HOW TO DETECT AND PREVENT
FINANCIAL STATEMENT FRAUD
GLOBAL HEADQUARTERS • THE GREGOR BUILDING
716 WEST AVE • AUSTIN, TX 78701-2727 • USA
HOW TO DETECT AND PREVENT FINANCIAL STATEMENT FRAUD
TABLE OF CONTENTS
I. INTRODUCTION
Trends in Financial Statement Fraud ..................................................................................................................... 1
The COSO Study on Financial Statement Fraud .......................................................................................... 2
About This Course ................................................................................................................................................... 3
Course Overview................................................................................................................................................ 3
Video Supplement.............................................................................................................................................. 4
Practical Problems CD-ROM .......................................................................................................................... 4
Review Questions and Final Examination ..................................................................................................... 4
II. FINANCIAL STATEMENT FRAUD OVERVIEW
Financial Statement Fraud Defined ....................................................................................................................... 7
Management’s Role................................................................................................................................................... 7
The Victims of Financial Statement Fraud ........................................................................................................... 7
Financial Statement Fraud Triangle ....................................................................................................................... 8
Pressures to Commit Financial Statement Fraud .......................................................................................... 8
Video .................................................................................................................................................................... 9
Opportunity for Financial Statement Fraud ................................................................................................10
Rationalizations for Financial Statement Fraud...........................................................................................10
Financial Statement Fraud Red Flags...................................................................................................................11
Introduction to Financial Statement Fraud Schemes and Examinations .......................................................12
Review Questions ...................................................................................................................................................13
III. EXAMINING FOR FINANCIAL STATEMENT FRAUD
The Role of the Certified Fraud Examiner .........................................................................................................15
Fraud Examination Methodology ........................................................................................................................15
Predication ........................................................................................................................................................16
Fraud Theory Approach .................................................................................................................................16
Financial Statement Fraud Examination Techniques ........................................................................................19
Document Examination ..................................................................................................................................20
Interviewing Witnesses and Conspirators ....................................................................................................21
Auditing Procedures ........................................................................................................................................23
Review Questions ...................................................................................................................................................26
IV. FRAUD PREVENTION AND DETECTION RESPONSIBILITIES
Prevention of Financial Statement Fraud ............................................................................................................29
Reducing Fraud Risk........................................................................................................................................30
Detection of Financial Statement Fraud .............................................................................................................35
The Tone at the Top .......................................................................................................................................35
Video ..................................................................................................................................................................36
Internal Audit Function ..................................................................................................................................36
Independent Audit Committee ......................................................................................................................37
External Auditors .............................................................................................................................................38
The Ethical Environment for Fraud Prevention and Detection .....................................................................40
The COSO Reports .........................................................................................................................................40
Video ..................................................................................................................................................................42
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HOW TO DETECT AND PREVENT FINANCIAL STATEMENT FRAUD
IV. FRAUD PREVENTION AND DETECTION RESPONSIBILITIES (CONT.)
The Legal Environment for Fraud Prevention and Detection ........................................................................46
The Sarbanes-Oxley Act .................................................................................................................................46
Securities and Exchange Commission ..........................................................................................................59
Private Securities Litigation Reform Act of 1995........................................................................................60
External Auditors’ Responsibilities for Prevention and Detection of Financial Statement Fraud .............61
AU Section 240 ................................................................................................................................................62
PCAOB Auditing Standard No. 5 .................................................................................................................72
Statement of Standards for Attestation Engagements No. 15 ..................................................................75
Risk-Based Audit Approach ...........................................................................................................................75
PCAOB Auditing Standard No. 3 .................................................................................................................76
AU Section 230 ................................................................................................................................................77
Internal Auditors’ Responsibilities for Prevention and Detection of Financial Statement Fraud ..............78
Standard 1210—Proficiency ...............................................................................................................................78
Standard 1220—Due Professional Care.............................................................................................................79
Standard 2060—Reporting to Senior Management and the Board ......................................................................79
Standard 2110—Governance .............................................................................................................................80
Standard 2120—Risk Management...................................................................................................................80
Standard 2130—Control ...................................................................................................................................80
Standard 2210—Engagement Objectives ............................................................................................................81
The IIA’s IPPF—Practice Guide: Internal Auditing and Fraud ........................................................................81
Review Questions ...................................................................................................................................................84
V. ACCOUNTING BASICS
Introduction .............................................................................................................................................................89
Accounting as a Language .....................................................................................................................................89
The Development of the Language...............................................................................................................89
The Concept of Debits and Credits ..............................................................................................................90
Accounting Methods ..............................................................................................................................................91
Accounting Principles ............................................................................................................................................92
Definition ..........................................................................................................................................................93
Underlying Principles of U.S. GAAP............................................................................................................93
Financial Statements Explained ............................................................................................................................94
The Balance Sheet ............................................................................................................................................95
The Income Statement ................................................................................................................................. 101
The Cash Flow Statement ............................................................................................................................ 106
The Statement of Retained Earnings ......................................................................................................... 111
Notes to the Financial Statements and Management’s Discussion ....................................................... 113
Video ............................................................................................................................................................... 114
Using Financial Statements to Get the Full Picture ................................................................................. 114
Review Questions ................................................................................................................................................ 116
VI. GENERAL TECHNIQUES FOR FINANCIAL STATEMENT ANALYSIS
Financial Statement Analysis .............................................................................................................................. 119
Comparative Techniques ............................................................................................................................. 120
Financial Relationships ................................................................................................................................. 121
Unexpected Relationships............................................................................................................................ 122
Analytical Procedures .......................................................................................................................................... 122
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HOW TO DETECT AND PREVENT FINANCIAL STATEMENT FRAUD
VI. GENERAL TECHNIQUES FOR FINANCIAL STATEMENT ANALYSIS (CONT.)
Percentage Analysis—Vertical and Horizontal......................................................................................... 123
Financial Ratio Analysis ............................................................................................................................... 125
Cash Flow Analysis ....................................................................................................................................... 129
Video ............................................................................................................................................................... 133
Data Analytics ...................................................................................................................................................... 133
Textual Analytics ........................................................................................................................................... 135
Visual Analytics ............................................................................................................................................. 135
Review Questions ................................................................................................................................................ 137
VII. SCHEMES AND SCENARIOS: AN INTRODUCTION
Financial Statement Fraud Schemes.................................................................................................................. 139
Video ............................................................................................................................................................... 143
Methods of Detection ......................................................................................................................................... 143
VIII. FICTITIOUS REVENUE
Fabricating Revenue ............................................................................................................................................ 149
Detecting Fabricated Revenues................................................................................................................... 150
Improper Recording of Sales Returns, Allowances, and Discounts ............................................................ 155
Sales Returns and Allowances ..................................................................................................................... 155
Sales Discounts .............................................................................................................................................. 156
Detecting Improper Recording of Sales Returns and Allowances and Discounts .............................. 156
Improper Recording of Sales with Conditions ................................................................................................ 157
Conditional Sales ........................................................................................................................................... 157
Consignment Sales ........................................................................................................................................ 158
Detecting Sales with Conditions ................................................................................................................. 158
Review Questions ................................................................................................................................................ 160
IX. TIMING DIFFERENCES
Revenue Recognition Schemes .......................................................................................................................... 164
Recording Revenue When Goods or Services Are Still Due.................................................................. 165
Shipping Merchandise Before the Sale Is Finalized ................................................................................. 165
Holding the Books Open ............................................................................................................................. 166
Long-Term Contracts ................................................................................................................................... 166
Multiple Deliverables .................................................................................................................................... 167
Channel Stuffing............................................................................................................................................ 167
Detecting Premature Revenue Recognition .............................................................................................. 168
Recording Expenses in the Wrong Period ....................................................................................................... 170
Delayed Expense Recognition .................................................................................................................... 170
Premature Expense Recognition ................................................................................................................ 174
Video ............................................................................................................................................................... 176
Review Questions ................................................................................................................................................ 177
X. CONCEALED LIABILITIES AND EXPENSES
Video ............................................................................................................................................................... 179
Failure to Record Liabilities or Expenses......................................................................................................... 179
Omitting Liabilities or Expenses ................................................................................................................ 180
Reporting Revenue Rather Than a Liability When Cash Is Received ................................................... 182
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X. CONCEALED LIABILITIES AND EXPENSES (CONT.)
Omission of Contingent Liabilities for Warranties, Products, or Environmental Impacts ...................... 183
Failure to Record Contingencies................................................................................................................. 183
Omission of Warranty Liabilities ................................................................................................................ 184
Omission of Product Liabilities .................................................................................................................. 185
Omission of Environmental Liabilities ...................................................................................................... 185
Using Off-Balance Sheet Entities to Conceal Expenses and Liabilities ...................................................... 187
Detecting Improper Off-Balance Sheet Accounting Arrangements ..................................................... 189
Review Questions ................................................................................................................................................ 190
XI. IMPROPER DISCLOSURES
Sarbanes-Oxley Required Disclosures .............................................................................................................. 193
Pro Forma Financial Information .............................................................................................................. 194
Disclosures in Periodic Reports .................................................................................................................. 194
Transactions Involving Management and Principal Stockholders......................................................... 194
Management Assessment of Internal Controls ........................................................................................ 194
Codes of Ethics for Senior Financial Officers.......................................................................................... 194
Audit Committee Financial Expert ............................................................................................................ 195
Real-Time Disclosures.................................................................................................................................. 195
Detecting Improper Sarbanes-Oxley Disclosures .................................................................................... 195
Accounting Methods and Changes ................................................................................................................... 195
Pensions, Compensation, and Other Benefits Disclosures .................................................................... 196
Backdating Stock Options ........................................................................................................................... 196
Detecting Improper Disclosure of Accounting Methods and Changes ............................................... 198
Liability-Related Disclosures .............................................................................................................................. 199
Loan Covenant and Default Omissions .................................................................................................... 199
Contingency and Commitment Omission ................................................................................................. 200
Significant Events ................................................................................................................................................ 200
Detecting Undisclosed Significant Events ................................................................................................ 201
Prior Management Fraud .................................................................................................................................... 201
Detecting Undisclosed Prior Management Fraud .................................................................................... 202
Related-Party Transactions ................................................................................................................................. 202
Detecting Undisclosed Related-Party Transactions ................................................................................. 203
Video ............................................................................................................................................................... 203
Review Questions ................................................................................................................................................ 204
XII. IMPROPER ASSET VALUATION
Video ............................................................................................................................................................... 207
Inventory Valuation ............................................................................................................................................. 207
Improper Estimates for Obsolete or Slow-Moving Goods.................................................................... 208
Fictitious Inventory and the Manipulation of Count Sheets .................................................................. 209
Failure to Record the Purchase of Inventory............................................................................................ 211
Improper Inventory Capitalization ............................................................................................................. 212
Accounts Receivable............................................................................................................................................ 213
Fictitious Accounts Receivable ................................................................................................................... 213
Failure to Write Down Accounts Receivable for Bad Debts ................................................................. 215
Fixed and Intangible Assets................................................................................................................................ 218
Booking Fictitious Long-Term Assets ....................................................................................................... 219
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HOW TO DETECT AND PREVENT FINANCIAL STATEMENT FRAUD
XII. IMPROPER ASSET VALUATION (CONT.)
Misrepresenting Asset Value ....................................................................................................................... 219
Improper Capitalization ............................................................................................................................... 221
Misclassification of Assets ........................................................................................................................... 221
Business Combinations ....................................................................................................................................... 222
Improper Valuation of Goodwill................................................................................................................ 222
Inflating Value of Assets to Provide Cheap Capital for Takeovers ....................................................... 223
Assets Related to Pensions and Other Post-Retirement Benefits ................................................................ 224
Detecting Improper Accounting for Pensions and Post-Retirement Benefits .................................... 226
Review Questions ................................................................................................................................................ 227
XIII. THE CRAZY EDDIE FRAUD
Video ............................................................................................................................................................... 231
Under-Reporting Income—Skimming ............................................................................................................. 231
Video ............................................................................................................................................................... 237
Fictitious Revenues .............................................................................................................................................. 237
The Panama Pump........................................................................................................................................ 238
The Zazy Check Scheme.............................................................................................................................. 238
The Falsification of Warranty Claims ........................................................................................................ 240
Video ............................................................................................................................................................... 240
Concealed Liabilities Fraud ................................................................................................................................ 240
The Use of Fraudulent Post-Dated Invoices to Understate Accounts Payable .................................. 240
The Phony Debit Memo Scheme ............................................................................................................... 241
The “Reeps” Return Scheme....................................................................................................................... 243
Video ............................................................................................................................................................... 243
Inventory Fraud Schemes ................................................................................................................................... 243
Fraudulent Inventory Inflation Schemes ................................................................................................... 243
Notes to the Financial Statements .............................................................................................................. 244
The Fraudulent Inflation of Inventory with Borrowed Merchandise ................................................... 245
Video ............................................................................................................................................................... 245
Disclosure of False and Fraudulent Financial Information to the Public ................................................... 245
Concealment of the Fraudulent Schemes......................................................................................................... 245
Comparative Techniques .................................................................................................................................... 246
Analytical Techniques.......................................................................................................................................... 246
Horizontal Analysis....................................................................................................................................... 247
Vertical Analysis ............................................................................................................................................ 249
Key Ratio Analysis ........................................................................................................................................ 251
Selling-Off Stock .................................................................................................................................................. 252
Red Flags ............................................................................................................................................................... 253
The End of the Story........................................................................................................................................... 254
XIV. THE SICK CASE OF HEALTHSOUTH’S ACCOUNTING FRAUDS
The Rise and Fall ................................................................................................................................................. 257
Cooking the Books .............................................................................................................................................. 257
Video ............................................................................................................................................................... 258
Fictitious Revenues and Overvalued Assets ............................................................................................. 258
Video ............................................................................................................................................................... 259
Notes to the Financial Statements .............................................................................................................. 260
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HOW TO DETECT AND PREVENT FINANCIAL STATEMENT FRAUD
XIV. THE SICK CASE OF HEALTHSOUTH’S ACCOUNTING FRAUDS (CONT.)
Fooling the Experts ............................................................................................................................................. 261
Waving the Red Flag ........................................................................................................................................... 262
Analytical Techniques.......................................................................................................................................... 263
Horizontal Analysis....................................................................................................................................... 263
Vertical Analysis ............................................................................................................................................ 265
Ratio Analysis ................................................................................................................................................ 267
Financial Statement Analysis ....................................................................................................................... 267
Warning Signs ....................................................................................................................................................... 268
The End of the Story........................................................................................................................................... 268
XV. CONCLUSION ........................................................................................................................................ 271
XVI. PRACTICAL PROBLEMS
Practical Problem 1 .............................................................................................................................................. 273
Practical Problem 2 .............................................................................................................................................. 276
Practical Problem 3 .............................................................................................................................................. 278
Practical Problem 4 .............................................................................................................................................. 283
Practical Problem 5 .............................................................................................................................................. 287
Practical Problem 6 .............................................................................................................................................. 289
Practical Problem 7 .............................................................................................................................................. 291
Practical Problem 8 .............................................................................................................................................. 293
Practical Problem 9 .............................................................................................................................................. 296
Practical Problem 10............................................................................................................................................ 299
Practical Problem 11............................................................................................................................................ 304
Practical Problem 12............................................................................................................................................ 305
Practical Problem 13............................................................................................................................................ 306
Practical Problem 14............................................................................................................................................ 308
Practical Problem 15............................................................................................................................................ 310
Practical Problem 16............................................................................................................................................ 311
Practical Problem 17............................................................................................................................................ 312
XVII. APPENDIX A: CRAZY EDDIE INC. ........................................................................................... 313
XVIII. APPENDIX B: VIDEO TRANSCRIPTS .................................................................................... 393
XIX. SOLUTIONS TO REVIEW QUESTIONS
II. Financial Statement Fraud Overview .......................................................................................................... 417
III. Examining for Financial Statement Fraud ................................................................................................ 422
IV. Fraud Prevention and Detection Responsibilities .................................................................................... 425
V. Accounting Basics........................................................................................................................................... 435
VI. General Techniques for Financial Statement Analysis ............................................................................ 439
VIII. Fictitious Revenue ..................................................................................................................................... 444
IX. Timing Differences ....................................................................................................................................... 449
X. Concealed Liabilities and Expenses ............................................................................................................. 453
XI. Improper Disclosures ................................................................................................................................... 457
XII. Improper Asset Valuation .......................................................................................................................... 461
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HOW TO DETECT AND PREVENT FINANCIAL STATEMENT FRAUD
XX. SOLUTIONS TO PRACTICAL PROBLEMS
Practical Problem 1 .............................................................................................................................................. 467
Practical Problem 2 .............................................................................................................................................. 469
Practical Problem 3 .............................................................................................................................................. 472
Practical Problem 4 .............................................................................................................................................. 477
Practical Problem 5 .............................................................................................................................................. 480
Practical Problem 6 .............................................................................................................................................. 482
Practical Problem 7 .............................................................................................................................................. 484
Practical Problem 8 .............................................................................................................................................. 486
Practical Problem 9 .............................................................................................................................................. 488
Practical Problem 10............................................................................................................................................ 489
Practical Problem 11............................................................................................................................................ 492
Practical Problem 12............................................................................................................................................ 494
Practical Problem 13............................................................................................................................................ 495
Practical Problem 14............................................................................................................................................ 497
Practical Problem 15............................................................................................................................................ 499
Practical Problem 16............................................................................................................................................ 500
Practical Problem 17............................................................................................................................................ 501
XXI. FINAL EXAMINATION .................................................................................................................... E-1
XXII. INDEX....................................................................................................................................................... I-1
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