HOW TO DETECT AND PREVENT
FINANCIAL STATEMENT FRAUD
(SECOND EDITION)
(NO. 99-5401)
HOW TO DETECT AND PREVENT FINANCIAL STATEMENT FRAUD
TABLE OF CONTENTS
I. INTRODUCTION TO EXAMINING FOR FINANCIAL STATEMENT FRAUD
TRENDS IN FINANCIAL STATEMENT FRAUD .......................................................................................1
ABOUT THIS COURSE ........................................................................................................................................4
ABOUT THE CD-ROM YOU RECEIVED .....................................................................................................5
II. FINANCIAL STATEMENT FRAUD OVERVIEW
FINANCIAL STATEMENT FRAUD DEFINED ...........................................................................................6
MANAGEMENT’S ROLE ....................................................................................................................................6
THE VICTIMS OF FINANCIAL STATEMENT FRAUD ............................................................................6
FINANCIAL STATEMENT FRAUD TRIANGLE ........................................................................................7
FINANCIAL STATEMENT FRAUD RED FLAGS .......................................................................................9
INTRODUCTION TO FINANCIAL STATEMENT FRAUD SCHEMES ............................................ 10
REVIEW QUESTIONS ...................................................................................................................................... 12
III. EXAMINING FOR FINANCIAL STATEMENT FRAUD
THE ROLE OF THE CERTIFIED FRAUD EXAMINER ........................................................................ 14
FRAUD EXAMINATION METHODOLOGY ............................................................................................ 14
FINANCIAL STATEMENT FRAUD EXAMINATION TECHNIQUES ............................................. 18
REVIEW QUESTIONS ...................................................................................................................................... 25
IV. FRAUD PREVENTION AND DETECTION RESPONSIBILITIES
PREVENTION OF FINANCIAL STATEMENT FRAUD........................................................................ 27
DETECTION OF FINANCIAL STATEMENT FRAUD .......................................................................... 32
THE TEN COMMANDMENTS FOR FRAUD AUDITORS .................................................................... 36
THE ETHICAL ENVIRONMENT FOR FRAUD PREVENTION AND DETECTION ................. 37
THE LEGAL ENVIRONMENT FOR FRAUD PREVENTION AND DETECTION ...................... 41
AUDITORS’ RESPONSIBILITIES FOR PREVENTION AND DETECTION OF FINANCIAL
STATEMENT FRAUD ....................................................................................................................................... 56
REVIEW QUESTIONS ...................................................................................................................................... 74
V. ACCOUNTING BASICS
INTRODUCTION ............................................................................................................................................... 78
ACCOUNTING AS A LANGUAGE .............................................................................................................. 78
ACCOUNTING METHODS ............................................................................................................................ 80
ACCOUNTING PRINCIPLES ......................................................................................................................... 81
FINANCIAL STATEMENTS EXPLAINED ................................................................................................ 83
REVIEW QUESTIONS .................................................................................................................................... 104
Financial Statement Fraud
-i-
HOW TO DETECT AND PREVENT FINANCIAL STATEMENT FRAUD
VI. INVESTIGATION TECHNIQUES FOR FRAUDULENT FINANCIAL STATEMENT
ALLEGATIONS
FINANCIAL STATEMENT ANALYSIS ..................................................................................................... 106
DATA MINING TECHNIQUES ................................................................................................................... 120
REVIEW QUESTIONS .................................................................................................................................... 123
VII. SCHEMES AND SCENARIOS: AN INTRODUCTION
FINANCIAL STATEMENT FRAUD SCHEMES ...................................................................................... 125
METHODS OF DETECTION ....................................................................................................................... 126
VIII. FICTITIOUS REVENUES
FABRICATING REVENUE ........................................................................................................................... 132
IMPROPER RECORDING OF SALES RETURNS, ALLOWANCES, AND DISCOUNTS ........... 137
IMPROPER RECORDING OF SALES WITH CONDITIONS ............................................................. 139
REVIEW QUESTIONS .................................................................................................................................... 141
IX. TIMING DIFFERENCES
REVENUE RECOGNITION SCHEMES.................................................................................................... 145
RECORDING EXPENSES IN THE WRONG PERIOD ........................................................................ 150
REVIEW QUESTIONS .................................................................................................................................... 157
X. CONCEALED LIABILITIES AND EXPENSES
CONCEALED LIABILITIES AND EXPENSES ....................................................................................... 159
IMPROPER DISCLOSURES ........................................................................................................................... 169
REVIEW QUESTIONS .................................................................................................................................... 180
XI. IMPROPER ASSET VALUATION
INVENTORY VALUATION .......................................................................................................................... 183
ACCOUNTS RECEIVABLE ........................................................................................................................... 189
FIXED AND INTANGIBLE ASSETS.......................................................................................................... 194
BUSINESS COMBINATIONS........................................................................................................................ 197
ASSETS RELATED TO PENSIONS AND OTHER POST-RETIREMENT BENEFITS ............... 200
REVIEW QUESTIONS .................................................................................................................................... 203
XII. THE CRAZY EDDIE FRAUD
UNDER-REPORTING INCOME — SKIMMING ................................................................................... 205
FICTITIOUS REVENUES............................................................................................................................... 211
CONCEALED LIABILITIES FRAUD ......................................................................................................... 214
INVENTORY FRAUD SCHEMES ............................................................................................................... 217
DISCLOSURE OF FALSE AND FRAUDULENT FINANCIAL INFORMATION TO THE
PUBLIC................................................................................................................................................................. 219
CONCEALMENT OF THE FRAUDULENT SCHEMES ....................................................................... 219
- ii -
Financial Statement Fraud
HOW TO DETECT AND PREVENT FINANCIAL STATEMENT FRAUD
XII. THE CRAZY EDDIE FRAUD (CONTINUED)
COMPARATIVE TECHNIQUES .................................................................................................................. 219
ANALYTICAL TECHNIQUES ...................................................................................................................... 220
SELLING-OFF STOCK ................................................................................................................................... 226
RED FLAGS ........................................................................................................................................................ 227
THE END OF THE STORY ........................................................................................................................... 228
XIII. THE SICK CASE OF HEALTHSOUTH'S ACCOUNTING FRAUDS
THE RISE AND FALL ..................................................................................................................................... 230
COOKING THE BOOKS ............................................................................................................................... 230
FOOLING THE EXPERTS ............................................................................................................................ 234
WAVING THE RED FLAG ............................................................................................................................ 235
ANALYTICAL TECHNIQUES ...................................................................................................................... 236
WARNING SIGNS ............................................................................................................................................ 242
THE END OF THE STORY ........................................................................................................................... 242
XIV. CONCLUSION ...................................................................................................................................... 244
XV. PRACTICAL PROBLEMS ................................................................................................................... 245
XVI. SOLUTIONS TO REVIEW QUESTIONS ................................................................................... 284
XVII. SOLUTIONS FOR PRACTICAL PROBLEMS ......................................................................... 333
XIII. APPENDIX ............................................................................................................................................. 363
XIX. FINAL EXAMINATION .................................................................................................................... E-1
Financial Statement Fraud
- iii -