Chapter 12: Fraudulent
Financial Statement
Schemes
{ Lecture 9
World Com Accounting Department
Here it is - $2 + $2 = $13,000,000
Financial Statement
Schemes
Fictitious revenues
Timing differences
 Concealed liabilities and expenses
 Improper disclosures
 Improper asset valuations
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Lecture 9
1
Financial Statement
Schemes by Category
28.3%
Timing Differences
37.5%
Improper Disclosures
40.0%
Asset Valuation
Fictitious Revenues
43.3%
45.0%
Concealed Liabilities
0.0%
5.0% 10.0% 15.0% 20.0% 25.0% 30.0% 35.0% 40.0% 45.0%
Fictitious Revenues
Four criteria for revenue
recognition:
 Definition
 Measurability
 Relevance
 Reliability
Defining Revenue
Actual or expected cash inflows
That have occurred or will occur
 As a result of the enterprise’s ongoing
major or central operations
 During the period
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Lecture 9
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Fictitious Revenues
Recording of goods or services that
did not occur
 Fake or phantom customers
 Legitimate customers
 Sales with conditions
 Pressures to boost revenues
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Red Flags – Fictitious
Revenues
Rapid growth or unusual profitability, especially
compared to that of other companies in the same
industry
 Recurring negative cash flows from operations or
an inability to generate cash flows from
operations while reporting earnings and earnings
growth
 Significant transactions with related parties or
special purpose entities not in the ordinary course
of business or where those entities are not
audited or are audited by another firm

Red Flags – Fictitious Revenues
Significant, unusual, or highly complex
transactions, especially those close to period end
that pose difficult “substance over form”
questions
 Unusual growth in the number of days’ sales in
receivables
 A significant volume of sales to entities whose
substance and ownership is not known
 An unusual surge in sales by a minority of units
within a company, or of sales recorded by
corporate headquarters
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Lecture 9
3
Fictitious Revenues
Case Study – 1985, 1986 & 1987
Houston-based Publicly Traded Company
 Sold “close out” electronics merchandise
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Would purchase large lots of merchandise from
manufacturers when they were closing out a line of
product
Purchased at substantial discounts from normal
distribution chain prices
Fictitious Revenues
Fiscal Year End – January 31
Large Year-end Sales to Retailers
 Sold large numbers of computer monitors to
retailers in January 1987 (in last 3 days)
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Lack’s Stores
Silo
Joske’s (now Dillard’s)
Total
$1,452,000
3,350,750
3,562,500
$8,365,250
Total Company Sales for ’87 - $87,831,141
 Over 9.5% of annual sales
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Fictitious Revenues

Average price on these computer monitors was
just under $200
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Lack’s Stores – 7,260 monitors
Silo – 16,754 monitors
Joske’s – 17,815 monitors
Total = 41,829 monitors sold
 Monitor Boxes = Approx. 12.5 cubic feet
 If stacked 5 boxes high
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Lecture 9
Would require almost 76,000 square feet of warehouse
space (about 2 acres)
4
Fictitious Revenues
Normal company sales terms were Net 30 days
– and this was on the invoices
 Terms on these sales were Net 90 days and
Net 120 days – according to the CEO
 Addresses on the invoices were to the home
addresses of certain company officers
 All of these sales were reversed in December
1987 and January 1988
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Fictitious Revenues

There can also be instances where revenues
are recorded, where no real sale has taken
place
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Window dressing

Revenues are recorded when inventory is sold
back to the company from which it was
purchased
Timing Differences
Recording revenue and/or expenses in
improper periods
 Shifts revenues or expenses between
one period and the next, increasing or
decreasing earnings as desired
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Lecture 9
5
Timing Differences
Matching revenues with expenses
Premature revenue recognition
 Long-term contracts
 Channel stuffing
 Recording expenses in the wrong period
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Red Flags – Timing Differences
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Rapid growth or unusual profitability, especially compared to
that of other companies in the same industry
Recurring negative cash flows from operations or an inability
to generate cash flows from operations while reporting
earnings and earnings growth
Significant, unusual, or highly complex transactions,
especially those close to period end that pose difficult
“substance over form” questions
Unusual increase in gross margin or margin in excess of
industry peers
Unusual growth in the number of days’ sales in receivables
Unusual decline in the number of days’ purchases in accounts
payable
Timing Differences

Revenue should be recognized in the
accounting records when the sale is
complete.
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Lecture 9
Sales with conditions
In service business, revenue is recognized
when the service has been rendered
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Timing Differences
Improper matching of revenues
Early revenue recognition
 Recording expenses in the wrong
period
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Timing Difference
Example
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Company –
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Perpetrators –
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A Houston-based rice milling and foods company
A subsidiary of a Fortune 100 Company
Senior Management – CEO, COO, CFO
Managed earnings to ensure maximum
bonuses each year
Timing Difference
Example
Physical Inventory was done each year on
November 30
 Just prior to inventory, management would
get the inventory to be whatever they wanted
it to be by:
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Lecture 9
Removing excess inventory off rice mill premises in
rail cars (when management had already maxed
out their bonuses); or
Borrowing rice from farmers for the inventory (if
needed to ensure maximum bonus)
7
Timing Difference
Example
Company’s former lead internal auditor (now
a controller at another client) told me about
this just before physical inventory
 Auditors rented a pick-up truck that also had
rail wheels so that we could go down the
tracks
 Found numerous rail cars about 1 mile down
on a side rail

Timing Difference
Example
We asked the farmer who the rice in the rail
cars belonged to
 He told us that the rice belonged to the
company and that management had told him
that they needed to store some rice on his
side rail due to some problems at the mill
and having too much rice
 He agreed to help
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Timing Difference
Example
The amount of the rice found was added to
the inventory
 Audit committee of the parent company was
notified
 Parent Company Management
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Lecture 9
Came to Houston
Terminated all of senior management at the rice
company (CEO, CFO, COO)
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Concealed Liabilities
Understating liabilities causes equity account
to increase in order to balance
 Understating expenses causes net income to
be artificially overstated thus increasing the
equity account
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Methods of Concealing
Liabilities
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Liability/expense omissions
Improper capitalizing/expensing
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World Com
Health South
Returns and allowances and warranties
Improper Disclosures
Financial statements and notes must
include all information necessary to
prevent a user from being misled.
Lecture 9
9
Improper Disclosures
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Related party transactions
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Liability omissions
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Significant events
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Management fraud
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Accounting changes
Improper Asset Valuation
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Assets should be recorded at original
cost
Some Assets are valued at lower cost
or market
Assets cannot be increased to reflect
current value
Improper Asset Valuation
Inventory

Valued at the lower cost or market

Should be written off if it has no
current value

Can be overstated by manipulation
of inventory count
Lecture 9
10
Improper Asset Valuation
Case Study – Miniscribe, Inc.
 Time period – mid-1980’s
 Company manufactured hard disk
drives for personal computers
 Fraud was perpetrated to enhance the
financial performance of the company
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To meet the expectations of the
company’s CEO
Improper Asset Valuation

Company manipulated inventory records and
inventory counts
Had re-labeled obsolete products (10 MB hard
disks) to current product line (40 MB hard
disks)
 Had placed “bricks” in some boxes so that
there would be weight in the boxes if they
were shaken
 Company had several inventory locations

Improper Asset Valuation
Physical inventory count was scheduled
over a three-day period, with counts being
conducted at a different location each day
 Company moved inventory from one
location to another overnight so that a
significant amount of inventory was
counted more than once
 Some inventory was actually counted
three times!
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Lecture 9
11
Improper Asset Valuation
Accounts receivable
 Fictitious receivables
 Failure to write down receivables as
bad debts
Improper Asset Valuation
Fixed Assets
 Booking fictitious assets
 Misrepresenting value
 Improper capitalizing inventory and
start-up costs
 Misclassifying assets
Case Study
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Victim Company Characteristics:
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Lecture 9
NYSE Company
Numerous, relatively autonomous operating
divisions around the US
Division Presidents had bonuses based on increase
in division pre-tax profits
Company had Internal Audit Department –
primarily focused on adherence to policy
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Case Study
Division profits had increased from $6.2 million
to $10.3 million
 Division President earned maximum bonus of
$1.2 million
 Division President and Division Controller
resigned the day the bonus was paid
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Case Study
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Company Board of Directors requested
that we look at the division records
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No internal audit work in the past two
years
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Given 30 days to see what we could find
Time was May 1982
Case Study
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What did we do?
Started with Financial Analysis
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Lecture 9
Average home sales price was up 10% from prior
year
Average cost of sales per home was up 9.9% from
the prior year
Average inventory per full equivalent home unit
was up 36% from the prior year
Similar increase in inventory in the prior year
This simply did not make sense
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Case Study

Review of Journal Entries
Journal Entry log book – JE’s started with
number 101, 102, 103, … each month
 Also reviewed general ledger for the posting
of journal entries
 In some months, we would find a journal
entry 007 in the G/L, but could never find the
corresponding documentation
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Case Study
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Monthly General Ledger – was a
computer print-out that was about 1014” thick each month
From the financial analysis, we suspected
we were looking for the transfer of
subdivision costs from one subdivision to
another
Case Study
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Lecture 9
When we found 007 entries, they were
always debits into subdivision costs
Also found that in the month in which
a subdivision was “closed-out” (all
costs removed) the subdivision was
purged from the computer system and
no G/L for the subdivision was printed
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Case Study
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Specific Analysis –
Selected a month with 007 journal entries
Added on a calculator, with a tape, each of
the 007 entries
 Highlighted each 007 entry in the general
ledger upon adding it to the calculator
 Total of 007 entry was the EXACT total of
the costs left in a subdivision the prior
month
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A subdivision that had been deleted
Case Study
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Expanded analysis to every month with 007
journal entries for past 2-1/2 years
Had computer programmer develop a
program to detail all of the debits and credits
in each 007 entry for the past 2-1/2 years
Case Study
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Results:
Unexpensed inventory costs of closedout subdivisions were improperly
transferred to new subdivisions
 Division was not properly expensing
subdivision costs to cost-of-sales
 $10.3 million profit became a $4.4
million loss
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Lecture 9
$14.7 million of unexpensed inventory costs had been
carried forward
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Case Study
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Company sued former Division President to
recover bonus paid
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Former President settled quickly by giving back 75% of
the bonus paid
Company Board of Directors was not satisfied
that he was able to get money from the
Company
Company turned the matter over to the U.S.
Department of Justice
Case Study
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The division was not hooked into the Company’s online computer system, and sent the monthly and
quarterly financial information to the home office by
U.S. Mail
U.S. Department of Justice filed Mail Fraud charges
against:
 Division President
 Division Controller
Both were convicted and sentenced to 5-year
federal prison terms
Characteristics of Fraudulent Journal
Entries
Made to unrelated, unusual or seldom-used
accounts
 Made by individuals who typically do not make
journal entries
 Recorded at the end of the period or as postclosing adjustments that have little or no
explanation or description
 Made either before or during the preparation
of the financial statements
 Containing round numbers
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Lecture 9
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Characteristics of Fraudulent Journal
Entries
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World Com Journal Entries
Debit to Capitalized Broadband Access
Costs
 Credit to Operating Expenses
 Amounts were large, round numbers
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$639,000,000.00 – the first journal entry made
Journal entry made at the instruction of the
CFO
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Someone that generally would not be making
such an entry
World Com Journal Entry
Capitalized Network Capacity $639,000,000
Operating Expenses
$639,000,000
Per instructions of Scott Sullivan (the CFO)
Components of Internal Control
1.
2.
3.
4.
5.
Lecture 9
The Control Environment
Risk Assessment
Control activities
Information and communication
Monitoring
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Components of Internal Control
1.
The Control Environment

The attitude of management or corporate
culture that either emphasizes designing and
implementing proper controls to assure the
achievement of the objectives of internal
controls
Components of Internal Control
2.
Risk Assessment
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Identification and analysis of risks related
to control objectives
The costs of controls should not exceed
the expected benefits
Components of Internal Control
3.
Control Activities (formerly called Control
Procedures)
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Accounting and other departmental policies and
procedures
Fraud-related control activities include:
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Lecture 9
Thorough background checks for all new hires
Segregation of duties and functions
Authorizations, reviews and approvals of certain
transactions such as sales, purchases or
payments
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Components of Internal Control
4.
Information and Communication
(formerly called the accounting system)

Expanded by SAS 78 to include identification,
capture and exchange of information (numbers,
data, reports, etc.) necessary to enable
employees to carry out their responsibilities
Components of Internal Control
5. Monitoring
 The process of assessing the quality of internal
control performance, including
 Fraud prevention
 Fraud deterrence
 Fraud detection
 Similar to internal audit type functions, whether
formal or informal
Fraudulent Financial Reporting
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Lecture 9
Manipulation, falsification or alteration of
accounting records or supporting
documents
Misrepresentation or intentional omissions
of information from financial statements
Intentional misapplication of accounting
principle
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Misappropriation of Assets
Misappropriation of assets can cause the
financial statements not to be presented in
accordance to GAAP
False or misleading documents
May involve management, employees or
third parties
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Assessment of Fraud Risk
Fraud in financial statements:
Management characteristics and influence
over control environment
 Industry conditions
 Operating characteristics and financial
stability
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Fraud Risk Factors
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Lecture 9
Size, complexity, and ownership
characteristics of the entity
Enforcement of formal code of conduct
Country-specific or business segment
operating level
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Financial Statement
Analysis
Vertical analysis
 Horizontal analysis
 Ratio analysis
 Net worth analysis
 Data mining techniques
 Industry Comparisons
 Historical Comparisons

Vertical Analysis
Compares general ledger or financial
statement balances to other balances within
the same year
 Used in both balance sheet & income stmt
 Highlights changes in account balances within
the year as compared to other years
 Measuring cost of goods sold as a percentage
of sales is a type of income statement vertical
analysis
 Comparing current assets to total assets is a
balance sheet vertical analysis

Horizontal Analysis
Compares changes in account balances from
year to year
 One year would be used as the base line to
calculate the percentage change in account
 Examining the percentage change in accounts
payable from year 3 as compared to year 2
and year one- would be a B/S example
 Examining changes in sales from year 3 to
earlier years would be an example of an
income statement horizontal analysis
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Lecture 9
21
Vertical & Horizontal Analysis Balance Sheet
Vertical & Horizontal Analysis Income Statement
Ratio Analysis
Analyzes relationships between financial
statement components
 Cash or current assets:
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Receivables/inventory:
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Current ratio
Quick ratio
Turnover ratios
Financial Statements:
Debt to equity
Profit margin
 Asset turnover
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Lecture 9
22
Ratio Analysis
Ratio Analysis
Deterrence of Financial
Statement Fraud
Reduce pressures to commit financial
statement fraud
 Reduce the opportunity to commit
financial statement fraud
 Reduce rationalization of financial
statement fraud
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Lecture 9
23
Reduce Pressures to Commit
Financial Statement Fraud
Establish effective board oversight of the “tone at
the top” created by management.
 Avoid setting unachievable financial goals.
 Avoid applying excessive pressure on employees to
achieve goals.
 Change goals if changed market conditions require it
 Ensure compensation systems are fair and do not
create too much incentive to commit fraud.
 Discourage excessive external expectations of future
corporate performance.
 Remove operational obstacles blocking effective
performance.

Reduce the Opportunity to Commit
Financial Statement Fraud
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Maintain accurate and complete internal accounting records.
Carefully monitor the business transactions and interpersonal
relationships of suppliers, buyers, purchasing agents, sales
representatives, and others who interface in the transactions
between financial units.
Establish a physical security system to secure company assets,
including finished goods, cash, capital equipment, tools, and
other valuable items.
Maintain accurate personnel records including background
checks on new employees.
Encourage strong supervisory and leadership relationships
within groups to ensure enforcement of accounting procedures.
Establish clear and uniform accounting procedures with no
exception clauses.
Reduce Rationalization of
Financial Statement Fraud
Promote strong values, based on integrity,
throughout the organization.
 Have policies that clearly define prohibited
behavior with respect to accounting and
financial statement fraud.
 Provide regular training to all employees
communicating prohibited behavior.
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Lecture 9
24
Reduce Rationalization of
Financial Statement Fraud
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Have confidential advice and reporting mechanisms to
communicate inappropriate behavior.
Have senior executives communicate to employees
that integrity takes priority and that goals must never
be achieved through fraud.
Ensure management practices what it preaches and
sets an example by promoting honesty in the
accounting area.
The consequences of violating the rules and the
punishment of violators should be clearly
communicated.
Detecting Financial Statement Fraud
Dr. Messod D. Beneish developed a model for
determining whether there had been earnings
manipulation in financial statements in 1999
 Called this the M-Score model
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M is for manipulation
The M-Score model is based on eight values
determined from the financial statements of the
company
Beneish M-Score Model

The variables are:

DSRI – Days’ Sales in Receivables Index
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GMI – Gross Margin Index
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Lecture 9
= Days’ Sales in Receivables – current year ÷ Days’
Sales in Receivables – prior year
Measures an indicator of revenue inflation
Measured as the ratio of the Gross Margin –
current year ÷ Gross Margin – prior year
A company with declining profitability is more likely
to manipulate earnings
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Beneish M-Score Model

AQI – Asset Quality Index
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Measured as the ratio of non-current assets other
than property, plant & equipment to total assets –
current year ÷ the same ratio for the prior year
SGI – Sales Growth Index –
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Current year sales ÷ Prior year sales
While sales growth is not itself a measure of
manipulation, growth companies are likely to find
themselves under pressure to manipulate in order
to keep up appearances
Beneish M-Score Model

DEPI – Depreciation Index
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Ratio of Depreciation – current year ÷ Depreciation –
prior year
A slower rate of depreciation (a DEPI > 1) may
mean that a firm is revising useful lives
SGAI – Sales, General and Administrative
Expenses Index
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SGA Expenses – current year ÷ SGA Expenses –
prior year
Suggests that analysts would interpret a
disproportionate increase in sales as a negative
signal about the firm’s future prospects
Beneish M-Score Model

LVGI – Leverage Index
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TATA – Total Accruals to Total Assets

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Lecture 9
Measured as Total Debt – current year ÷ Total Debt
– prior year
Debt includes all borrowings, all accounts payable
and all accrued liabilities
Intended to capture debt covenant incentives for
earnings manipulation
Total accruals are calculated as the change in
working capital other than cash less depreciation –
Total current year ÷ Total prior year
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Beneish M-Score Model


M = -4.84 + (0.92*DSRI ) + (0.528*GMI) +
(0.404*AQI) + (0.892*SGI) + (0.115*DEPI) (0.172*SGAI) + (4.679*TATA) – (0.327*LVGI)
An M-Score > -2.22 indicates a strong likelihood
of the company being a manipulator
A score of -2.85 would indicate the company is not
likely a manipulator
 A score of 1.27 would indicate the company is
likely a manipulator

Beneish M-Score Model

Two available Excel models that can be downloaded from the
Internet:


http://investexcel.net/2793/beneish-m-score
www.docstoc.com/docs/113140504/beneish-mscore-(exceldownload)
Basic Methods of White-Collar
Criminals
White collar criminals consider your humanity,
ethics, morality, and good intentions as
weaknesses to be exploited in the execution of
their crimes.
 White collar criminals measure their effectiveness
by the comfort level of their victims.
 White collar criminals build a wall of false
integrity around themselves to gain the trust of
their victims.
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Lecture 9
27
Economics of Fraud
Understating Profits vs. Overstating
Profits

You get a "bigger bang for the buck" by
inflating earnings and overpaying taxes
as a public company than you get by
understating income and underpaying
taxes as a private company.
XXX
How most white-collar crime is uncovered:
1.
2.
3.
Lecture 9
Ex-lovers: Divorced spouses, former
girlfriends and boyfriends.
Ex-business associates: Former customers,
suppliers, and partners
Ex-employees: Fired employees, laid off
employees, and employee who quit working
for the entity.
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