Cooking the Books:
What Every Accountant
Should Know About Fraud
World Headquarters • the gregor building
716 West Ave • Austin, TX 78701-2727 • USA
COOKING THE BOOKS: WHAT EVERY ACCOUNTANT SHOULD
KNOW ABOUT FRAUD
TABLE OF CONTENTS
I. INTRODUCTION
ZZZZ BEST Carpet Cleaning ......................................................................................................................... 2
Regina Vacuum Cleaner Company.................................................................................................................. 3
ESM Government Securities............................................................................................................................ 4
II. OVERVIEW
Who Commits Financial Statement Fraud? ................................................................................................... 6
Who Are the Victims of Fraudulent Financial Reporting? .......................................................................... 6
What Is Fraud? ................................................................................................................................................... 6
What Is Financial Statement Fraud? ............................................................................................................... 7
What Is a Financial Statement? ................................................................................................................. 7
The Cost of Financial Statement Fraud ................................................................................................... 8
Why Is Financial Statement Fraud Committed?..................................................................................... 9
The COSO Study on Financial Statement Fraud ................................................................................. 10
What Are Typical Financial Statement Frauds? .................................................................................... 11
Review Questions ............................................................................................................................................ 14
III. LEGAL ELEMENTS OF FINANCIAL STATEMENT FRAUD
Intent ................................................................................................................................................................. 15
Materially Misleading Financial Statements ................................................................................................. 15
What Is Materiality? .................................................................................................................................. 15
Prosecution ....................................................................................................................................................... 16
Criminal Enforcement .............................................................................................................................. 16
Civil Enforcement ..................................................................................................................................... 18
What Is the Genesis of Accountants’ and Auditors’ Liability? ................................................................. 19
Breach of Contract .................................................................................................................................... 20
Negligence .................................................................................................................................................. 20
Gross Negligence ...................................................................................................................................... 20
Fraud ........................................................................................................................................................... 20
Constructive Fraud ................................................................................................................................... 20
Review Questions ............................................................................................................................................ 24
IV. MANAGEMENT'S, AUDITORS', AND FRAUD EXAMINERS' RESPONSIBILITIES
Management ............................................................................................................................................... 26
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COOKING THE BOOKS: WHAT EVERY ACCOUNTANT SHOULD
KNOW ABOUT FRAUD
IV. MANAGEMENT'S, AUDITORS', AND FRAUD EXAMINERS' RESPONSIBILITIES
(CONT.)
The Treadway Commission ..................................................................................................................... 26
The COSO Report .................................................................................................................................... 27
Document Retention Policies ................................................................................................................. 28
Fraud Prevention Programs .................................................................................................................... 30
Certified Fraud Examiners ............................................................................................................................. 31
Help Resolve Allegations of Fraud......................................................................................................... 31
Obtain Evidence ....................................................................................................................................... 31
Take Statements ........................................................................................................................................ 31
Write Reports............................................................................................................................................. 31
Testify to Findings .................................................................................................................................... 32
Assist in the Detection and Prevention of Fraud ................................................................................. 32
External Auditors ............................................................................................................................................. 32
AU Section 316—Consideration of Fraud in a Financial Statement Audit ................................................ 33
PCAOB Auditing Standard No. 5—An Audit of Internal Control Over Financial Reporting That Is
Integrated with an Audit of Financial Statements ........................................................................................... 43
AT Section 501—An Examination of an Entity’s Internal Control Over Financial Reporting That Is Integrated
With an Audit of Its Financial Statements (Source: Statement of Standards for Attestation Engagements No. 15)
..................................................................................................................................................................... 47
AU Section 314—Understanding the Entity and Its Environment and Assessing the Risks of Material
Misstatement ................................................................................................................................................. 47
PCAOB Auditing Standard No. 3—Audit Documentation .................................................................... 49
AU Section 339—Audit Documentation ................................................................................................... 50
Internal Auditor Responsibilities ................................................................................................................... 51
Standard 1210—Proficiency .................................................................................................................... 51
Standard 1220—Due Professional Care ................................................................................................ 51
Standard 2060—Reporting to Senior Management and the Board ................................................... 52
Standard 2110—Governance .................................................................................................................. 52
Standard 2120—Risk Management ........................................................................................................ 52
Standard 2130—Control .......................................................................................................................... 53
Standard 2210—Engagement Objectives.............................................................................................. 53
IIA’s IPPF—Practice Guide: Internal Auditing and Fraud ......................................................................... 54
GAO Auditing Standards ............................................................................................................................... 56
Purpose and Applicability ........................................................................................................................ 56
Ethical Principles in Government Auditing .......................................................................................... 56
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Cooking the Books
COOKING THE BOOKS: WHAT EVERY ACCOUNTANT SHOULD
KNOW ABOUT FRAUD
IV. MANAGEMENT'S, AUDITORS', AND FRAUD EXAMINERS' RESPONSIBILITIES
(CONT.)
Types of Government Audit Engagements .......................................................................................... 58
Audit Standards ......................................................................................................................................... 59
The Sarbanes-Oxley Act ................................................................................................................................. 65
Public Company Accounting Oversight Board .................................................................................... 65
Officers and Directors.............................................................................................................................. 67
Audit Committee ....................................................................................................................................... 72
External Auditors ...................................................................................................................................... 76
Whistleblower Protection ........................................................................................................................ 76
Civil and Criminal Penalties for Noncompliance ................................................................................. 77
Private Securities Litigation Reform Act ...................................................................................................... 77
Review Questions ............................................................................................................................................ 80
V. SCHEMES
Fictitious Revenues .......................................................................................................................................... 85
Fabricating Revenue ................................................................................................................................. 85
Detecting Fictitious Revenues ................................................................................................................. 87
Improper Recording of Sales Returns, Allowances, and Discounts .................................................. 90
Sales with Conditions ............................................................................................................................... 92
What Red Flags Are Associated with Fictitious Revenues? ................................................................ 93
Practical Problem 1 .......................................................................................................................................... 94
Timing Differences .......................................................................................................................................... 97
Revenue Recognition Defined ................................................................................................................ 98
Premature Revenue Recognition ............................................................................................................ 98
Long-Term Contracts ............................................................................................................................ 100
Multiple Deliverables ............................................................................................................................. 100
Channel Stuffing..................................................................................................................................... 101
Recording Expenses in the Wrong Period ......................................................................................... 101
Red Flags Associated with Timing Differences................................................................................. 105
Practical Problem 2 ........................................................................................................................................ 106
Practical Problem 3 ....................................................................................................................................... 110
Improper Asset Valuation ........................................................................................................................... 114
Inventory Valuation ............................................................................................................................... 114
Accounts Receivable .............................................................................................................................. 116
Business Combinations ......................................................................................................................... 117
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COOKING THE BOOKS: WHAT EVERY ACCOUNTANT SHOULD
KNOW ABOUT FRAUD
V. SCHEMES (CONT.)
Fixed Assets ............................................................................................................................................ 117
Red Flags Associated with Improper Asset Valuation ..................................................................... 119
ZZZZ BEST Co., Inc. ................................................................................................................................. 120
Concealed Liabilities and Expenses ........................................................................................................... 125
Liability/Expense Omissions ............................................................................................................... 125
Capitalized Expenses ............................................................................................................................. 126
Returns and Allowances and Warranties ............................................................................................ 126
Red Flags Associated with Concealed Liabilities and Expenses ..................................................... 126
Improper Disclosures ................................................................................................................................... 127
Liability Omissions ................................................................................................................................ 127
Subsequent Events ................................................................................................................................. 128
Management Fraud ................................................................................................................................ 128
Related-Party Transactions ................................................................................................................... 128
Accounting Changes .............................................................................................................................. 129
Backdating Stock Options .................................................................................................................... 129
Red Flags Associated with Improper Disclosures ............................................................................ 131
Practical Problem 5 ....................................................................................................................................... 132
Review Questions ......................................................................................................................................... 134
VI. APPENDIX A ...................................................................................................................................... 137
A. Ratios ......................................................................................................................................................... 137
B. Vertical Analysis ....................................................................................................................................... 139
C. Horizontal Analysis ................................................................................................................................. 139
VII. APPENDIX B .................................................................................................................................... 140
A. WorldCom, Inc. ....................................................................................................................................... 140
B. Adelphia..................................................................................................................................................... 141
VIII. SOLUTIONS TO REVIEW QUESTIONS............................................................................ 143
IX. SOLUTIONS TO PRACTICAL PROBLEMS .......................................................................... 166
X. FINAL EXAMINATION ...................................................................................................................E-1
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