products to
any distributor willing to accept the company’s products before year-end. The
company failed to disclose this practice in its quarterly 10Q. As a result, the SEC
charged that the company’s 10Q statement was misleading and that the
company had eroded future sales and profit margins by pulling them into the
current period.
Channel stuffing often is indicated by an increase in shipments, which is usually
accompanied by an increase in shipping costs, at or near the end of period.
Where these circumstances occur, the auditor or auditor should (i) inquire
whether the goods were sold at steep discounts and (ii) review customer
contracts and side agreements for unusual discounts in exchange for sales and
rights of return provisions. The auditor should also inquire of sales personnel and
shipping personnel regarding management influence to alter normal sales
channel requirements.
20
FIRST DRAFT
In addition, customers offered deep discounts often purchase inventory in excess
of required needs to take advantage of the reduced prices.
This excess,
inventory is often returned by the customer after the close of the period as it
cannot be resold. The auditor thus should consider the amount of returns shortly
after the close of a period as compared to prior periods and margins on sales
recorded immediately before the end of a reporting period.
5.5 Early Delivery of Product
Companies can circumvent the SAB 101 delivery requirement in a variety of
ways including:




Shipping unfinished or incomplete products to customers, or at a time prior
to when customers are ready to accept them;
Engaging in “soft sales” (shipping of products to customers who have not
agreed to purchase);
Recognizing the full amount of revenue on contracts where services are
still due to the client, and/or
Recognizing the full amount of revenue on fees collected up front.
Based on the provisions of SAB 101, income should not be recognized under
these circumstances because delivery has not actually occurred.
Customers on the other side of early delivery schemes often return the
unfinished product or demand more completion before payment is rendered.
Analytics that may reveal the existence of an early delivery scheme include:



Comparing returns in the current period and prior periods;
Comparing shipping costs in current period and prior periods; and
Comparing shipping costs as a percentage of revenue in the current
period and prior periods.
Careful scrutiny of the sales contract will also assist to detect these schemes.
When must payment be made in relation to delivery? Which party bears the risk
of loss on shipment? The audit or investigative team should then compare these
contract terms with the requirements of SAB 101 and other accounting literature.
21
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The auditor should also make broad inquiries of non-financial personnel such as:



Shipping department personnel:
- Were shipments earlier than normal for customers?
- Is inventory stored in the warehouse documented as shipped?
- Was there inventory shipped to addresses other than customer sites?
- Were there any adjustments to shipping dates?
- Whether there exists consigned goods and their location.
Sales force personnel:
- Are shipments of any products designed to arrive ahead of the
customer’s required delivery date?
- Do sales personnel pick up product and deliver to customers?
- Are there sales personnel with excessive “samples”?
- Do sales personnel have free reign in access to the warehouse?
Warehouse personnel:
- Are there any misstatements in the amount of merchandise the
company ships or receives?
- Has there been destruction, concealment, predating, or postdating of
shipping and/or inventory documents?
- Has there been an acceleration of shipments prior to month or yearend?
- Have there been shipments to a temporary or holding warehouses
prior to final shipment to the customers’ premises?
- Are there any other unusual, questionable, or improper practices?
Additional audit procedures include:









Comparing the purchase order date with the shipment date;
Determine whether sales personnel are paid commissions based on
the sale of product or upon collection;
Inquiring of outside related business interests of key/sales personnel
that may be suspected in an improper revenue recognition scheme;
Performing public records searches on certain entities and individuals;
Determining whether shipments have been made to these outside
business interests;
Reviewing amounts and trends of shipping costs at or near the end of
a period even to legitimate customers;
Reviewing rate of returns;
Inspecting shipping documents for missing, altered or incorrect
information; and
Reviewing customer complaint logs or e-mail correspondence for
complaints of shipments of goods prior to the customer’s readiness to
accept.
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5.5.1 Partial Shipments
Many companies will prematurely recognize 100% of revenue on partial or
incomplete shipments of customer orders. The delivery requirement is not met, if
the unshipped portion constitutes a substantial portion of the total deliverable.
Case Illustration
The SEC’s enforcement action against FastComm Communications Corp is
illustrative.26 In 1999, the SEC charged FastComm with recognizing revenue on
the sale of products that were not fully assembled or functional.
The SEC
charged that it was improper because delivery had not yet occurred.
Auditing for partial shipments is similar to auditing for early product delivery. The
auditor must consider:





Numerous returns of incomplete products after the close of period by
customers seeking the full product;
Large, numerous or unusual transactions occurring shortly before the end
of the period;
Examining product details on the invoices;
Is the invoice cut with all products ordered whether shipped or not?
 Obtain understanding of drop shipments to customers; if a drop
shipment is partial, is the invoice to the customer also partial?
 How does the company ensure all drop shipped products are
properly accounted for in the sales invoice process and also in
paying for the goods to the supplier?
Reviewing customer complaints regarding lack of completeness in
shipments.
In addition, the auditor will want to inquire of management and sales personnel
regarding the policy and process for billing partially filled orders. A review of the
shipping documents and comparison to the sales journal will also often reveal
what was booked as sales and what was actually shipped. The auditor may also
consider talking to customers or reviewing correspondence from customers to
see if there are numerous complaints from customers regarding partial
shipments.
23
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5.5.2 Soft Sales
Case Illustration
In 1996, the SEC charged Advanced Medical Products employees with
recognizing revenues on “soft sales” or sales for which the customer had
expressed interest but not actually committed to purchasing.
The company
shipped the products to its field representatives, who held them while the
customer decided whether to purchase the product.
The company however, recognized the revenue as of the date of the shipment to
the field representative.
Employees withheld sending invoices and monthly
statements to prevent customer complaints resulting from being invoiced for
equipment that they had not agreed to purchase.
To detect this scheme, the auditor may wish to review customer complaint logs
and correspondence for complaints of goods shipped prior to the customer’s
readiness to accept or when the customer was merely making inquiry into the
goods.
5.5.3 Contracts With Multiple Deliverables
Another common scheme occurs when companies ship product or equipment to
customers who are not obligated to pay for such equipment until it is “accepted.”
Acceptance typically requires a seller to substantially complete or fulfil all the
terms of an arrangement before delivery is deemed to have occurred. Common
customer acceptance provisions included in contracts that, if not satisfied by the
seller, would preclude recognition include:



Seller’s obligation to perform additional services subsequent to the
delivery, e.g., product installation and activation;
Product testing prior to payment; and
Training of personnel with respect to produce use.
24
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If a contract requires the seller to provide “multiple deliverables” or elements, the
delivery is not deemed complete unless substantially all elements or deliverables
are delivered. The sales revenue should be recognized only if inconsequential
elements remain to be delivered.
When assessing whether revenue can be recognized prior to delivery of all
required elements or deliverables, the criteria under GAAP is whether the
undelivered portion is “essential to the functionality” of the total deliverable. 27
SAB 101 enumerates several factors that should be considered in determining
whether remaining performance obligations are substantial or inconsequential.28
Case Illustration
The SEC action against Advanced Medical Products is a classic example of
improperly recognizing revenue on contracts with multiple deliverables. 29 Rather
than shipping the product to the customer, Advanced Medical Products shipped
products to company’s field representatives, who were responsible for installing
the product and training the customer’s employees. The SEC charged that the
company
incorrectly
representatives.
recognized
revenue
upon
shipment
to
the
field
This policy contravened GAAP as there was no economic
exchange and risk of loss had not passed to the customer because the products
were still in the control of the company.
In addition to the general indicators listed above, this scheme, which has been
prevalent in the software industry, can possibly be uncovered by confirming with
major customers whether all services have been performed with respect to the
products purchased and received.
For companies that deal with distributors of
their product, auditors should obtain an understanding as to whether the
company “forces” a pre-determined listing of SKUs to its distributors, without an
order from the distributors. If this is the case, there may be a culture of forcing
product out to distributors to ‘meet the numbers.’ A rash of returns from the
25
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distributors in subsequent months might also reveal this practice.
Further
manipulation of the books and records can occur by the entity when these
returns are not processed in a timely fashion.
5.5.4 Up-Front Fees
Some firms will collect up-front fees for services provided over an extended
period, e.g., maintenance contracts. SAB 101 provides that up-front fees should
generally be recognized over the life of the contract or the expected period of
performance.
5.6 Bill and Hold Transactions
“Bill and Hold” schemes are another common method of bypassing the delivery
requirement.
As its name implies, a legitimate sales order is received,
processed, and ready for shipment.
The customer however, for whatever
reason, may not be ready, willing, or able to accept delivery of the product at that
particular point in time. The seller holds the goods in its facility or ships them to a
different location, such as a third party warehouse for storage until the customer
is ready to accept shipment.
The seller however, recognizes revenue immediately upon shipment.
The
auditor must consider whether the seller has met (or is seeking to circumvent)
enumerated specific criteria established by the SEC30, including whether:






Risk of ownership has passed to the buyer;
Customer has made a fixed commitment to purchase the goods,
preferably in written documentation;
Buyer must request that the transaction be on a bill and hold basis;
Buyer must have a substantial business purpose for ordering the goods on
a bill and hold basis;
Delivery must be fixed and on a schedule that is reasonable and
consistent with the buyer's business purpose;
Seller must not retain any specific performance obligations under the
agreement such that the earning process is not complete;
26
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

Ordered goods must be segregated from the seller's inventory and not be
subject to being used to fill other orders; and
Product must be complete and ready for shipment.
In addition to the above factors, the SEC also recommends preparers of financial
statements to consider:





The date by which the seller expects payment, and whether the seller has
modified its normal billing and credit terms for this buyer;
The seller's past experiences with and pattern of bill and hold transactions;
Whether the buyer has the expected risk of loss in the event of a decline
in the market value of goods;
Whether the seller's custodial risks are insurable and insured; and
Whether extended procedures are necessary in order to assure that there
are no exceptions to the buyer's commitment to accept and pay for the
goods sold (i.e., that the business reasons for the bill and hold have not
introduced a contingency to the buyer's commitment).31
Auditors coming across agreements that do not meet the above criteria should
be wary of potential bill and hold schemes. Auditors should consider whether:






Bills of lading are signed by a company employee rather than shipping
company;
Review of shipping documents indicates excessive shipments made to
warehouses rather than to a customer's regular address (which could
mean that shipments are made to the seller’s warehouses rather than
customer locations);
Shipping information is missing on invoices;
High shipping costs incurred near the end of the accounting period;
Large, numerous or unusual sales transactions occurring shortly before
the end of the period; or
Decrease in current year monthly sales from the prior year that may
indicate the reversal of fraudulent bill and hold transactions in a
subsequent period.
When confronted with the above indicators, the auditor should first inquire of
management regarding any bill and hold policies and any customers with bill and
hold arrangements.
The auditor should also make inquiry of warehouse
personnel regarding “customer” inventory being held on the premises in a third
party warehouse, or shipped to another company facility. Finally, the auditor
should inquire of shipping department or finance personnel if they have ever
been asked to falsify or alter shipping documents.
27
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If additional investigation is warranted, the auditor should review the customer
contracts to determine whether they meet the requirements of SAB 101
enumerated above. The auditor should also:







Review underlying shipping documents for accuracy and verify existence
of transactions;
Compare shipping costs to prior periods for reasonableness.
Review warehouse costs and understand the business purpose of all
warehouses owned/used by the company;
Confirm special bill and hold terms with customers directly including
transfer of risk of loss and liability to pay for the bill and hold goods;
Test reconciliation of goods shipped to goods billed for accuracy;
Select a sample of sales transactions from the sales journal, obtain the
supporting documentation and
- Inspect the sales order for approved credit terms;
- Compare the details among the sales orders, shipping documents and
sales invoices for inconsistencies;
- Compare the prices on sales invoices against published prices; and
- Re-compute any extensions on sales invoices; and
In conjunction with the physical inventory, tour the facility or warehouse
and inquire of warehouse personnel about any held customer products.
Case Illustration
In 2003, the SEC charged Anika Therapeutics with improperly recognizing
approximately $1.5 million in revenue form a bill and hold transaction.
A
distributor placed orders with Anika for a total of approximately 15,000 units of a
particular product in April and July 1998. As part of the agreement with the
distributor, Anika invoiced the distributor for the total 15,000 units for over
$500,000 in September 1998 but held the product at Anika’s refrigerated facility
until the distributor requested the product, which did not occur until March 1999.
However, Anika recorded the revenue for this sale in the quarter ended
September 30, 1998. 32
28
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5.7 Fictitious Revenue Schemes
Schemes to create fictitious revenues, as opposed to prematurely recognize
revenue, cross the line between the potentially defensible and the completely
indefensible.
5.7.1 Fictitious Sales to Existing or Non Existent Customers
A common technique to overstate revenues is to create fictitious orders either for
existing or fictitious customers.
These schemes involve the preparation of false
supporting documentation to provide “backup” to non-existing sales or services
never rendered.
Fictitious revenue schemes can and often will be detected by the same methods
used to detect premature revenue recognition schemes.
Auditors should
consider:






Discovery of significant revenue adjustments to revenue at the end of the
reporting period;
Unexpected increases in sales by month at period end;
Customers with unknown names or addresses or which have no apparent
business relation to the business;
Increased sales accompanied by stagnant or decreasing cost of sales and
corresponding improvement in gross margins;
Improvement in bad debts as a percentage of sales; and/or
Decrease of shipping costs compared with sales.
Fictitious revenue schemes are relatively easy to investigate, once detected.
The audit or investigative team should focus on accounting personnel and inquire
whether:



Revenues are recorded outside of the normal invoicing process, or
standard monthly journal entries;
Journal entries have adequate, proper and bona fide supporting
documentation;
Accounting personnel have been pressured to make or adjust journal
entries; and
29
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
Accounting or sales personnel have been pressured to create false
invoices for existing or fictitious customers.
The auditor should also inquire whether sales or shipping personnel have noted
any unusually high sales or shipments to customers with no reasonable
explanation or noted any significant sales or shipments to unfamiliar new
customers.
Auditors should also consider the following detection procedures:






Send confirmations to customers who may be associated with suspicious
transactions;
Perform alternative procedures for confirmations not returned or returned
with material exceptions such as:
- Including other matters on the confirmations such as any
consigned inventories held at the customer location or held for the
customer; and
- Including amount of pending returns on the confirmation as a blank
line for the customer to complete.
Review journal entries and supporting documentation, and verify their
accuracy;
Identify amount of returns in subsequent period;
Look for sales which reverse in the subsequent period; and
Conduct research of publicly available information (e.g., on-line database,
manual record and Internet) to verify existence and legitimacy of
customers. Follow up physical visits may also be prudent.
Case Illustration
Consider the case of medical device supplier, Boston Japan33, which during fiscal
years 1997-1998 recognized over $75 million dollars of revenue from fraudulent
sales. Company sales managers leased commercial warehouses, recorded false
sales to distributors, and shipped the goods to the leased warehouses. The
company masked the fact that the distributors never paid for the goods by issuing
credits to the distributors and then recording false sales of the same goods to
other distributors, without ever moving the goods out of the leased warehouses.
Company employees even recorded sales to distributors that were not involved
in the medical device business, but that had agreed with company sales
managers to collude in the fraud.
Some of the false sales were made to
30
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distributors that never resold any of the goods and never paid Boston Japan for
any purported sales.
The sales managers and cooperating independent
distributors further colluded to cover up false sales by falsely confirming the
legitimacy of the sales to the company’s auditors.
5.7.2 Round Tripping
Round tripping consists of recording transactions that occur between companies
for which there is no economic benefit to either company.
For example, a
company that provides a loan to a customer so that the customer can purchase
the product engages in round tripping if the loan was issued with no real prospect
that the customer will ever repay the loan.
These transactions are deemed
completed for the sole purpose of inflating revenue and creating the appearance
of strong sales.
Round tripping recently has occurred extensively in the telecommunications and
oil and gas industries. For example, numerous telecommunication companies
boosted their sales volume by exchanging the indefeasible rights of use on their
fiber-optic networks to other telecommunications companies (this practice was
known in the industry as “capacity swaps.”) These transactions were sometimes
booked as income even though the swaps generated no net cash for either
company.
Case Illustration
In 2002, the SEC began investigating the way telecom giant Qwest
Communications International Inc. and some of its competitors, such as Global
Crossing accounted for sales of fiber-optic capacity and whether it was proper for
the company to recognize the revenue right away immediately.
Qwest sold capacity on their fiber-optic network to carriers and also purchased
capacity from them. Both companies recognized revenue from capacity swaps
31
FIRST DRAFT
and indefeasible rights of use (“IRU”) that allowed another carrier or company the
unfettered use of the capacity over a long period of time. In some cases, the
amount of the sale and purchase were almost identical.
Qwest booked the
revenue from these sales all at one time instead of deferring part of it over many
years. GAAP however, requires companies to record the revenue generated by
an
IRU
over
the
time
of
the
contract.
The effect was to boost Qwest's revenue by $1 billion in 2001 and $465 million in
2000.
Since most roundtrip transactions involve counterparties in the same line of
business, an auditor should review a list of the company’s significant customers.
If there is a customer in the same line of business, the auditor should scrutinize
the transactions for evidence of any round tripping. The auditor should also
review the vendor list and compare it to the customer list. The same company
appearing on both lists might indicate round tripping.
There is always the
possibility of an intermediary being involved in the transaction, so an auditor
should be aware of companies that appear on the two lists but would not be valid
customers or vendors. Round tripping often takes place with related parties so
the auditor should be aware of related party transactions and follow the steps
outlined in Section 5.9.5
5.8
Other Improper Recognition Schemes
5.8.1 Recognizing Revenue On Disputed Claims Against Customers
Reasonable assurance of payment is basic to revenue recognition. Companies
sometimes circumvent this requirement by recognizing the full amount of revenue
even though the customer has for some reason disputed payment. Auditors
should inquire as to all receivables that are in dispute and, if necessary, confer
with legal counsel for the company to assess whether collection of the revenue is
sufficiently certain to be able to be properly recognized.
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5.8.2 Holding The Books Open Past the End of a Period
Improperly holding open the books beyond the end of an accounting period can
enable companies to record additional end of period sales that are invoiced and
shipped after the end of a reporting period. While standard cut-off testing will
often discloses these schemes, auditors should be cognizant and skilled in
detecting manipulation of information systems to achieve this result.
Direct
inquiry of accounting personnel, billing clerks and warehouse personnel may
assist in determining whether the books are held open past the end of the period.
Computer forensics can also be used to ferret out these schemes.
Case Illustration
In 1993, the management of Platinum Software Corp., was concerned about the
company’s "days sales outstanding" ("DSO") – the measure of the time a
company takes to collect its receivables. The company’s DSO had increased
throughout 1993, in part because it had improperly recognized revenue on
contingent or cancelled license agreements. One of the company’s responses to
the increasing DSO was to hold open the company’s open for cash received after
period-end.
Management recorded checks received by the company in July
1993, on the company’s balance sheet as an increase in cash and a reduction in
receivables as of June 30.
Holding the books open resulted in a cash
overstatement and associated receivable understatement.
Similarly, for the
quarter ending September 1993, management included cash that the company
received for about a week into October, resulting in a cash overstatement and
accounts receivable understatement of $724,000. The same pattern continued
through December 1993, resulting in a cash overstatement and accounts
receivable understatement of $3,463,000. The company was ultimately ordered
to cease and desist in this practice by the SEC.
5.8.3
Recognizing Income on Consignment Sales or Products
Shipped for Trial/Evaluation Purposes
33
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SAB 101 prohibits revenue recognition from consignment arrangements until
completion of actual sale.
The same criteria apply to products delivered for
demonstration purposes. 34 The reason for this is that in a typical consignment
arrangement, neither title nor the risks and rewards of ownership pass from the
seller to the buyer.
Consignment sales and sales shipped under trial or
evaluation purposes are thus merely specific examples of contingent events
which must be satisfied before revenue can be recognized. Particular attention
must be paid to the terms, facts and circumstances of any agreement in which:

The buyer has the right to return the product and
-
-
-
Buyer does not pay the seller at the time of sale, and the buyer is
not obligated to pay the seller at a specified date or dates;
Buyer does not pay the seller at the time of sale but rather is
obligated to pay at a specified date or dates, and the buyer’s
obligation to pay is contractually or implicitly excused until the buyer
resells the product or subsequently consumes or uses the product;
Buyer’s obligation to the seller would be changed (e.g., the seller
would forgive the obligation or grant a refund) in the event of theft
or physical destruction or damage of the product;
Buyer acquiring the product for resale does not have economic
substance apart from that provided by the seller; or
Seller has significant obligations for future performance to directly
bring about resale of the product by the buyer; and
The product is delivered for demonstration purposes.35
Case Illustration
In the second quarter of 1998, FLIR Systems inappropriately recognized
$225,000 in revenue relating to a consignment sale.
The purchase order
submitted by the FLIR’s customers stated “…payment for each system to be
made when a system is sold by [the customer] to an outside customer.” Despite
these words, FLIR recognized revenue from this sale, even though no end-user
was ever identified at the time of the purchase order.36
5.8.4 Contract Accounting Schemes
GAAP provides for contract revenue to be recognized using either the
percentage of completion or completed contract method.
The percentage of
34
FIRST DRAFT
completion method applies only if management can reliably estimate progress
toward the completion of a contract; that is; management must be able to
estimate reliably the total costs required to complete the contract.37 Conversely,
GAAP requires the "completed contract" method when management cannot
reliably estimate progress toward completion. The completed contract method
requires the company to postpone recognizing revenue until the contractual
obligations have been met.38
The percentage of completion is the method that is most often subject to abuse.
Some companies will use the percentage of completion method notwithstanding
that they do not qualify for that method.
Companies can artificially inflate
revenue by increasing the costs incurred toward completion, underestimating the
costs of completion, or overestimating the percentage completed.
The auditor should perform the following procedures when performing an audit or
investigation of contracts:










Select a sample of contracts and confirm:
o Original contract price;
o Total approved change orders;
o Total billings and payments;
o Details of claims;
o Back charges or disputes; and
o Estimated completion date.
Ensure that all incurred costs are supported with adequate documentation
detailing the nature and amount of expense;
Audit estimated costs to complete by reviewing estimates and comparing
with actual costs incurred after the balance sheet date;
Ensure that all estimated costs to complete the contract should be
supported by reasonable assumptions;
Ensure that all contracts are approved by appropriate personnel;
Review unapproved change orders;
Identify unique contracts and retest the estimates of cost and progress on
the contract;
Test contract costs to ensure costs are matched with appropriate
contracts and costs are not shifted from unprofitable contracts to profitable
ones;
Ensure that losses are recorded as incurred;
Review all disputes and claims;
35
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

Visit the construction contract site to view the progress of a contract;
and/or
Interview project managers, subcontractors, engineering and technical
personnel to get additional information on the progress of an engagement
and the assumptions behind the contract.
Case Illustration
In 1996, the SEC charged 3Net Systems with improperly recognizing over $1
million of revenue in both 1991 and 1992, by misrepresenting to its outside
auditors the degree to which certain work had been completed under certain
contracts with existing customers. In fact, 3Net had not completed any of the
contracts, and in addition, had not even determined the costs to complete.
Further, 3Net had no other means of reliably estimating progress toward
completion for these contracts, as it lacked the systems necessary to estimate
and track progress on their development.
Because 3Net could not reliably
estimate progress toward completion, the contracts in question did not qualify for
the percentage of completion method. The SEC charged 3Net should have used
the completed contract method for the contracts. Had it done so, 3Net would not
have reported revenue in fiscal 1991 because it completed none of these
contracts by the end of fiscal 1991.39
5.8.5 Sham Related Party Transactions
Sham related party transactions are transactions between related parties where
either little or no consideration is given for the product or service. The existence
of related party transactions cuts to the very first criteria of SAB 101 that there be
persuasive evidence of an arms length arrangement. Sales transactions should
stem from express or implied contracts and represent exchanges between
independent parties at arm’s-length prices and terms. Accordingly, arms-length
transactions cannot be achieved in those situations where the parties are related
or where one party can exercise substantial control over the other.
36
FIRST DRAFT
Related party transactions carry the presumption that one or both parties have
received a benefit that they would not have otherwise received had the
transactions been truly arms length. Related party schemes can take place in
the context of any of the schemes listed in this chapter.
Transactions between related parties are often difficult to audit as these
transactions are not always accounted for in a manner that communicates their
substance and effect with transparency. The possibility of collusion always exists
given that the parties are, by definition, related.
Internal controls, moreover,
might not identify the transactions as involving related parties.
An auditor may encounter related parties that are known by some members of
the company; however, the relationships are not properly disclosed in the books
and records. The auditor should inquire as to outside business interests and
then try to determine whether they are properly disclosed, and the volume of
transactions, if any, that are occurring between the entities.
Auditors should also focus on the relationship and identity of the other party to
the transaction and whether the transaction emphasizes form over substance.
Common indicators of such related party, sham transactions include but are not
limited to:
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Borrowing or lending on an interest-free basis or at a rate of interest
significantly above or below market rates;
Selling real estate at prices that differ significantly from appraised value;
Exchanging property for similar property in a non-monetary transaction;
Loans with no scheduled terms for when or how the funds will be repaid.40
Loans with accruing interest differing significantly from market rates;
Loans to parties lacking the capacity to repay;
Loans advanced for valid business purpose and later written off as
uncollectible;41
Non-recourse loans to shareholders;
Agreements requiring one party to pay the expenses on the other’s behalf;
Round tripping sales arrangements (seller has concurrent obligation to
purchase from the buyer);
Business arrangements where the entity pays or receives payments of
amounts at other than market values;
37
FIRST DRAFT

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Failure to adequately disclose the nature and amounts of related party
relationships and transactions as required by GAAP42;
Consulting arrangements with directors, officers or other members of
management;
Land sales and other transactions with buyers of marginal credit risk;
Monies transferred to or from the company from a related party for goods
or services that were never rendered;
Goods purchased or sent to another party at less than cost;
Material receivables or payables from to or from related parties such as
officers, directors and other employees;43
Discovery of a previously undisclosed related party;
Large, unusual transactions with one or a few other parties on or at period
end; and
Sales to high-risk jurisdictions or jurisdictions where the entity would not
be expected to conduct business.
.
If related party transactions are detected or suspected, the auditor should
consider further inquiry, including:

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Conducting public records searches/background investigations on
customers, suppliers and other individuals to identify related parties and
confirm legitimacy of business;
Performing data mining to determine whether transactions appear on
computerized files;
Performing document review of identified transactions to obtain additional
information for further inquiry;
Searching for unusual or complex transactions occurring close to the end
of a reporting period;
Searching for significant bank accounting or operations for which there is
no apparent business purpose;
Reviewing the nature and extent of business transacted with major
suppliers, customers, borrowers and lenders to look for previously
undisclosed relationships;
Reviewing confirmations of loans receivable and payable for indications of
guarantees;
Performing alternative procedures if confirmations are not returned or
returned with material exceptions;
Reviewing material cash disbursements, advances and investments to
determine if the company is funding a related entity;
Testing related party sales to supporting documentation (i.e., contract and
sales order) to ensure appropriately recorded;
Discussing with counsel, prior auditors and other service providers the
extent of their knowledge of parties to material transactions; and
Inquiring about side agreements with related parties for right of return or
contract cancellation without recourse
38
FIRST DRAFT
6. Asset Overstatement/Liability Understatement Schemes
Improper reporting of assets is another way for companies to overstate earnings.
A direct relationship exists between overstatement of assets/understatement of
liabilities on the balance sheet and the inflation of earnings. The WorldCom
scandal for example, exemplifies how expenses improperly capitalized as assets
on the balance sheet can serve to inflate income.
In many cases, perpetrators
are looking for a place on the balance sheet to place the debit. Overstating an
asset or understating a liability usually occurs with this scheme. Accounts such
as inter-company and foreign currency exchange gain/loss should not be
overlooked as potential places to hide the debit.
Common asset overstatement fraud schemes include:

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Creating fictitious assets;
Manipulating balances of legitimate assets with the intent to overstate
value;
Understating liabilities or expenses, including failing to record (or
deliberately under estimating) accrued expenses, environmental litigation
liabilities and other business problems;
Misstating inter-company expenses; and
Manipulating foreign currency exchanges.
An auditor can often become alert to the possibility of fictitious or over inflated
assets by inquiring as to whether the entity intends to secure financing. If the
answer is yes and if that financing is contingent on the value of particular assets
such as receivables or inventory, that should lead the auditor to ask more
questions and perform additional procedures to verify the existence, and location
and value of these assets. As with certain other schemes, the auditor can most
often detect these schemes by observing the company’s operations and inquiring
as to unusual items.
6.1 Inventory Schemes
39
FIRST DRAFT
The original COSO Report found that fraudulent asset valuations comprised
nearly half of the cases of financial fraud statements.
Misstatements of
inventory, in turn, comprised the majority of asset valuation frauds.
Generally, when inventory is sold, the amounts are transferred to cost of goods
sold and included in the income statement as a direct reduction of sales. An
overvaluation of ending inventory will understate cost of goods sold and in turn,
overstate net income.
Inventory schemes can generally fall into three categories:


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Artificially inflating the quantity of inventory on hand;
Inflating the value of inventory by
- Postponing write-downs for obsolescence);
- Manipulating unit of measurement to inflate value;
- Under-reporting reserves for obsolete inventory, especially in
industries where products are being updated or have a short shelf
life; and
- Changing between inventory reporting methods (average costing,
last invoice price, LIFO, FIFO, etc.);
Fraudulent or improper inventory capitalization.
Following are indicators an auditor can look for to detect possible inventory
manipulation:

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A gross profit margin which is higher than expected;
Inventory that increases faster than sales;
Inventory turnover that decreases from one period to the next;
Shipping costs that decrease as a percentage of inventory;
Inventory as a percentage of total assets that rise faster than expected;
Decreasing cost of sales as a percentage of sales;
Cost of goods sold per the books that do not agree with the company's tax
return;
Falling shipping costs while total inventory or cost of sales have increased;
and
Monthly trend analyses that indicate spikes in inventory balances near
year-end.
6.1.1 Inflating Inventory Quantity (Fictitious Inventory)
40
FIRST DRAFT
The simplest way to overstate inventory is to add fictitious items to inventory.
Companies can accomplish this by creating fake or fictitious:




Journal entries;
Shipping and receiving reports;
Purchase orders; and
Quantities on cycle counts or physical counts.
Some companies even go as far as maintaining empty boxes in a warehouse.
The most effective way for the auditor or auditor to confirm the inventory balance
is physically to observe the client’s inventory, particularly at times when an
inventory count is being performed.
In fact, Generally Accepted Auditing
Standards (“GAAS”) require auditors to physically observe, test, and inquire as to
the amount of inventory on hand and to satisfy themselves with respect to the
methods of inventory taking and the measure of reliance placed upon the client’s
representations about the quantities and physical condition of inventories.44
When the auditor cannot be satisfied as to the inventories he or she must
physically count the inventory and test transactions in that account. 45 Where
inventory is stored outside the company site, such as public warehouses,
auditors should conduct additional procedures to confirm balance.
Case Illustration
Fraud history is filled with names of companies made famous or infamous by
fictitious inventory schemes including McKesson and Robbins, ZZZ Best and
Crazy Eddie. The most famous bogus inventory fraud perhaps is the “Salad Oil
Swindle” of the 1960s.
In that case, management of the company rented
petroleum tanks and filled them with seawater.
The company was able to
convince the auditors that the tanks contained over $100 million in vegetable oil
because the oil rose to the top of banks. In fact, the little oil that was present was
pumped from one tank to the next depending on the company’s advance
knowledge of the auditor’s inventory observation plan.46
41
FIRST DRAFT
The auditor should look for the following operational factors may arouse
suspicions of fictitious inventory:
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
Inventory that cannot be easily physically inspected;
Unsupported inventory, cost of sales or accounts payable journal entries;
Unusual or suspicious shipping and receiving reports;
Unusual or suspicious purchase orders;
Large test count differences;
Inventory that does not appear to have been used for some time or that is
stored in unusual locations;
Large quantities of high cost items in summarized inventory;
Unclear or ineffective cut-off procedures or inclusions in inventory of
merchandise already sold or for which purchases are not recorded;
Adjusting entries which have increased inventory over time;
Material reversing entries to the inventory account after the close of the
accounting period;
Inventory that is not subject to a physical count at year end;
Improper or “accidental” sales that are reversed and included in inventory
but not counted in physical observation (for example a company
“accidentally” delivers a specifics product to a customer, tells the customer
it was a mistake and requests the customer to send the product back);
and
Excessive inter-company and interplant movement of inventory with little
or no related controls or documentation.
Even physical observation however, is not fail-proof. Even when an auditor can
observe inventory, a company can still perpetrate fraud by:

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
Following the auditor during the course of the count and adding fictitious
inventory to the items not tested;
Obtaining advance notice of the timing and location of the inventory
counts thereby permitting the company to conceal shortages at locations
not visited;
Stacking empty containers at the warehouse which are not checked during
the count;
Entering additional quantities on count sheets, cards, scanners, etc. that
do not exist or adding a digit in front of the actual count;
Falsifying shipping documents to show that inventory is in transit from one
company location to another;
Falsifying documents to show that inventory is located at a public
warehouse or other location not controlled by the company;
Including consigned items as part of the inventory count; and
Including items being held for customers as part of the inventory count.
42
FIRST DRAFT
To deter management from inflating inventory during physical counts, the auditor
should consider:
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


Reviewing company policy for inventory counts (frequency and
procedures);
Inquiring of management and internal audit as to the dollar adjustment of
the book to physical counts and the reasons for the significant differences;
Inquiring as to whether all inventory shrinkages have been reported;
Inquiring and observe inventory at third-party locations/off-site storage
locations;
Observing a physical inventory unannounced; and
Conducting physical inventories for multi –locations all on the same date.
6.1.2 Inflating Inventory Value
GAAP requires that inventory be reported at the lower of replacement cost or
market value (i.e., current replacement cost.)47 Companies inflate inventory value
for a variety of reasons other than to boost earnings. For instance, a common
reason to inflate the value of inventory is to obtain some form of financing using
the inventory as collateral. The higher the value of the inventory, the more the
company will be able to obtain in the form of financing.
Inflating inventory value achieves the same impact on earnings as manipulating
the physical count. Management can accomplish this simply by creating false
journal entries designed to increase the balance in the inventory account.
Another common way to inflate inventory value is to delay the write-down of
obsolete or slow moving inventory, since a write down would require a charge
against earnings.
Auditors thus should be fully aware of the items comprising inventory and their
life cycles, particularly as it relates to that industry.
In addition, during the
physical observation of the inventory, the auditor must look for and inquire about
older items that appear to be obsolete. Few or no write-downs to market or no
provisions for obsolescence in industries where there have been changes in
product lines or technology or rapid declines in sales or markets warrant further
investigation as to why the company has not accounted for such declines even
when the inventory in question may be relatively new.
43
FIRST DRAFT
When a potential inventory valuation problem is detected or suspected, the
auditor should consider:
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
Inquiring of accounting personnel as to the company’s inventory pricing
policy and how they identify net realizable value mark-downs;
Inquiring of management, accounting and finance personnel as to
whether the company has shown historical patterns in the past of over
valuation (i.e., prior year write down which became value impaired);
Inquiring of accounting personnel as to whether they have ever been
requested to delay inventory write downs due to obsolescence etc.;
Touring the warehouse looking for items which appear to be old or
obsolete and asking warehouse personnel if stock is slow moving,
damaged or obsolete;
Inquiring of accounting personnel if they are aware of any items being
sold below cost; and
Inquiring of industry experts whether the products are saleable and at
what cost.
6.1.3 Fraudulent Or Improper Inventory Capitalization
Improper capitalization of expenses is discussed in detail in Section 6.4. With
respect to inventory fraud however, companies will sometimes seek to inflate
inventory by capitalizing certain expenditures associated with inventory, such as
selling expenses and general and administrative overhead. Amounts that are
actually expenses instead are improperly reported as additions to the asset
balance, thereby artificially increasing inventory value.
Auditors and investigators need to be cognizant of the company’s capitalization
policies, as well industry practice with respect to the expenses in question.
Moreover, the auditor should consider whether past accounting policies have
been aggressive with respect to capitalization, which would tend to indicate the
need for further investigation. Finally, the auditor should look for changes to
standardized cost amounts that increase the amounts capitalized to inventory.
6.2
Accounts Receivable Schemes
44
FIRST DRAFT
Companies can manipulate accounts receivable with the same techniques that
they can manipulate inventory; that is, by creating:


Fictitious receivables; and
Inflating the value of receivables.
Analytics that may assist in detecting overstated receivables include:

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
A decrease in the company’s quick or current ratio;
Unexplained decrease in accounts receivable turnover
Unexplained increase in days sales outstanding; and
An increase of the ratio of credit sales to cash sales.
6.2.1 Creating Fictitious Receivables
The indicia of fictitious receivables are generally similar to those in our discussion
of fictitious earnings:
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Unexpected increases in sales and corresponding receivables by month at
period end;
Large discounts, allowances, credits or returns after the close of the
accounting period;
Large receivable balances from related parties or conversely from
customers with unknown names or addresses or which have no apparent
business relation to the business;
Receivable balances increasing faster than sales;
Organizations that pay commissions based on sales rather than the
collection of the receivable;
Increased receivable balances accompanied by stable or decreasing cost
of sales and corresponding improvement in gross margins;
Lengthening of aging of receivables or granting of extended credit terms;
Excessive write offs of customer receivable balances after period end;
Re-aging of receivables;
Excessive use of account called “miscellaneous/unidentified customer”
Large unapplied cash balance;
Increased trend of past due receivables; and
Lack of adequate controls in the sales and billing functions.
As part of the inquiry process, the auditor should:


Inquire of finance personnel and management as to whether the company
is trying to obtain financing secured by its receivables;
Inquire of sales personnel as to whether they have been pressured to
create fictitious or fraudulent sales invoices;
45
FIRST DRAFT


Inquire of accounting or sales personnel as to whether they have been
pressured to:
- Overstate the value of receivables;
- Create fictitious journal entries or invoices for the sales of inventory
or assets; and
Inquire whether customers have been pressured to accept large volume
orders close to the end of period.
Fictitious receivables schemes can also often involve related parties, as related
parties are more likely to assist in collusion and providing of false information to
the auditor. Auditors should inquire into the legitimacy of receivables if they
appear to involve a related party.
Case Illustration
One of the most famous financial frauds occurred in the 1980’s by “Crazy” Eddie
Antar, who operated a chain of consumer electronic stores.
Among other
techniques used by Antar to overstate income was the creation of fictitious
receivables by having employees create phoney sales invoices showing
merchandise sales. Antar even had the cooperation of major suppliers, who lied
when auditors sought confirmations of receivable balances.48
6.2.2 Inflating The Value Of Receivables
Inflating the value of legitimate receivables has the same impact as creating
fictitious ones.
GAAP requires accounts receivable to be reported at net
realizable value. Net realizable value is the gross value of the receivable less an
estimated allowance for uncollectible accounts.49 GAAP requires companies to
estimate the uncollectible portion of a receivable to determine the net realizable
value of receivables. The GAAP preferred method to determine uncollectible
receivables is to periodically record the estimate of uncollectible receivables as a
percentage of sales, outstanding receivables, or based on an aging of
outstanding receivables.
46
FIRST DRAFT
Under the allowance method bad debt provisions are recorded as a debit to bad
debt expense, (an income statement account) and a credit to allowance for
doubtful accounts, (a balance sheet contra receivable account.) When all or a
portion of the receivable becomes uncollectible, the uncollectible amount is
charged against the allowance account. When receivables are recorded at their
true net realizable value, the recording of a bad debt provision decreases
accounts receivable, current assets, working capital and most importantly, net
income.
Companies circumvent these rules by underestimating the uncollectible portion of
a receivable.
Underestimating the value of the provision (i.e., the amount
deemed uncollectible) artificially inflates the value of the receivable and records it
at an amount higher than net realizable value.
Overvaluing receivables also serve to understate the allowance account, such
that the provision is insufficient to accommodate receivables that in fact become
uncollectible.
A related scheme is not writing off (or delaying the write-off) of receivables that
have in fact become uncollectible. These schemes are relatively easy to execute
given the subjectivity involved in estimating bad debt provisions.
Potential auditing procedures include:
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
Spending adequate time to review and understand the provision;
Inquiring of management and accounting personnel as to the reasoning
behind the amount of the provision; and
Determining the reasonableness of the provision in relation to the true
facts surrounding the receivables.
Indicia of the potential overvaluation of receivables include:

Minimum bad debt provisions or reserves that appear to be inadequate in
relation to prior periods;
47
FIRST DRAFT
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A history of extending payment terms to customers with limited ability to
repay;
A history of inadequate reserves for uncollectible receivables;
Deteriorating economic conditions, e.g., declining sales;
Deteriorating accounts receivable days outstanding;
Untimely reconciliations and/or reconciliations that are “back of the
envelope”;
History of inadequate reserves for uncollectible receivables;
Net receivables (i.e., net of the allowance for doubtful account) which are
increasing faster than revenues;
Uncollectible accounts which have been on the books for extended
periods of time but have not been written off; and
Recorded disputes with a customer that may potentially threaten ability to
collect.
Follow up procedures include inquiring of:
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Company changes to its credit policy and the reason for such changes;
Management as to the reason for any change in the reserve rates or
policy for reserves in accounts receivable;
The sales force and Credit Department about whether they have been
pressured or requested to grant credit to customers who are not credit
worthy;
The Credit Department if they have been requested to extend payment
terms for certain customers;
The Credit Department to determine whether certain sales people have
instructed them to approve a customer and to avoid/circumvent the normal
approval process; and
The nature and details surrounding any disputes with customers.
Case Illustration
In 2002, pharmaceutical company Andrx Corp. announced the company would
have to restate its results going back to 1999 due to the discovery that an
employee of one of its subsidiaries altered certain accounting records pertaining
to accounts receivable balances and their associated aging relating to its
pharmaceutical and distribution operations.50
6.3 Investment Schemes
48
FIRST DRAFT
Fraudulent investment schemes provide another method for a company to
overstate assets.
Similar to schemes relating to inventory and receivables,
management can create fictitious investments or deliberately over-value existing
ones.
As discussed below, the auditor must first be familiar with all of the entity’s
investments and understand their classifications. This knowledge is necessary to
spot the red flags of potential fraudulent accounting practices. The auditor must
also be aware of the current market status of all investments and must confirm
that the entity’s books and records reflect all increase or decreases in such
status. In addition, the auditor should question all classifications of securities to
ensure that they are indeed classified in a manner that is consistent with the
company’s intentions and not just done to recognize gain or forgo recognizing
loss. The auditor should be also wary of losses on securities held as available
for sale that are accumulating in the other comprehensive income account. The
company must eventually take a charge for these losses either through a sale or
through a permanent write down. Evidence of accumulating losses may lead the
auditor to conclude that management is intentionally delaying the recognition of
such a loss.
6.3.1 Fictitious Investments
Fictitious investments are similar to the creation of other fictitious assets. Indicia
include:
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Missing supporting documentation;
Missing brokerage statements; and
Unusual investments (i.e., gold bullion) or ones held in remote locations or
with obscure third parties.
Follow up procedures an auditor can conduct include:


Confirming the existence of the investment by physical inspection or by
confirmation with the issuer or custodian;
Confirming unsettled transactions with the broker-dealer;
49
FIRST DRAFT


Reviewing the minutes of board of directors meetings and the company’s
Treasury policies to ensure that all investments were authorized by the
Board and that company policy was followed in the trading of and
investment in securities; and
Reviewing internal controls to ensure that the duties of purchasing,
recording, and custody are adequately segregated.
6.3.2 Manipulating the Value of Investments
Companies can also manipulate their financial statements by inflating the value
of investments by misclassifying them or failing to record unrealized declines in
market value for those investments.
We begin our discussion with a brief
overview of the applicable GAAP requirements.
GAAP requires investments of debt securities (i.e., bonds and other corporate
paper) to be classified as either trading, held to maturity or available for sale.
51
Investments may be classified as held to maturity only if the holder has the
positive intent and ability to hold those securities to maturity. Held to maturity
securities are reported at amortized cost with no adjustment made for unrealized
holdings gains or losses unless the value has declined below cost and is not
expected to recover. In the latter instance, the security is written down to fair
value and a loss recorded in earnings.52
GAAP requires investments to be classified as trading if they are bought and held
principally for sale in the near term. Investments not classified as trading or as
held-to-maturity are classified as available-for-sale securities.53
Trading and available for sale securities are reported at fair market value and
must be periodically adjusted for unrealized gains and losses to bring them to fair
market value. Unrealized gains or losses from trading securities are included in
income for the period.
Unrealized gains or losses from changes held as
available for sale are reported as a component of other comprehensive income. 54
Equity securities (i.e., common or preferred stock) on the other hand, can be
classified only as trading or available for sale. Unrealized gains or losses from
50
FIRST DRAFT
changes in fair market value are reported in earnings for trading securities and as
a component of other comprehensive income for securities held as available for
sale.
The transfer of a security between categories of investments is required to be
accounted for at fair value. Securities transferred from the trading category will
already have had any unrealized holding gain or loss reflected in earnings. For
securities transferred into the trading category, the unrealized holding gain or
loss at the date of the transfer are to be recognized in earnings immediately. For
a debt security transferred into the available-for-sale category from the held-tomaturity category, the unrealized holding gain or loss at the date of the transfer
must be reported in other comprehensive income. Securities transferred from
available for sale to held to maturity report unrealized holding gain or loss at the
date of the transfer as a separate component of other comprehensive income
and amortized to interest income over the remaining life of the security. 55
Generally, with respect to investments, auditors should consider inquiring of:


Management as to company policies regarding the recording of unrealised
gains or losses on trading and available for sale securities; and
Accounting personnel as to they have been asked to:
-

Record held to maturity securities at anything but amortized cost;
Not record all unrealised gains and losses in available for sale and
trading securities have been recorded and if not the reason; and
Postpone a write down of a debt security.
Misclassification of Investments
Companies can manipulate financial statements by intentionally misclassifying
securities or transferring securities to a class that would trigger the recognition of
gain or conversely postpone the recognition of a loss. For example, a company
might misclassify a debt security as held to maturity to avoid recognizing a
decline of value in the current period. Similarly, transferring a security from held
to maturity to either trading or available for sale would permit the recognition of
gains that had not been previously recognized.
51
FIRST DRAFT
The Treasury function most commonly decides the classification at the time that
the security is acquired. Auditors should review any changes in classification for
possible abuse.

Recording Unrealized Declines in Fair Market Value
Deciding whether to write down a security due to a permanent decline in value is
highly subjective and ordinarily left to the discretion of management. Accepting a
write down results in a charge against net income. The auditor thus should
consider whether management has inappropriately failed to or delayed a write
down an impaired security to inflate income.
6.4 Improper Capitalization Of Expenses
Capitalization of company expenditures is another fertile area for abuse. The
most common way is to record expenditures as capital items rather than ordinary
expenses. This technique allows the company to capitalize and amortize the
expense over many periods rather than recognize it in its entirety in the current
period.
The start of any audit with respect to questionable capitalization policies should
be the company’s accounting policy with respect to this area in addition to the
policies of other entities in the industry. Is the company being overly aggressive
with its policies as compared to other companies? Due consideration must also
be given to management’s reasons for selecting the policy. The auditor will also
want to consider whether the costs in question are providing future benefit
thereby warranting capitalization. Detecting capitalization policies can often be
achieved by considering or reviewing the following items:


Is there a heavy capitalization of fixed assets?
Are capitalized costs that are increasing faster than revenue over lengthy
periods?
52
FIRST DRAFT



Are repair and maintenance expenses (or other operating expense)
dropping out of line with operations (indicating these are possibly being
capitalized instead of expensed?
With respect to construction contracts, does interest expense properly
increase when construction and capitalization of expenditures has
ceased?
Have prior accounting policies have been aggressive with respect to
capitalization?
Case Illustration
The WorldCom case is perhaps the most infamous example of how a company
can inflate earnings through improper capitalization of expenses. The company’s
internal audit department discovered that management had categorized billions
of dollars as capital expenditures in 2001 that, in fact, were ordinary expenses
paid to local telephone companies to complete calls.
The scheme allowed
WorldCom to turn a $662 million loss into a $2.4 billion profit.
6.4.1 Software Development
GAAP requires companies to treat costs associated with developing new
software as expenses until the point of technological feasibility. Technological
feasibility is established upon completion of a detail program design or, in its
absence, completion of a working model.
Upon technological feasibility, all
software production costs must be capitalized and subsequently reported at the
lower of unamortized cost or net realizable value.56
Whether technological feasibility has been reached is a subjective decision and
thus subject to abuse.
By arbitrarily determining technological feasibility,
management can manipulate income by increasing or decreasing the amount
capitalized or expensed. Auditors should consult with the company’s technical
personnel (i.e. engineers, programmers) in reviewing management’s assertions
that technological feasibility has been achieved.
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6.4.2 Research and Development (“R&D”)
GAAP generally requires R&D costs to be expensed due to the uncertainty of the
amount and timing of economic benefits to be gained from R&D. A company,
however, may capitalize materials, equipment, intangibles, or facilities that have
alternate future uses.57 The SEC has also been particularly concerned about
mergers and the acquirers who classify a large part of the acquisition price as in
process research and development (“R&D”), thereby allowing the entity to
immediately expense the costs.58 This practice allows the entity to write off the
R&D in a single chunk in the year of acquisition and not burdening future
earnings with amortized R&D charges. This type of practice also involves the
creation of liabilities for future operating expenses.
Case Illustration
The SEC action against Pinnacle Holdings, Inc. arising from its acquisition of
certain assets from Motorola is illustrative. The SEC found that that Pinnacle
improperly established more than $24 million of liabilities that did not represent
liabilities at the time of the acquisition.59
6.4.3 Start Up Costs
Similar to R&D, GAAP requires all start-up costs to be expensed in the year
incurred.60 However, many entities will label start up activities as other costs
thereby attempting to capitalize them.
6.4.4 Interest Costs
SFAS 34, Capitalization of Interest Costs61, requires the capitalization of interest
costs incurred during the acquisition and construction of an asset. The interest
cost capitalized is added to the cost of acquiring the asset and then amortized
over the useful life of the asset. The total interest cost capitalized in a period
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may not exceed the interest cost incurred during that period. Capitalization is no
longer allowed when the cost of the asset exceeds its net realizable value. One
potential scheme in this area is for the company to continue capitalizing interest
after construction has been completed.
6.4.5 Advertising Costs
SOP 93-7, Reporting on Advertising Costs62, provides that all advertising
expenses must be expensed as incurred unless there exists persuasive historic
evidence that allow the entity to make a reliable estimate of future revenue to be
obtained as a result of the advertising in which case the expenditures are allowed
to be capitalized.
Case Illustration
In 2000, the SEC charged America Online, (“AOL”), with incorrectly amortizing
for the fiscal years 1995 and 1996, the subscriber acquisition costs associated
with the manufacturing and distributing of computer disks containing its program
to prospective customers. The SEC claimed that because of the volatile and
unstable nature of the internet industry during the period in question, AOL could
not with any reliability make a prediction of future net revenues.
Thus, the
subscriber costs were more like advertising costs and required expensing in
accordance with SOP 93-7. AOL had reported profits for six of the eight quarters
in 1995-1996 instead of the losses it would have reported had these costs been
expensed. The costs improperly capitalized amounted to approximately $385
million by September 30, 1996 when AOL decided to write them off.
6.5 Recording Fictitious Fixed Assets
Similar to the concept of recording fictitious sales or receivables, entities will
record fictitious assets to improve the balance sheet which, as previously
discussed, inflates earnings as well.
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Indicia of fictitious assets include:







Fixed assets on books and records which do not have an apparent
relation to the business;
Lack of a subsidiary ledger to record additions and retirements;
Lack of adequate policies and procedures to determine whether property
and equipment are received and properly recorded;
Lack of procedures to account for fixed assets that may have been moved
from one facility to another;
Existence of a second-hand storage facility for fixed assets that may still
have useful life but for some reason are not being used;
Lack of adequate written policies and procedures concerning the
recording, retirement and disposition of fixed assets; and
Sub-ledgers that do not reconcile to the general ledger.
Follow up procedures to consider if any of these indicia are present include:



Tour of the client’s facility to review fixed assets: select certain fixed
assets from the fixed asset listing (especially new, significant additions),
physically confirming that the fixed asset exists and physically inspecting
the asset’s serial number if applicable;
Determine that retired assets are no longer included in financial
statements; and
Review internal controls to ensure that there are written policies covering
retirement procedures which include serially [sequentially] numbered
retirement work orders, reasons for retirement and all necessary
approvals.
6.6 Depreciation & Amortization Schemes
An
easy
way
to
inflate
the
value
of
an
asset
is
to
extend
its
depreciable/amortizable life so that it is carried on the books for a longer period.
Depreciation is another area in which management is given leeway to choose
any method so long is that method allocates the costs in a “rational and
systematic manner.”
Detection of these schemes begins with a review of the company’s depreciation
policy. Most companies have written policies for depreciating assets. Lack of a
written policy heightens the potential for abuse as it enables management
potentially to record depreciation on an ad hoc basis with no particular rational.
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Similarly, recent changes to the entity’s depreciation policy should be scrutinized
for both their purpose and effect on the entity’s assets.
Auditors who have suspicions should consider:





Reviewing the records of depreciable assets for unusually slow
depreciation or lengthy amortization periods;
Comparing prior years depreciation charges with current year for
reasonableness;
Identifying changes in policy which may affect the rate of depreciation that
appears to boost earnings;
Inquire into historical depreciation policies to determine the extent of their
aggressiveness; and
Reviewing a detailed list of fixed assets as well as the assigned lives of
the assets and then randomly selecting certain fixed assets and
recalculating the net book value at reporting date based upon the recorded
life of the asset.
7. Understatement Liabilities and Expenses
7.1
General
Understating liabilities and expenses mirrors overstating income and assets - both serve to inflate artificially earnings and/or the company’s financial condition.
Auditors can use various analytical indicators to search for indicia of these
schemes, including:




An increasing current ratio (current assets/current liabilities) or quick
ratio (cash + marketable securities + net receivables/current liabilities)
from one period to the next;
Unexpected improvements in gross margins from one period to the
next;
Change in inventory with no simultaneous increase in accounts
payable or accrued expenses between periods; and
A comparison of the percent change in the accrued expense account
with revenues reveals that revenue is increasing faster than accrued
expense payable.
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In addition to the above analytical procedures, an auditor should also inquire of
accounting personnel as to whether they have ever been asked to postpone
expenses until a subsequent period. Finally, the auditor should also:







7.2
Review expense ledger and perform cut-off test to ensure that
expenses are recorded in proper period and not postponed until a
subsequent period;
Review prior years expenses and liabilities and look for unusual trends;
Perform current or quick ratio analysis which may indicate the
concealment of liabilities;
Examine account detail looking for unusual debits to liabilities which
would have the affect of reclassifying an expense to the balance sheet
and also improving the current ratio (certain levels of current ratio may
be required for debt covenant compliance);
Consider performing data mining procedures to identify significant
payments for further review to determine whether the payment should
have been capitalized;
Review internal controls to ensure expenses are record in proper
period and not postponed until a subsequent period; and
Review expenditures to determine whether they are more appropriately
classified as expenses.
Establishing Off-Balance Sheet Entities
The Enron scandal highlighted the practice of fraud by using “off-balance sheet”
vehicles to transfer and conceal debt.63
It must be noted however, that off-
balance sheet vehicles, despite a recent significant tightening in accounting
rules, are in fact permissible under GAAP. The fraud occurs when companies
use them to, for example, conceal debt thereby misleading investors about the
risks and rewards of a transaction, particularly when inadequate or misleading
disclosure is provided.
Off-balance sheet transactions also have an income
statement impact as well. With an off-balance sheet transaction, a company’s
“investment” account on the income statement will reflect the relevant proportion
of net profit or loss that results from operation of the underlying net assets. In
other words, the effect of non-consolidation should leave income the same as if
the off-balance sheet investment had been consolidated. However, the individual
line items composing that net income or loss are not explicitly shown.
A
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consolidation treatment conversely, would show individual revenue and expense
line items.
7.2.1 Off-Balance Sheet Treatment Versus Consolidation
Off-balance sheet transactions are transactions wherein a company retains the
benefits of assets in a corporate vehicle not consolidated for financial accounting
purposes. These investments can typically appear in the asset section of the
balance sheet as a single net line item, titled variously as an “investment in
affiliate”, “retained interest in securitization”, etc.
Off-balance sheet transactions enable the company to avoid showing the
individual asset of the off-balance sheet vehicle in the balance sheet, and more
importantly, the associated debt used to acquire the off-balance sheet vehicle’s
assets. Stated differently, the company executing the transaction reports only its
proportion of the net assets of the off balance sheet vehicle as an asset, rather
than reporting the gross assets of the vehicle, including the vehicle’s total debt
and outside interests held by other parties.
While this form of reporting
technically would not change the net equity of the company executing the
transaction, the consolidated balance sheet would show greater total assets and
greater total debt.
Thus, in executing an off-balance sheet transaction, the
company looks more financially attractive. In addition, there is an impact upon
balance-sheet dependent financial ratios; for instance, it is likely that debt to
equity ratios will be higher, and therefore less favorable, under consolidation
treatment as compared to non-consolidation.
Off-balance sheet treatment has historically been used for among other things:


Securitization transactions - financial assets such as receivables are
sold to an off-balance sheet vehicle while the seller retains a
subordinated interest in that entity;
Leasing transactions – long-lived assets are acquired by an offbalance sheet entity. The use of the assets is conveyed to a third party
via an operating lease; and
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
Non-controlling investments: assets or businesses are
entity that does not convey control back to the investors.
example is a jointly controlled joint venture. The assets
that venture remains off-balance sheet for at least
partner/investors involved.
held by an
One simple
and debt of
one of the
7.2.2 The Old Rules
Enron has resulted in substantial changes to the accounting rules for off-balance
sheet transactions. Until recently, accounting rules relied on two basic “models”
to determine whether consolidation treatment was proper.
The first model
focused upon voting control, and required consolidation if one entity controlled
another. This “voting-control” model was heavily relied upon in situations where
the subject of the analysis was a business, rather than just a pool of assets and
debt.
The second model, the “SPE model,” applied primarily to entities seen as
“special purpose entities.” Factors which would typically tend to indicate that a
vehicle is an SPE are (i) limited powers in the vehicle’s powers/charter or (ii) the
housing of assets, rather than a business, for which there were a limited purpose
and with respect to which few decisions need be made.
The potential for abuse under the old rules generally occurred in the following
areas:



Intentional manipulation in the determination of whether to apply
the voting control or the SPE model - - the result being that the
wrong conclusion had been reached;
Intentional manipulation in the application of the correct accounting
model; and
Intentional and overaggressive use of the wrong accounting model.
7.2.3 The “New Rules”
In light of the Enron scandal, the Financial Accounting Standards Board (“FASB”)
expanded upon the accounting guidance that governs when a company should
include the assets and liabilities of another entity in its own financial statements.
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Financial Interpretation No. (“FIN”) 46, Consolidation of Variable Interest Entities,
applies consolidation requirements to applicable entities created after January
31, 2003. While the technical rules of the new rule are beyond the scope of this
chapter, it is worth providing a brief synopsis of the major provisions.
The
underlying principle behind the new Interpretation is that if a business enterprise
has the majority financial interest in an entity, which is defined in the guidance as
a variable interest entity (“VIE”), the assets, liabilities and results of the activities
of the VIE should be included in consolidated financial statements with those of
the business enterprise. Prior to FIN 46, one company generally has included
another entity in its consolidated financial statements only if it controlled the
entity through voting interests.
FIN 46 changes that by requiring a variable
interest entity to be consolidated by a company if that company is subject to a
majority of the risk of loss from the VIE’s activities or entitled to receive a majority
of the entity's residual returns or both. A company that consolidates a VIE is
called the primary beneficiary of that entity.
In general, a variable interest entity is a corporation, partnership, trust, or any
other legal structure used for business purposes that does not have sufficient
equity investment at risk to permit it to finance its activities without additional
subordinated financial support. The Interpretation is also applicable to an entity
whose equity holders do not have (i) the direct or indirect right to make decisions
about the entity's activities through voting rights or similar rights, (ii) the obligation
to absorb the expected losses of the entity if they occur or (iii) the right to receive
the expected residual returns of the entity. A variable interest entity often holds
financial assets, including loans or receivables, real estate or other property.
FIN 46 places much emphasis on a risk and reward model of consolidation and
contains a new scope test that serves to direct whether an off-balance sheet
entity is a VIE, and thus whether the provisions of FIN 46 govern and require
consolidation of the off-balance sheet entity.
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The scope test itself is composed of two key questions. The first question is
whether there is sufficient equity in the entity. The second question is whether
the equity has the proper characteristics.
A “no” answer to either question
means the entity is a variable interest entity that must apply the new model and
consolidate.
To demonstrate whether an entity has enough residual equity
between the equity holders to absorb expected losses, as defined by FIN 46, in
most cases requires a demonstration that equity exceeds the expected losses, if
any. If they do not, the entity is a VIE requiring consolidation under FIN 46. The
second question asks whether the equity of the entity does have has certain
characteristics that make it act like true e residual common equity.
One of the issues involved with the scope test is the high degree of subjectivity
involved.
What is sufficient equity as required by the rule? The rule creates a
rebuttable presumption that an equity investment of less than 10 percent of an
entity's total assets is not sufficient to permit an entity to finance its activities
without additional subordinated financial support. One can rebut the presumption
by demonstrating that the entity:



Is currently or intends to finance its activities without additional
subordinated financial support;
Has at least as much equity invested as other entities holding only
assets similar in quantity and quality that operate without additional
subordinated financial support; or
The amount of equity invested in the entity is greater than a reasonably
reliable estimate of the entity's expected losses.64
Assuming an entity is a variable interest entity, and thus within the scope of FIN
46, the rule then focuses upon which party to the transaction has a majority of
the risks and/or rewards. However, in order to determine who bears a majority of
the risk or reward, a projection of cash flows may be required. These projections
are an opening for a great degree of subjectivity and therefore manipulation.
The above rules are too new to have resulted any fraud cases. Obviously, hiding
or disguising information from the auditor or investing public is the easiest way
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for a company to keep assets and liabilities off its books or inflate income.
Another possibility as mentioned above, is manipulation of the amount of equity
reported in the entity to avoid coming under the provisions of FIN 46.
Management might also manipulate the estimate of expected losses in their cash
flow projections in order to obtain off-balance sheet treatment. Manipulation can
take many forms such as failing to recognize impairments that would decrease
expected cash flows.
Auditors will need to consider the potential of these new schemes on a case-bycase basis.
7.3 Overstatement of Liability Reserves (“Cookie Jar Reserves”)
While most fraud schemes are geared toward inflating the current financial
position, companies sometimes overstate the amount of provisions to cover the
expected costs of liabilities such as taxes, litigation, bad debts, job cuts and
acquisitions. In doing so, management will establish inflated accruals in those
years where the company is extremely profitable and doing well and can afford to
incur larger expense amounts. These “cookie jar reserves” are then tucked away
for management to reach into and reverse in future years where the company is
unprofitable or marginally profitable when a boost to earnings would be
beneficial.
Company managers estimate reserves. The outside auditor judges whether the
reserves are reasonable.
Generally, it is difficult for auditors to challenge
company estimates because there are no clear accounting guidelines.
This
creates a ripe environment for abuse.
Be mindful of account descriptions.
A title such as “Miscellaneous Provision”
may be an indicator of a Cookie Jar reserve account. Fro example, in a recent
investigation conducted by PwC, inquiry was made of the internal auditor as to
which account the company used when it needed to ‘make the numbers’?
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Without hesitation, the internal auditor cited an account number, which was
associated with an account named “Miscellaneous Provision.” Through account
analysis and collaboration with company employees, it was determined that over
$7 million was in this account to use for a rainy day. The explanation provided
was that the company had already met the goals to pay bonuses for the end of
the period, so this account had some reserve left if need be for future periods.
Case Illustration
In 2002, Microsoft Corp. settled SEC allegations that it had misstated earnings by
maintaining unsupported reserves regarding accruals, allowances, and liability
accounts relating to marketing expenses, sales to original equipment
manufacturers, accelerated depreciation, inventory obsolescence, valuation of
financial assets, interest income, and impairment of manufacturing facilities.
These reserves totalled between $200 million to $900 million during the fiscal
years ended June 30, 1995 through June 30, 1998. These corporate reserves
did not have properly substantiated bases but were based, in part, on judgment
regarding the likelihood of future business events. The SEC further charged the
company with failing to maintain sufficient documentation of the bases for these
reserve accounts and to apply its own accounting policy relating to the
reconciliation of entries in its accounting system. Microsoft failed to maintain
sufficient documentation of the bases for these reserve accounts and to apply its
own accounting policy relating to the reconciliation of entries in its accounting
system.65
8. Improper and Inadequate Disclosures
Financial statement fraud is not limited to numbers.
A company can also
misrepresent the financial condition of the company through misstatements and
omissions of the facts and circumstances behind the numbers.
Improper
disclosures can take various forms notably, misrepresentations, intentional
inaccuracies, or deliberate omissions in:
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


Descriptions of the company or its products, in news reports,
interviews, annual reports, websites, etc.;
Management discussions and other non-financial statement sections
of annual reports, 10-Ks, 10-Qs, and other reports; and
Footnotes to the financial statements.
In all these instances, management has perpetrated a fraud on the readers of the
financial statements by not providing sufficient information required to make an
informed decision regarding the financial position of the company.
Case Illustration
Enron has become famous for its misleading disclosures. Consider for example,
the following disclosure provided by Enron Corp. in its 2000 Proxy Statement:
“During 2000, certain Enron subsidiaries…entered into a number of
transactions with LJM2 Co-Investment…Andrew S. Fastow, Executive
Vice President and Chief Financial Officer of Enron, is the managing
member of LJM2’s general partner.”
The paragraph describing the “transactions” read as follows:
“These transactions occurred in the ordinary course of Enron’s business
and were negotiated on an arm’s length basis with senior officers of Enron
other than Mr. Fastow. Management believes that the terms of the
transactions were reasonable and no less favourable than the terms of
similar arrangements with unrelated third parties.”
These disclosures misled average investors, as well as seasoned analysts, to
assume that Enron was engaged in legitimate transactions that were providing
the company with enormous amounts of revenue. We all now know however that
these transactions were anything but arms length and reasonable and certainly
not less favourable than other transactions entered into by the company.
Consider another example of an improper Enron disclosure. In the company’s
financial statements in Forms 10-Q and 10-K beginning with the second quarter
of 1999 and through the second quarter of 2001, the company made the
following footnote disclosure with respect to its related party transactions:
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“A senior officer of Enron is managing member of LJM’s general partner.”
This clearly inadequate disclosure was made despite the fact that SEC
Regulations expressly requires a description of any transactions involving a
registrant that exceed $60,000 and in which an executive of the company has a
material interest.66
The Sarbanes-Oxley Act of 200267 ,(“Sarbanes”), attempts to correct many of the
shortcomings of non-financial disclosures. Sarbanes requires CEOs and CFOs
to acknowledge their duty to establish and maintain “disclosure controls and
procedures” (“DC&P”) and to confirm the effectiveness of the company’s such
disclosure controls & procedures. The term DC&P is a new term that expands
beyond traditional notions of internal controls, as it includes both financial and
non-financial information. DC&P includes all information in the company’s public
filings including such items as market share, information on competitive
environment, regulatory environment, business goals, objectives and strategy,
governance matters, planned acquisitions, customers, supply chain, and
contracts. Sarbanes also requires prompt disclosure (in plain English) of all
material changes in the company’s financial condition and other significant
company news.
The statute also requires disclosure of off-balance sheet
transactions, as defined under the statute.68
Sarbanes likely will create a new array of fraud schemes as unscrupulous
companies and individuals seek to circumvent the disclosure requirements and
other reforms in the statute.
Whether auditors will be required to audit the
accuracy of non-financial statement disclosure has not been settled as of the
writing of this chapter. Nonetheless, auditors should scrutinize all disclosures
carefully and, where appropriate, inquire into the source and truthfulness of nonfinancial statements, such as description of business plans, claims of market
share, etc. The auditor should consider seeking access to normally restricted
files such as internal memos, minutes of board meetings, business plans, and
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other information not normally looked at during the course of a financial
statement audit. If the company denies access, it may tip off the auditor that
there is something the company does not want you to see.
9.
Materiality
No discussion of financial statement fraud is complete without a discussion of
materiality. Companies (and sometimes auditors) dismiss improprieties because
they are not “material” to the financial statements.
Materiality is a mixed question of legal and accounting principles. Guidance can
be found from the Supreme Court, SEC, FASB, and academia. The Supreme
Court has defined something as material if “…there is substantial likelihood that
the disclosure of the omitted fact would have been viewed by the reasonable
investor as having significantly altered the ‘total mix’ of information made
available.”69 The SEC echoes this in Regulation S-X where in it defines material
items to be limited to “…those matters to which an average prudent investor
ought to be reasonably informed before purchasing the registered security.” 70
The FASB has defined materiality to be “…the magnitude of an omission or
misstatement of accounting information that, in the light of surrounding
circumstances, makes it probable that the judgement of a reasonable person
relying on the information would have been changed or influenced by the
omission or misstatement.”71
Over time, companies and their auditors have also developed certain “rules of
thumb” to assist them in determining when a matter might be deemed material.
One frequently used rule of thumb is that a misstatement or omission that is less
than 5% of some factor (i.e., net income or net assets, etc.) is not material.
The SEC sought to settle the issue of materiality and remedy the potential for
earnings management abuse with the release of SAB No. 99, Materiality.72 SAB
No. 99 provides guidance for preparers and auditors on evaluating the materiality
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of misstatements in the financial reporting and auditing process by summarizing
and analysing GAAP and federal securities laws as they relate to materiality in
addition to offering examples of what is and is not acceptable with regard to
materiality. While the SEC does not object to the use of the 5% threshold as a
preliminary assessment of materiality, it emphasizes that exclusive reliance on
quantitative benchmarks, such as the 5% rule can only be the beginning of a
materiality analysis and not a substitute for a full analysis of one. SAB 99 goes
on to note that when considering materiality, certain qualitative factors can cause
even quantitatively small misstatements to become material.
Examples of
qualitative factors to be considered include whether the misstatements







Arise from imprecise estimates;
Mask changes in earnings trends;
Cause financial statements to meet analysts’ expectations;
Would change a loss to income or vice versa;
Affect compliance with regulations or contracts;
Affect management compensation; or
Arise from illegal acts.
Thus, it is clear that numerical tests also will no longer satisfy a materiality
analysis and that the auditor must question the facts and circumstances
surrounding all suspicious transactions and cannot simply pass on them if they
are deemed financially immaterial.
10. Misappropriation of Assets
The chapter has so far focused on reporting fraudulent financial reporting by the
corporation. However, financial fraud can and often is committed against the
corporation - - the most common being external or internal misappropriation of
assets. The Association of Certified Fraud Examiners estimates that up to 6% of
organizational revenues are lost to fraud.73 While most misappropriations are
often quantitatively immaterial when looked at in isolation, often times they occur
enough so that they rapidly become material to an organization.
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The chapter does not detail each and every way employees and third parties
steal from companies.
characteristics.
Many schemes are interrelated and share similar
For instance, register disbursement schemes can often be
detected by and prevented with the same techniques used to stop billing
schemes.
The discussion of one satisfies the other.
One common theme
however, is the importance of having and applying strong internal controls, which
cannot be circumvented or overridden.
In addition, this section does not detail every asset a company may have that is
subject to misappropriation but seeks only to list those assets that appear on the
balance sheet of most entities. Companies in different industries have various
types of assets on their balance sheet. Thus there will be certain assets not
listed here. For instance, intellectual property is an asset which can be subject to
theft. However due to the complexities of issues surrounding that asset, it is not
listed in this chapter.
Case Illustration
After Robert Maxwell, founder of the Mirror Newspaper Group drowned
mysteriously while cruising off the Canary Islands, investigators discovered that
he had misappropriated approximately 440 million pounds from his companies
and their pension plans to finance his corporate expansion. Maxwell’s companies
were forced to file for bankruptcy protection in Great Britain and the United
States in 1992.
10.1 Misappropriation of Cash
Cash schemes are the most common form of misappropriation of assets. The
major categories include: (i) skimming and larceny of cash and (ii) fraudulent
disbursements. Fraudulent disbursements include: (i) billing schemes, (ii) payroll
schemes, (iii) expense reimbursement schemes, (iv) check theft and tampering
of checks and (v) register disbursement schemes.74
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10.1.1 Skimming of Cash

Unrecorded or Understated Sales or Receivables - (Failure to record
the full amount of sales or other items of income.)
Many asset misappropriation schemes start at the entry point of the sale. An
employee can embezzle monies by not recording the sale or full amount of the
monies received.
Deterrence of skimming activities requires adequate
segregation of duties among the individuals recording the sales, receiving the
monies, and recording the sales in the books. In addition, particular attention
must be paid to those individuals, such as consultants and sales people, who
handle cash in offsite locations.
These individuals often operate without
sufficient controls governing their conduct that can lead to the perpetration of this
scheme.
Case Illustration
In 2003, at least eight Southwest Airlines employees were accused of
misappropriating more than $1.1 million from the airline company using a variety
of skimming techniques. In one method, a ticket counter worker saved an old
ticket that should have been voided. The unmarked ticket then was sold to a
cash-paying customer, who used the ticket. The employee pocketed the money.
Special attention should also be given to payments made on the account.
Perpetrators can convert the cash and then either wait for an alternative source
of funds to make up for the replace the funds converted (This practice, more
commonly known as lapping, will be discussed in detail below.) The perpetrator
may simply not record the payment against the customer’s account at all. The
customer’s receivable balance will remain unchanged or slightly changed despite
the fact that they have been making payments. After the receivable has aged
significantly, the perpetrator writes off the receivable balance as unpaid.
Adequate segregation of duties again is key. The same individual should not be
in charge of recording and monitoring receivables in addition to being given the
responsibility of authorizing and recording write offs.
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The auditor should review the customer complaint log for complaints regarding
the misapplication or lack of payment to their receivable account balance and
follow-up on any recorded complaints with both management and the customer
to see what the nature of the problem was, how it was resolved, by whom within
the organization and finally whether the problem occurred subsequently.
The auditor should also consider performing certain analytics and noting
particular trends such as:








Cash that is decreasing in relation to total current assets;
Cash that is decreasing in relation to credit sales;
Decrease in sales accompanied by an increase in cost of sales;
Current ratio which has decreased significantly from prior periods;
Decreasing gross margins from the prior to the current period;
Cash collections which are significantly less than reported revenues;
Significant amount of write offs in the current period as compared to the
previous period; and
Decreasing trend of payments on accounts receivable.
Other indicia of the existence of this scheme include:








Lack of segregation of duties between the sales, receipts and recording
functions;
Poor controls over the completeness of recording sales;
Sharp increase in the average length of time that customer cash receipts
are maintained in an account before being applied to customer’s
outstanding balance;
Periodic or large or numerous debits or other write offs to aged accounts;
Recorded customer complaints regarding misapplication of payments to
their account;
Forced account balances such as overstatements of cash balances that
are made to match the accounts receivable balance;
Numerous or significant reversing entries or other adjustments been made
which have caused the books or register to reconcile to the amount if cash
on hand; and
Large or numerous suspicious debit adjustments to aged receivable
accounts.
Finally, an auditor confronted with these high risk factors should consider:
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





Inquiring of management or internal audit group whether there ever been
previous problems with employee theft of incoming cash receipts;
Inquiring as to the company’s policy for monitoring off site sales people (if
applicable) or rental properties that generate cash flows for the company;
Inquiring on how reconciling items or discrepancies are treated and
reviewed by management;
Inquiring of management and sales personnel regarding customer
complaints about billing and/or payments not being applied to their
accounts;
Following up with customers regarding any recorded complaints; and
Inquiring of management and others whether they are aware of any
employees having financial difficulties.

Lapping
Lapping generally involves converting one customer’s payment and then using a
subsequent payment, usually from another customer, to cover the payment
converted from the previous customer's account. For example, the perpetrator
will steals the payment intended for customer A’s account. When a payment is
received from customer B, the thief credits it to A’s account. And when customer
C pays, that money is credited to B.
Lapping tends to increase at exponential rates and lapping schemes often tend
to reveal themselves because the employee is unable to keep track or obtain
additional payments to cover up the prior skimming.75
Case Illustration
In 1998, Canadian police arrested a bank manager of the Canadian Imperial
Bank of Commerce and charged her with forging her client’s signatures and
using the lapping scheme to misappropriate more than USD $500,000 of client
funds.
Approximately USD $158,000 of this money was used for her own
purposes. According to police, the manager began the scheme by forging a
client's
signature
to
prematurely
cash
an
investment
certificate.
She redeemed that first set of investments and when she redeemed the second
set, it would cover the shortage in the first set, with a little bit left over for her own
use. Before that second set of investments came due, the manager would cash
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another set to pay that second set off, and so on. In each case, the amount taken
increased and eventually totalled USD $500,000 worth of her clients'
The controls, analytical and other indicators that apply to skimming also apply to
lapping. However, one of the most effective ways to control a potential lapping
scheme is to require a daily bank deposit in addition to an independent
confirmation that the deposit was properly made. Additionally, the auditor be
aware, pay attention and inquire into any delays in the processing of payments to
customer’s accounts and inquire as to the reason for those delays.
10.1.2
Fraudulent Disbursements
Cash schemes involve the theft of revenues before they have been recorded in
the books and records of the company. Fraudulent disbursement schemes, on
the other hand, involve theft of funds already entered into the books and records.
Fraudulent disbursement schemes generally fall into five main categories:





Billing schemes;
Theft of company checks;
Payroll schemes;
Expense reimbursement schemes; and
Register disbursement schemes.
These five categories in turn can be broken down further to include a host of
other individual schemes many which, like the cash skimming schemes
discussed above are similar in their nature and means of detection.

Billing Schemes - Creation of Fictitious Vendors or the Use of Shell
Companies to Convert Monies
A common billing scheme is the creation of fictitious vendors or shell companies.
The perpetrator will create a fictitious vendor, usually a company owned by him
or her self, and then have the fictitious bill the entity for goods or services it does
not receive.
Alternatively, the perpetrator can create a shell company to
purchase goods or services, which are then marked up and sold to the employer
through the shell. This scheme is most easily accomplished when one or few
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individuals maintain control over multiple functions and duties such as
purchasing, selecting vendors, and receiving, and approving payments. Lack of
adequate written cash disbursement procedures, such as requiring independent
approval for disbursements over a particular amount, also heightens the risk of
this scheme.
Third party vendor diligence is a useful prevention and detection technique.
Such diligence should include:




Verification of the name and address of the new vendor by obtaining
and maintaining on file copies of corporate records and other relevant
documents evidencing its existence (and not simply a shell);
Obtaining credit references from Dun and Bradstreet or other similar
reports;
Requesting the vendor to furnish credit and other references
establishing its identity; and
Checking the vendor address against the employee database to
ensure that it does not match the known addresses of any employees
or to determine whether any other relations exist between employees
and the vendor. In addition, the auditor should be alert for addresses
that are PO boxes. These should be instant red flags of the existence
of a fictitious vendor.
Once the new vendor has been approved, he or she should be entered into a
master vendor database to which only a select few individuals have authority to
enter into and change.
These changes should be made in accordance with
written procedures requiring proper authorization. An independent third party
should periodically audit the database to ensure that the listed vendors are
indeed still active and not being used to process fictitious invoices.
Once the company commences business with the vendor, an appropriate
independent person should approve all purchase orders prior to being
processed. In addition, adequate supporting documentation including an original
invoice from the supplier, and a receipt to indicate that the product was delivered,
should be requested and reviewed to support all cash disbursements.
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The same person should not be able to both request and approve purchase
orders.
Likewise, only designated check signers should be able to disburse
payment.
New accounts should also be monitored for some time for:




Increases in the amount or frequency of billings;
Variances from budgets or projections;
Discrepancies between the vendor’s prices and those charged by other
sources; and
Frequent or sizeable price increases by certain vendors with no
explanation.
Auditors should follow up fraud indicators by looking for:








Transactions lacking all required supporting documentation;
Numerous disbursements approved by one particular employee to a
particular vendor which are just below the employee’s spending authority
or which are for large even amounts or which are made on unusual dates
such as weekends and holidays;
Invoices which do not match with the original purchase order and if
applicable the original sales contract;
Multiple payments to the same vendors in the same period by the same
employee usually under the employee’s spending limit;
Excessive “soft expenses” such as consulting fees, sales commissions,
and advertising where there are no tangible products attached to the
payable, paid to the same vendor by the same or few employees;
Checks made to “cash” or “bearer” for alleged services or products
received;
Suspect endorsements on checks; and
Checks with more than one endorsement, checks payable to businesses
or individuals that were cashed and not deposited and checks endorsed
by individuals.
Computer assisted auditing programs are available for many of these indicators.
The auditor should compare the master vendor database against the prior year’s
database. The auditor should inquire into the selection and approval process of
new vendors. Further, the auditor should match the checks issued against the
master vendor database, and investigate any payments to vendors who are not
in the master database.
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Case Illustration
A former controller of a well-known hotel misappropriated over $15 million in
cash by setting up a dummy corporation and issuing phoney invoices for services
never rendered to the hotel.
The controller was able to get away with this
scheme for over 6 years because he maintained sole control over the hotel bank
account and was able to submit phoney invoices and issue checks or wire funds
to the dummy corporation controlled by him.

Billing Schemes - False Credits, Refunds, Rebates and Kickbacks
These fraudulent disbursement schemes require collusion between an internal
employee and a third party to issue false rebates, discounts or credits. These
schemes can occur with suppliers, as well as customers.
Deterrence and detection begin with the company’s process for issuing and
reviewing refunds, credits, rebates and discounts. Does the credit/refund/rebate
process contain sufficient levels of review by independent supervisory authority?
Do cash register employees possess authority to void their own transactions?
Are only selected individuals authorized to offer rebates/discounts to vendors and
customers? Do the appropriate people verify the rebate/credit transactions or
are they merely
“rubber stamped”?
Is there adequate segregation of
incompatible functions such as approval of vendors, maintaining the vendor
master file, purchasing, processing of payments, and issuing and authorizing
disbursements? Is there an adequate segregation of duties between individuals
authorized to process checks and those in supervisory role? Is access to cash,
checks, or purchase orders, shared by many employees?
Potential red flags for this scheme include:




Duplicate or multiple large amounts of refunds, credits or rebates, issued
just under the review limit or in round numbers to the same vendor;
Excessive number of “voided” purchase or sales transactions for which no
supporting documentation is found;
Unusual reconciling items or lack of timely resolution of reconciling items;
Large or numerous payments to particular vendors for which there is little
or no supporting documentation or where the documentation contains
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

discrepancies between the payment information and the back up
documentation;
Supporting documentation that contains anomalies such as invoices from
several suppliers with different names but with the same address or which
are signed by the same person or which return to a post office number;
and
Sales contract specifications, purchase orders and invoices that are vague
in nature;
The auditor can employ many of the procedures outlined in the fictitious vendor
discussion above. In addition, the auditor should consider whether to:




Review outgoing credits and rebates to ensure that such payments are
made in accordance with company rules and that any discount terms are
accurately recorded;
Review and question supporting documentation for voided or refunded
sales transactions;
Determine whether certain vendors are receiving preferential treatment
with respect to credits and rebates; and
Inquire of personnel in the purchasing and cash departments whether they
are aware of any vendors who maintain any sort of relationship with other
personnel in the company.
Finally, as a note, whether searching for red flags or trying to actually detect the
existence of this scheme, the auditor must always be cognizant of the existence
of related parties whom the perpetrator may be using to commit this scheme.

Billing Schemes - Over Billing
An over billing scheme also involves collusion between an employee and third
party. These generally involve extra illegitimate charges to a legitimate business
expense or trade payable. This scheme is similar to false credits schemes and
shares the same indicators. The auditor should be particularly wary of invoices
carrying “extra” or “special” charges as well as discrepancies between the
purchase order and invoice amount.

Billing Schemes - Pay and Return Scheme
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Pay and return schemes involve employee perpetrators, who improperly pay a
vendor or pay an invoice twice. The employee calls the vendor and requests
return of the improperly issued or duplicate check. The employee then intercepts
and converts the incoming check to his own use. This scheme is similar to
unrecorded sales schemes and can be deterred and detected by techniques
discussed in that section above.

Fraudulent Disbursements – Theft of Company Checks
Cash larceny occurs when the perpetrator steals currency from the company.
The theft can be of cash or its equivalent including checks, CDs etc. Theft of
company checks is a common and easy way to accomplish cash larceny
particularly when there is a clear lack of controls and segregation of duties in
incompatible functions. Another basic but effective control is the maintenance of
pre-numbered checks. Thus, any check out of sequence will be easy to identify
and investigated immediately.
Case Illustration
In 2001, a South Dakota accountant was arrested, charged and pleaded guilty to
stealing more than $100,000 from his former employer by stealing company
checks. The evidence showed that the accountant had stolen approximately 15
checks that had been improperly entered into corporate check registers. Nine of
the checks showed the accountant as the payee, and he had endorsed 11 of
them.
In addition to the risks identified throughout this section, the auditor should be
aware of the following factors that may facilitate the perpetration of this scheme:



Lack of adequate physical safeguarding of cash or incoming checks;
Excessive amounts of voided checks;
Numerous checks payable to employees other than regular payroll
checks;
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

Excessive soft expenses (advertising, legal consulting etc.) or unexpected
trends in expenses; and
Checks payable to “cash” or “bearer.”
Once the auditor has detected the possible existence of this scheme, there are
various procedures he or she can perform to confirm this possibility. The starting
point should be to review bank accounts established by company to ensure that
they have been properly authorized and that only authorized personnel are
drawing on them. Concurrent with such review, the auditor should also ensure
that the company is maintaining policies and procedures which ensure that
access to cash and bank accounts is maintained by select authorized employees
and further that all assets including company checks are adequately safeguarded
and that access is restricted to a few select employees. The next step should be
to perform reconciliations of various accounts looking for shortages or overages
and reviewing bank reconciliations for old outstanding checks that have not been
followed up on. Other potentially helpful procedures include selecting sample
checks for review of various potential indicators including:



Evidence of alterations or other tampering;
Reviewing the endorsements to ensure that endorsements have been
made by proper parties and checks are deposited into authorized bank
accounts; and
Reviewing endorsements for evidence of forgery, altered terms or other
forms of tampering
Finally, if a perpetrator is going to steal checks he will likely write them to either
himself or to entities or individuals related to him or herself. Thus, the auditor
should look for checks with payments to “cash”, “bearer”, or unknown vendors.
Similarly, the auditor should review the list of vendors for shell companies or for
companies with no apparent business purpose to determine if the vendor is
linked to employees in any manner. (See, Section 10.1.2 for indicators and
procedures to confirm the existence of shell companies.) In this regard, any
payments of excessive “soft” expenses to such vendors might be made with
stolen checks. The auditor should also review bank deposits to ensure that that
the control total of checks received matches the checks withdrawn.
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
Payroll Fraud
Fewer and fewer companies pay employees in cash and many hire third parties
to process payroll. Ironically, while these changes have simplified the processing
of payroll, they also have increased the risk of payroll fraud.
Payroll fraud schemes generally occur in two major forms: the creation of
fictitious employees and the padding of hours to cheat on time cards. Other
payroll frauds include inflated overtime claims, the use of incorrect hourly rates,
and overpayment of expenses or underpayment of deductions.
These schemes have different indicators and different means by which they are
perpetrated.
The intent of both is essentially the same; to defraud the
corporation and steal from it.
 Payroll Fraud - Ghost Employees
Ghost
employee
schemes
involve
payments
to
fictitious
employees.
Computerized payrolls, absent adequate controls are highly vulnerable to these
schemes, as the computer does not know whether the employee is real or
fictitious. A related scheme is to simply not remove former employees from the
payroll.
Segregation of the duties of hiring, payroll processing and disbursement is
essential to mitigating this risk. This helps to ensure that those in charge of
processing employees into the payroll system do not get involved in disbursing
checks to fictitious employees they have created.
Other significant controls
include adequate procedures governing the hiring and firing process, and
controls to ensure that new hires are adequately screened and that rigorous
background checks are performed on them.
Once entered into the payroll
system, there must be checks and audits to ensure that the payroll, or individual
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records on it, cannot generate more than one payment for each period.
Additionally, there should be checks to ensure that all payroll data is entered
promptly, accurately and only once and in the proper accounting period. Finally,
all employees who have been terminated or have otherwise left the firm should
be promptly removed from the payroll system.
Procedures the auditor can perform to try to detect this scheme include:











Comparing a list of current and former employees to the current payroll list
to search for and verify additions to payroll;
Matching master information from the payroll file with the organization’s
personnel file to determine whether there are "ghost" employees on the
payroll;
Comparing suspected employee’s social security numbers against list of
valid numbers and test for duplicate employees on the entire payroll file
(appending or joining payroll files if necessary.);
Reviewing direct deposit account numbers to look for duplicate deposits;
Obtaining a payroll check run to ensure that all checks are numerical;
Randomly selecting employees and trace hours worked to time sheet (to
ensure that all hours are approved by supervisor for hourly employees)
and obtain employee file to ensure all proper documentation validating
hiring of the employee is in place;
Ensuring that changes to payroll are adequately documented and
supported;
Comparing the payroll file at two dates (i.e. beginning and end of a month)
to determine whether recorded starters and leavers (hires and
terminations) are as expected and if any employees have received
unusually large salary increases;
Ensuring each employee's salary is between the minimum and maximum
for his/her position or grade; and
Comparing holidays and sick leave taken to the limits for a particular
grade or position and if there is a high rate of absenteeism for sickness
analysing by department to identify problem areas
Payroll Fraud - Falsified Hours
Cheating on hours worked is a very easy way to steal from an employer, as it is
very difficult to validate the hours an employee spends on a given assignment.
To guard against this practice an employer must establish strong internal controls
that encompass some or all of the following procedures:
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





Maintain checks to ensure that all payroll data is entered promptly,
accurately and only once and in the proper accounting period;
Require that all sales commission claims be made in writing;
Ensure that all claims are checked to vouchers and any other supporting
documentation prior to authorisation;
Establish procedures to check claims to ensure that the correct
reimbursement rates have been used;
Establish procedures to ensure that all alterations to claim forms are
countersigned; and
Establish procedures to ensure that signatures of authorised countersignatories are checked before payment is made.
The auditor in turn can attempt to detect this by:


Reconciling time cards/sheets (with approved supervisor signature and
employee signature) to pay check or check run; and
Recalculating commissions by testing sales invoices, back to sales orders,
shipper, and customer receipt.
10.2 Misappropriation of Inventory
Inventory fraud in its most basic definition is the misappropriation of inventory
from a business. There are three basic ways that inventory is stolen:



Physical removal of the inventory from the company location either
after it has been purchased and delivered and without manipulation of
the books and records or after it has been purchased but before
delivery to the client;
False write offs or other credits to inventory;
Recording false sales of inventory.
Anyone with access to inventory can engage in misappropriation - - the
difference between the schemes lies in how the theft is concealed. A purchasing
officer, for example, will usually not be able to adjust inventory records, so those
types of frauds will not be available to him. A sales person has access to sales
records and this will cover his theft differently than the purchasing officer.
10.2.1 Conversion of Inventory
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The most basic form of inventory theft is the physical conversion of existing
stock. Adequate physical security, which is beyond the scope of this chapter, is
the obvious solution.
Conversion of inventory before it has reached the company is more
sophisticated.
This form of conversion occurs by the perpetrator who has
authority to order inventory without supervision and authorization.
Once the
inventory is ordered, the perpetrator can direct the location to which it is
delivered. Prevention of this scheme requires stringent controls regarding the
ordering and approval functions.
All orders should also require adequate
documentation including shipping records to verify that the inventory was actually
delivered to the company location.
10.2.2 False Write-offs and Other Debits to Inventory
Employees with the authority to write off inventory as damaged or scrap (or lack
adequate supervision) often perpetrate false write-off schemes. The company
will not detect that the inventory is missing once it is written off in the books and
records.
Companies can institute controls to deter inventory manipulation. In addition to
adequate physical security, controls include independent verification of records
and separation of incompatible functions such as purchasing as writing off of
inventory. Inventory counts should be performed by people independent to the
inventory records department, or by independent third parties.
A supervisor
should verify all write offs and monitor disposal. All entries on the perpetual
system should be referenced to a purchase, sale, or other record.
Periodic
checks should be performed on those records.
10.2.3 False Sales of Inventory
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False sale frauds are very similar to recording a fictitious sale in the inventory
records of the business. The false sale is never recorded as a sale in the sales
records, which are usually kept independently from the inventory records. As
there is no sale and no amount to collect or bank, the “sale” is never recorded
and thus never missed.
Alternatively, the false credit sale may be recorded
(probably under a false name) but the amount never collected and eventually
written off. A variation of the scheme is for the perpetrator to skim the proceeds
of a valid sale to a real purchaser and not record the sale and the payment for
the sale that is misappropriated.
Sales frauds, like other misappropriation frauds, occur due to a lack of controls or
a breakdown of the controls in the sales process. Sales department employees
should be monitored.
All sales should require appropriate authorization in
addition to sufficient documentation to support the sale.
Furthermore, the
individuals in the sales department should not be in charge of monitoring or
writing off receivables and should have no influence over that department.
The auditor should perform observations of physical inventory and compare the
inventory account for discrepancies between physical inventory and books. The
auditor should determine whether inventory purchases are properly authorized,
reconciled, and in possession of the company. Independent departments should
authorize sales, write offs and, other debits. Inventory data should be entered
completely, accurately, and only once. Finally, the auditor should ensure that
spot checks verifying the existence of inventory are per formed on a regular basis
by departments independent of the purchasing and sales departments or by
independent third parties.
11. Other Fraudulent Income and Expenses
This final category of financial fraud arguably is a subset of either fraudulent
financial reporting or misappropriation of assets. We however treat these frauds
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separately as accountants and auditors generally do not consider them as a part
of the financial statements.
11.1 Revenue and Assets Obtained By Fraud
Revenue obtained by fraud refers generally to the reverse side of a transaction
involving a misappropriation of assets. Assume, for example, that Company A
misappropriates cash from Company B by overcharging or by charging for nonexistent goods or services. From Company A’s perspective, the monies stolen
from Company B represents revenue, albeit revenue obtained by fraud. Tax laws
require Company A to pay tax and declare as income the illegal proceeds
received from Company B.
Some would contend that, for financial statement purposes, Company A should
not recognize the fraudulently obtained proceeds as revenue. This argument
finds support in both legal and accounting principles.
The legal argument would be Company A holds the revenue as a “constructive
trust” for Company B, since the revenue was obtained by fraud.
Stated
differently, the legal argument would be that Company A, while it has use and
possession of the revenue received from the fraud, does not actually have title.
The accounting argument would be that the transaction fails to satisfy two of the
four recognition criteria required by SAB 101, namely:


Persuasive evidence that an arrangement exists; and
Evidence that delivery has occurred or that services have been rendered
From the perspective of victim, neither of these conditions is met. If fraud has
occurred, the victim would argue that no arrangement exists to support the
transaction. Likewise, the victim would most certainly argue that the counterparty has failed to deliver product or services in support of the revenue.
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SAS 99 does not require auditors to consider these frauds, even though it
presumably would be highly relevant for an investor to know whether the
revenues were earned legitimately or illegitimately. Financial statement auditors
consider these types of frauds to be beyond their scope because the financial
audit does not inquire to quality of the operations. Financial statement auditors
rather would contend that these types of issues are the province of internal audit
and operational audits. It remains to be seen whether the Sarbanes-Oxley Act
regulations eventually require financial statement auditors to consider thse type
of issues.
11.2 Expenditures And Liabilities For An Improper Purpose
Bribery of a government official exemplifies an expenditure made for an improper
purpose.
Committing to pay some future expense of the same government
official is assuming a liability for an improper purpose. Should either transaction
be treated as a misappropriation of an asset? Does either transaction result in a
financial misstatement?
Both transactions involve business expenditures, legitimate or not.
But, an
unwitting shareholder probably would argue that such expenditures are nothing
more than a misappropriation of corporate assets.
Most auditors would conclude that illegal payments do not constitute a
misappropriation of asset. Differences of opinion likely will arise over whether
the payments result in a financial misstatement and over the duty of the financial
statement auditor to detect improper payments.
Assume, for discussion purposes, that the company’s financial statements do not
disclose that improper payments have been made. If the company were a public
company, the omission would give rise to a “books and records” violation of the
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Foreign Corrupt Practices Act.76 Moreover, it would be material for an investor to
know this information.
From a financial statement perspective, however, the numbers are generally
correct, barring issues unrelated to the illegality of the payment. A misstatement
occurs only as result of management’s failure to disclose the nature of the
payment.
Financial statement auditors would contend that they are not responsible for
determining
whether
management
has
failed
to
disclose
non-financial
information.
SAS 99 generally supports this position, as it refers only to
misstatements resulting from fraudulent financial reporting and misappropriation
of assets.
Financial statement auditors would argue, moreover, they are not police and not
required to investigate their clients. They would contend that these types of
frauds, like revenue and assets obtained by fraud, are the province of a
compliance or operational audit and therefore beyond their scope. It remains to
be seen whether Sarbanes regulations eventually require financial statement
auditors to consider these types of frauds.
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Chapter Endnotes
1
Issued October, 2002
Securities and Exchange Commission, Annual Report, (Securities and Exchange Commission
1999.)
3 The SEC’s enforcement action against Edison Schools (“Edison”) is illustrative; SEA Rel. No.
45925, AAE Rel. No. 1555 (May, 2002.)
Edison operates public schools on behalf of local governments, which paid directly certain school
expenses. Edison Schools recognized these payments as revenue, even though they did not
flow through their accounts. The SEC launched an enforcement action notwithstanding that the
accounting technically complied with GAAP.
4 See, Accounting Research Bulletin (“ARB”), No. 43, Chap. 9; Also see, Accounting Technology
Bulletin No. 1
5 Arthur Levitt, “The “Numbers Game” speech at the New York University Center for Law and
Business (Sep. 28, 1998.)
6 Id. at p.3.
7 Id.
8 October 1987. Available at www.coso.org
9 The Committee of Sponsoring Organizations of the Treadway Commission ‘s Report on
Fraudulent Financial Reporting 1987 to 1997, (March 1999.)
10 Richard H. Walker, “Behind the Numbers of the SEC's Recent Financial Fraud Cases”, Speech
at 27th Annual National AICPA Conference on Current SEC Developments, (Dec. 7, 1999.)
11 PricewaterhouseCoopers LLP 2000 Securities Litigation Study.
12 PricewaterhouseCoopers LLP 2001 Securities Litigation Study.
13 Revenue Recognition Update, Christian R Bartholomew, Morgan Lewis & Bockius LLP (2002.)
14 17 CFR Part 211, Dec. 3, 1999.
15 Issued Oct. 27, 1997.
16 See e.g., Statement of Position 81-1 Accounting for Performance of Construction-Type and
Certain Production-Type Contracts, (July 15, 1981.); Also see, Statement of Financial Accounting
Standards No. 51, Financial Reporting by Cable Television Companies (Nov. 1981.)
17 Issued 1999.
18 Issued Feb. 2, 2002.
19
Effective interviewing techniques are considered in another chapter.
20 SEC SA Rel. No. 42326, AAE Rel No. 1215, (Jan. 11, 2000.)
21 Statement of Position 91-1, Software Revenue Recognition, Issued 1991. SOP 91-1 has since
been superseded by SOP 97-2, Software Revenue Recognition, Issued 1997, which retains the
basic recognition criteria of SOP 91-1.
22 Issued June 1981.
23 Id. at ¶6.
24 SEA Rel. No. 37847;AAE Rel No. No. 846 (Oct. 22, 1996.)
25 SA Rel No. 44305; AAE Rel No. 1393, (May 15, 2001.)
26 AAE Rel. No. 1187 (Sept. 28, 1999.)
27 SAB 101 FAQ Question No. 3.
28 Id.
29 SEA Rel. No. 37649, AAE Rel. No. 812 (Sept. 5, 1996).
30 See In the Matter of Stewart Parness, Accounting and Auditing Enforcement (AAE) Rel. No.
108 (August 5, 1986); Also see SFAC No. 5, ¶84(a) and SOP 97-2, ¶22.
31 Id.
32 SEA. Rel No. 47167; AAE Rel No. 1699 ( Jan. 13, 2003.)
33 SEA. Rel No. 43183, AAE Rel. No. 1295, (Aug. 21, 2000.)
34 SAB 101, Topic 13A, Question 2.
35 SAB 101, Topic 13A, Question 2.
2
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36
SEA Rel. No. 8135; AAE Rel. No. 1637 (Sept. 30, 2002.)
See, AICPA SOP 81-1, ¶.23.
38 Id., ¶.30
39 SEC Rel. No. 37746; AAE Rel. No. 833 (Sept. 30, 1996.)
40 SAS No. 45, Related Parties, AU §334.
41 Practice Alert, Auditing Related Parties and Related Party Transactions
42 See, FASB no. 57, Related Party Disclosures, Issued
43 See, Accounting and Auditing for Related Parties and Related Party Transactions, A Toolkit for
Accountants and Auditors, AICPA (Dec. 2001.)
44 Statement on Auditing Standards (“SAS”) No. 1 § 331 (Amer. Inst. of Certified Pub.
Accountants 1972); AU §331.11.
45 Id.
46 Norman C. Miller, The Great Salad Oil Swindle, New York; Howard McCann, 1965.
47 ARB No. 43, Inventory Pricing, Chap. 4, Statement 5.
48 Joseph T. Wells, So That’s Why It’s Called a Pyramid Scheme, Journal of Accountancy,
October 2000.
49 SFAS No. 5, Accounting for Contingencies, (Mar. 1975.)
50 CITE CASE
51
See, SFAS 115, Accounting for Certain Investments in Debt and Equity Securities, (May
1993), at ¶6.
52 Id. at ¶7.
53 Id at ¶12 (a) and (b).
54 Other comprehensive income is generally defined as the change in equity of a business
enterprise during a period from all transactions and events except those resulting from
investments by owners and distributions to owners.
55
SFAS 115, ¶15.
56 See, SFAS No. 86, Accounting for the Costs of Computer Software to Be Sold, Leased, or
Otherwise Marketed, (Aug. 1985)
57 See, Financial Concepts No. 2, Accounting for Research and Development Costs, (Oct. 1974.)
58 Arthur Levitt, “The “Numbers Game” speech.
59 See, In the Matter of Pinnacle Holdings, Inc., SEA Rel. No. 45135, AAE Rel No. 1476 (Dec. 6,
2001)
60 SOP 98-5, Reporting on the Costs of Start-Up Activities, (Apr. 1998)
61 Issued October, 1979
62 Issued Dec. 29, 1993.
63 Up until the issuance of new guidance by FASB, off-balance sheet vehicles were commonly
referred to as “SPE’s” or special purpose entities. Under the new accounting rules, they are
known as variable interest entities. It must be noted that the types of entities that are likely to be
deemed VIEs are broader than those that most practitioners would have thought were SPEs.
64 Fin 46 ¶9.
65 SEA Rel No. 46017; AAE Rel. No. 1563 (Jun. 3, 2002.)
66 See, SEC Regulation S-K §229.404, Certain Relationships and Related Transactions (1996.)
67 17 CFR Parts 228, 229, 232, 240, 249, 270 and 274 (Aug. 29, 2002.) §302.
68 The statute requires companies to
“disclose all material off-balance sheet transactions,
arrangements, obligations (including contingent obligations), and other relationships of the issuer
with unconsolidated entities or other persons that may have a material current or future effect on
the issuer's financial condition, results of operations, liquidity, capital expenditures, capital
resources or significant components of revenues or expenses.”
69 TSC Industries, Inc. v. Northway, Inc., 426 U.S. 438, 449 (1976.)
70 Rule 1-02.
71 Statement of Financial Accounting Concepts (“SFAC”) No. 2, (1980.)
72 Issued August, 1999.
73
Association of Certified Fraud Examiners, Report to the Nation, (2002.)
74Id.
75 Joseph T. Wells, Lapping It Up, Journal of Accountancy (Feb. 2002)
37
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76
15 U.S.C. §§ 78dd-1, et seq (1977.)
90