Fraud in Financial Statements
Gerard M. Zack
Table of Contents
Chapter 1 – Introduction to Revenue-Based Financial Reporting Fraud Schemes ............................ 3
Learning Objectives ............................................................................................................................. 3
Revenue Recognition Principles........................................................................................................... 3
Changes Proposed By FASB and IASB ............................................................................................... 4
Overview of Revenue‐Based Schemes ................................................................................................ 4
Review Questions ................................................................................................................................ 6
Review Answers .................................................................................................................................. 7
Chapter 2 – Timing Schemes ................................................................................................................ 8
Learning Objectives ............................................................................................................................. 8
Alteration of Records ........................................................................................................................... 8
Shipping Schemes ............................................................................................................................... 9
Percentage of Completion Schemes .................................................................................................. 10
Improper Estimates of Revenue Recognition Period........................................................................... 12
Multiple‐Element Revenue Recognition Schemes .............................................................................. 12
Customer Loyalty Programs ............................................................................................................... 16
Channel Stuffing ................................................................................................................................ 17
Bristol‐Myers Squibb ...................................................................................................................... 18
McAfee, Inc.................................................................................................................................... 18
Krispy Kreme Doughnuts ............................................................................................................... 18
ClearOne Communications, Inc. ..................................................................................................... 18
Lantronix, Inc. ................................................................................................................................ 18
Bill and Hold Schemes ....................................................................................................................... 19
Sales With Right of Return ................................................................................................................. 20
Improper Pushing of Current Revenue to Future Periods.................................................................... 20
Use of Reserves as a Rainy Day Fund ............................................................................................... 21
Review Questions .............................................................................................................................. 23
Review Answers ................................................................................................................................ 24
Chapter 3 – Fictitious and Inflated Revenue ...................................................................................... 25
Learning Objectives ........................................................................................................................... 25
Fictitious Revenue Schemes .............................................................................................................. 25
Satyam Computer Services Ltd. ..................................................................................................... 25
Symmetry Medical Sheffield ........................................................................................................... 26
LocatePlus Holdings Corporation ................................................................................................... 26
Sales to Related Parties..................................................................................................................... 27
Inflated Revenue Schemes ................................................................................................................ 30
Consignment or Financing Arrangements .......................................................................................... 31
Review Questions .............................................................................................................................. 33
Review Answers ................................................................................................................................ 34
Chapter 4 – Misclassification Schemes.............................................................................................. 35
Learning Objectives ........................................................................................................................... 35
Recording Financing Arrangements as Revenue................................................................................ 35
One‐Time Credits Reported as Revenue............................................................................................ 36
Sales Incentive Schemes ................................................................................................................... 36
From the Customer’s Perspective—Incentives Received from a Vendor ......................................... 37
From the Vendor’s Perspective—Incentives Provided by the Vendor .............................................. 37
Example of Scheme Perpetrated by a Customer—The Royal Ahold Case ...................................... 38
Table of Contents
Example of Scheme Perpetrated by a Vendor—The Carter’s Case ................................................ 39
Review Questions .............................................................................................................................. 40
Review Answers ................................................................................................................................ 41
Chapter 5 – Gross-Up Schemes.......................................................................................................... 42
Learning Objectives ........................................................................................................................... 42
Introduction........................................................................................................................................ 42
Agent Versus Principal ....................................................................................................................... 42
Barter and Round‐Trip Transactions .................................................................................................. 43
Phony Revenue and Expenses .......................................................................................................... 44
Review Questions .............................................................................................................................. 45
Review Answers ................................................................................................................................ 46
Chapter 6 – Improper Capitalization of Costs .................................................................................... 49
Learning Objectives ........................................................................................................................... 49
Introduction........................................................................................................................................ 49
Start‐Up Costs ................................................................................................................................... 50
Research and Development Costs ..................................................................................................... 50
Property and Equipment .................................................................................................................... 51
Accounting for the Acquisition ........................................................................................................ 51
Costs Incurred During Ownership................................................................................................... 51
Software Development and Acquisition Costs .................................................................................... 52
Website Costs ................................................................................................................................... 54
Intangible Assets ............................................................................................................................... 55
Advertising Costs ............................................................................................................................... 56
Other Deferrals and Prepaid Expenses .............................................................................................. 57
Inventory Capitalization Schemes ...................................................................................................... 58
Inventory Flow Assumptions .............................................................................................................. 59
Review Questions .............................................................................................................................. 61
Review Answers ................................................................................................................................ 62
Chapter 7 – Asset Valuation Schemes ............................................................................................... 64
Learning Objectives ........................................................................................................................... 64
Fictitious Assets ................................................................................................................................. 64
Inventory Valuation Schemes............................................................................................................. 64
Inflating the Basis of Property and Equipment .................................................................................... 66
Inflating the Basis of Assets Acquired in Noncash Transactions ......................................................... 66
Assets Acquired From Related Parties ............................................................................................... 68
Understating Depreciation and Amortization Expense ........................................................................ 69
Investment Property........................................................................................................................... 70
Improper Valuation of Investments—Financial Assets ........................................................................ 71
Unlisted Equity Instruments............................................................................................................ 72
How an Impaired Investment Becomes Goodwill ............................................................................ 72
Impairment Losses......................................................................................................................... 73
Loans ................................................................................................................................................ 75
Equity Method Investments ................................................................................................................ 78
Proportionate Consolidation ............................................................................................................... 78
Improper Classification or Amortization of Intangible Assets ............................................................... 79
Impairment Losses—Nonfinancial Assets........................................................................................... 80
ASC 360 ........................................................................................................................................ 80
ASC 350 ........................................................................................................................................ 81
Investments in Insurance Contracts ................................................................................................... 81
Table of Contents
Review Questions .............................................................................................................................. 83
Review Answers ................................................................................................................................ 84
Chapter 8 – Fair Value Accounting ..................................................................................................... 85
Learning Objectives ........................................................................................................................... 85
Fair Value Considerations .................................................................................................................. 85
Methods of Measuring Fair Value....................................................................................................... 85
Market Approach ........................................................................................................................... 85
Income Approach........................................................................................................................... 86
Cost Approach ............................................................................................................................... 89
Internal Versus Externally Developed Valuations ............................................................................... 90
Inputs Used in Measuring Fair Value.................................................................................................. 91
Review Questions .............................................................................................................................. 93
Review Answers ................................................................................................................................ 94
Chapter 9 – Shifting Expenses to Future Periods .............................................................................. 97
Learning Objectives ........................................................................................................................... 97
Timing Schemes Involving Liabilities .................................................................................................. 97
Accounts Payable .............................................................................................................................. 97
Compensated Absences .................................................................................................................... 97
Contingent Liabilities .......................................................................................................................... 98
Accrued Compensation .................................................................................................................... 101
Improper Use of Liability “Reserves” ................................................................................................ 101
Review Questions ............................................................................................................................ 102
Review Answers .............................................................................................................................. 103
Chapter 10 – Omissions and Underreporting of Liabilities ............................................................. 104
Learning Objectives ......................................................................................................................... 104
Debt ................................................................................................................................................ 104
Guarantees...................................................................................................................................... 107
Recognition—U.S. GAAP............................................................................................................. 107
Measurement—U.S. GAAP .......................................................................................................... 108
Recognition—IFRS ...................................................................................................................... 108
Pension Liabilities ............................................................................................................................ 109
Sources of U.S. GAAP and IFRS ................................................................................................. 109
Recognition and Measurement—U.S. GAAP ................................................................................ 110
Recognition and Measurement—IFRS ......................................................................................... 110
Conditional Asset Retirement Obligations ........................................................................................ 111
Review Questions ............................................................................................................................ 112
Review Answers .............................................................................................................................. 113
Chapter 11 – Consolidations and Business Combinations ............................................................. 117
Learning Objectives ......................................................................................................................... 117
Fraudulent Reporting Involving Consolidations ................................................................................. 117
Consolidation Accounting Principles............................................................................................. 117
U.S. GAAP................................................................................................................................... 117
IFRS ............................................................................................................................................ 119
Cases .......................................................................................................................................... 119
Business Combinations.................................................................................................................... 121
Review Questions ............................................................................................................................ 125
Review Answers .............................................................................................................................. 126
Table of Contents
Chapter 12 – Financial Reporting Fraud as a Concealment Tool .................................................... 127
Learning Objectives ......................................................................................................................... 127
Introduction...................................................................................................................................... 127
Financial Statement Fraud To Conceal Asset Misappropriations ...................................................... 127
Financial Statement Fraud To Conceal Illegal Acts........................................................................... 128
Review Questions ............................................................................................................................ 130
Review Answers .............................................................................................................................. 131
Chapter 13 – Financial Statement Fraud by Not-for-Profit Organizations ...................................... 132
Learning Objectives ......................................................................................................................... 132
Introduction...................................................................................................................................... 132
Inflating the Value of Non‐Cash Contributions .................................................................................. 133
Improperly Reporting Contributions Raised for Others ...................................................................... 133
Netting the Results of Fund‐Raising Events ..................................................................................... 134
Improper Allocation of Costs Associated With Joint Activities ........................................................... 134
Misclassification of Expenses........................................................................................................... 136
Review Questions ............................................................................................................................ 138
Review Answers .............................................................................................................................. 139
Chapter 14 – Disclosure Fraud ......................................................................................................... 140
Learning Objectives ......................................................................................................................... 140
Introduction...................................................................................................................................... 140
Categories of Disclosure Fraud ........................................................................................................ 141
Common Disclosure Risks ............................................................................................................... 141
Loss Contingencies...................................................................................................................... 141
Commitments .............................................................................................................................. 142
Related Party Transactions .......................................................................................................... 142
Changes in Accounting Principles ................................................................................................ 143
Changes in Accounting Estimates ................................................................................................ 144
Subsequent Events ...................................................................................................................... 144
Review Questions ............................................................................................................................ 146
Review Answers .............................................................................................................................. 147
Chapter 15 – Detecting Financial Statement Fraud.......................................................................... 151
Learning Objectives ......................................................................................................................... 151
Introduction...................................................................................................................................... 151
Motives for Financial Statement Fraud ............................................................................................. 151
Fraud Risk Indicators ....................................................................................................................... 153
Internal Control Indicators ................................................................................................................ 153
Control Environment .................................................................................................................... 154
Risk Assessment ......................................................................................................................... 154
Control Activities .......................................................................................................................... 154
Information and Communication................................................................................................... 155
Monitoring.................................................................................................................................... 155
Review Questions ............................................................................................................................ 157
Review Answers .............................................................................................................................. 158
Chapter 16 – Financial Statement Analysis...................................................................................... 159
Learning Objectives ......................................................................................................................... 159
Use of Analytical Techniques to Detect Fraud .................................................................................. 159
Horizontal Analysis .......................................................................................................................... 159
Vertical Analysis .............................................................................................................................. 160
Table of Contents
Budget Variance Analysis ................................................................................................................ 161
Review Questions ............................................................................................................................ 162
Review Answers .............................................................................................................................. 163
Chapter 17 – Ratio Analysis .............................................................................................................. 164
Learning Objectives ......................................................................................................................... 164
Introduction...................................................................................................................................... 164
Research on Ratio Analysis ............................................................................................................. 164
Use of Operating Ratio Analysis To Detect Financial Statement Fraud ............................................. 165
Liquidity Ratios ............................................................................................................................ 165
Activity Ratios .............................................................................................................................. 166
Leverage Ratios........................................................................................................................... 169
Profitability Ratios ........................................................................................................................ 170
Another Useful Measure: Working Capital to Total Assets ................................................................ 170
Review Questions ............................................................................................................................ 172
Review Answers .............................................................................................................................. 173
Chapter 18 – Other Detection Procedures........................................................................................ 174
Learning Objectives ......................................................................................................................... 174
Analysis Utilizing Multiple Ratios ...................................................................................................... 174
The M‐Score ................................................................................................................................ 174
The F‐Score................................................................................................................................. 175
Altman Z‐Score ............................................................................................................................ 176
Ratios Involving Nonfinancial Data ................................................................................................... 176
Other Information and Disclosures in Financial Statements .............................................................. 177
Who Performed the Audit? ........................................................................................................... 177
Cash Flows from Operating Activities ........................................................................................... 178
Fair Value Disclosures ................................................................................................................. 178
Understandability of Financial Statement Disclosures....................................................................... 178
Testing of Journal Entries ................................................................................................................ 179
Review Questions ............................................................................................................................ 181
Review Answers .............................................................................................................................. 182
Chapter 19 – Fraud or Honest Mistake? ........................................................................................... 183
Learning Objectives ......................................................................................................................... 183
Introduction...................................................................................................................................... 183
The “Smoking Gun” ......................................................................................................................... 183
Witnesses ........................................................................................................................................ 183
Altered Documents .......................................................................................................................... 184
Multiple Records .............................................................................................................................. 184
Destruction of Evidence ................................................................................................................... 185
Actions That Contradict Recommendations ...................................................................................... 185
Patterns of Behavior ........................................................................................................................ 185
Personal Gain .................................................................................................................................. 186
There’s No Other Explanation For It ................................................................................................. 186
Review Questions ............................................................................................................................ 187
Review Answers .............................................................................................................................. 188
Chapter 20 – Assessing (or Minimizing) Auditor Liability ............................................................... 189
Learning Objectives ......................................................................................................................... 189
Introduction...................................................................................................................................... 189
Litigation Against Auditors................................................................................................................ 189
Table of Contents
Concealment From the Auditors ....................................................................................................... 190
Auditing Standards .......................................................................................................................... 191
Consideration of the Risks of Material Misstatement ........................................................................ 191
Improper or Inadequate Use of Analytical Procedures ...................................................................... 194
Auditing Accounting Estimates and Fair Values................................................................................ 196
Revenue Recognition Risks ............................................................................................................. 199
Insufficient Consideration of Related Party Transactions .................................................................. 201
Auditing Disclosures in the Financial Statements ............................................................................. 201
Overreliance on the Management Representation Letter .................................................................. 202
Review Questions ............................................................................................................................ 203
Review Answers .............................................................................................................................. 204
Appendix - Financial Statement Fraud Indicators............................................................................ 205
Revenue‐Based Schemes ............................................................................................................... 205
Asset‐Based Schemes..................................................................................................................... 206
Expense/Liability‐Based Schemes ................................................................................................... 207
Bibliography ...................................................................................................................................... 209
Glossary ............................................................................................................................................. 211
Index .................................................................................................................................................. 217
Index to Cases ................................................................................................................................... 221