Lecture notes for:
Cooking the Books
This video will discuss three cases of fraud: how fraud was perpetrated, how it was
detected, and why it was perpetrated. Pay close attention to how (why) it got started.
There seems to be a similarity between the three cases and to the next video (PharMor).
Most of the notes that are in this document are information that is provided in overheads
shown in the video. These overheads go way too fast to be able to write down - so I am
writing it down for you.
Fraud is defined as the intentional misstatement of information for the purpose of
obtaining some advantage. The importance here is that fraud is misrepresentation. It is
not embezzlement except to the extent that embezzlement involves intentional
misstatement.
The video begins with a discussion of eight common methods of perpetrating fraud.
These are worth knowing:
The first four relate to the overstatement of revenues:
1. Premature revenue recognition (recognizing revenue before it is earned).
2. Improper treatment of sales (for example - recording a consignment as a sale - or
worse - making sales up)
3. Revenue substance versus form (for example - selling to a related party in a bogus
transaction)
4. Percentage of completion accounting (saying that more is earned than actually is)
Four other methods of perpetrating fraud are:
5. Deferral of costs and expenses (holding off recognizing an expense)
6. Improper asset valuation
7. Related party transactions
8. Inadequate disclosures
This list is not very concrete, but it is good to know (you will see it again in auditing)
ZZZ Best
They did a bunch of things to manufacture their fraud. Among these things were:
• Creating false accounts receivable and sales
• Creating false documents (using photocopies of real documents)
• Kiting checks (depositing a check in one bank account from second bank account and
then depositing a check into the second bank account from a third bank account to
cover that first check. Then they deposit a check in the third bank from the first bank
in order to cover the second check, etc.)
• Compromising the independence of the internal auditors (this is a theme that runs
through EVERY one of the major frauds we will discuss today).
• Create documents that made it appear receivables were being collected.
The video notes that auditors use two primary means of verifying that a company’s
reported Accounts receivable are in fact true:
1. Confirmations (sending a letter to the customer and asking if they do in fact owe
money)
2. Looking for subsequent collection of receivables.
Barry Minkow knew this and created fictitious collections on accounts receivable.
Barry Minkow also compromised the independence of the auditors by “making them feel
good” and diverting their attention from problem areas.
According to the AICPA (American Institute of Certified Public Accountants) Statement
on Auditing Standards (SAS) No. 53, the auditor’s responsibility for finding fraud
include:
1. Understanding the characteristics of errors and irregularities (fraud)
2. Assessing the risk of material (significant) fraud
3. Designing audit procedures to provide reasonable assurance that material fraud will
be detected.
4. Plan, perform, and evaluate the audit carefully.
5. Approach the audit with professional skepticism.
Barry Minkow offered the following as red flags that should alert auditors to an increased
likelihood of fraud:
1. The company is highly leveraged (a lot of debt relative to the assets)
2. A large proportion of the fixed assets are leased (and not owned).
3. Unbelievable growth (if it looks to good to be true, it probably is)
The first and third of these are common threads that run throughout many frauds.
There are two main stages in the auditor’s assessment of the risk of fraudulent financial
reporting:
1. Analyzing the company’s internal and external environment
2. Determining how these environments affect risk.
Note that in the ZZZ Best case, they are in a low-margin industry. How are they growing
so fast? This will also apply to PharMor, Regina Vacuum, and ESM Group.
Internal environment fraud risk factors include:
1. The strength of internal controls
2. The accounting system
3. Management’s attitude towards fraud
4. Administration and Operations
5. Business is dominated by a few individuals
The auditor should consider (in assessing the risk of fraud):
1. Liquidity (how much cash they have)
2. Profitability
3. Ability to borrow money
4. The quality of their receivables
Barry Minkow notes that if growth is essential, this should be a red flag to auditors.
Growth (perpetuating the fraud) is typically essential in a fraud. It may be desirable in a
high growth company - but it is not usually essential!
SAS No. 53 states that the auditor should consider:
1. Recent changes in operations or products (Regina)
2. New production techniques
3. Business with a few major customers (only)
4. Industry trends
5. Assets or inventory with valuation problems
6. Large or unusual adjustments at or near year-end.
For ZZZ Best, industry comparisons would have pointed to anomalies.
Also, past trends analysis would have indicated that something was now quite different.
Regina Vacuum
Premature revenue recognition can happen in several ways:
1. Holding books open past the end of a period (to get some extra sales in)
2. Bill and hold schemes (premature or bogus invoicing for a customer without sending
it)
3. Conditional sales counted as regular sales
4. Delayed posting of sales returns
For Regina Vacuum, sales returns were not posted, they created false invoices, and they
under-reported expenses.
ESM Group
Don’t worry too much about them - the fraud was fairly complicated. There are a few
features of this story that I think are important though:
1. What made them start engaging in fraud.
2. Notice that after they started it escalated to enormous proportions and the “original
reason” was not the only reason it was perpetuated and escalated.
3. Notice how the auditor got caught in a web
a. His independence was compromised
b. He was relatively inexperienced
c. Once he “didn’t catch” the fraud in year 1, he was afraid to turn them in once he
did. This is typical of auditors and employees.