Financial St. Fraud Flashcards
3 elements of legal definition of fraud
1 intentional misrepresentation of fact by perpetrator
2 reliance on misrepresentation by victim
3 injury to victim resulting from reliance on misrepresentation
Financial statement fraud (FSF)
Any undisclosed or grossly negligent violation of GAAP that
Materially affects the info in any financial statement
Aside from recording inaccurate info, fraud also includes?
Undisclosed material
Which organization studies financial statement fraud schemes?
Committee of Sponsoring Organizations (COSO)
6 most common financial fraud schemes?
1 improper revenue recognition 2 overstatement of assets (other than A/R) 3 understatement of expenses/liabilities 4 misappropriation of assets 5 inappropriate disclosure 6 other misc. techniques
Overstating revenues: sham sales
Recording fictitious sales
and frequently includes falsified sales, inventory and shipping
Records
Ex. Sometimes fraudster hides inventory to make it seem like sale went through
Overstating revenues: premature revenue recognition
Process where company employees record sales after receiving customer orders but before shipping goods
Overstating revenues: Recognition of conditional sales
employees record sales for transactions that aren’t yet complete
Because unresolved contingencies
In some cases employees make secret agreements with customer
That alter terms of the sale
Ex. Company could secretly agree that customer can return all unsold goods
Overstating revenues: abuse of cutoff date of sales
Sales that occur after closing date of reporting period,
and included in current period’s income statement
Overstating revenues: misstatement of percentage of completion
Employees overstate percentage of project completed
Thus overstating revenues
Ex. Overstating percentage completed of construction projects
Overstating revenues: unauthorized shipments
Employees create sales orders at end of accounting period by
Shipping goods that haven’t been ordered to record current
Period sales
When goods returned the next period, they’re charged against
Next period’s sales
Overstating revenues: channel stuffing
Company ships unsold goods to distributor and records sales
Overstating revenues: consignment sales fraud
1 Employees ship goods to customers on consignment basis,
But report shipments as normal sales
2 Done at end of accounting period to record sale in current period
3 when goods returned next period, they’re charged against
Next period’s sales
Overstating Assets: Inventory Fraud, most common type?
2) Why is it overstated?
Most commonly involves overstatement of ending inventories
Why is ending inventory overstated?
Ending inventory overstatement is simple matter because it
Involves miss counting the inventories on hand without creating
Fraudulent transactions
Inventory equation and variables
BI + P - EI = COGS
BI = beginning inventory P = inventory purchases during current period EI = ending inventory
Why is beginning inventory not subject to fraud?
Because Beginning inventory must match ending inventory
amount from Previous period
How does a company overstate current period purchasing inventory?
Company must create fictitious purchase entries
These fraudulent entries go into A/P, cash and purchases
Accounts
Overstating assets: A/R, how is it overstated?
A/R overstated by understating allowances for bad debts or
Falsifying account balances
Overstating Assets: Property, plant and equipment
1 Depreciation isn’t taken when it should be
2 Or property, plant and equipment are simply overstated,
3 Corresponding overstatement is made to revenues
Overstating Assets: other over statements
Involve other accounts including loans/ notes receivable, cash,
Investments, etc.
In some cases expenses may be understated
Overstating Assets: 6 common cases of Improper Accounting Treatment
1 recording asset at FMV instead of cost
2 failing to charge proper depreciation/amortization
3 capitalizing asset when should be expensed
4 improperly recording transfer of goods from related companies
As sales
5 not recording liabilities to keep off balance sheet
6 omitting contingent liabilities from financial statements
Overstating Assets: fictitious and fraudulent transactions
Recording sham transactions and legitimate transactions
Improperly
Overstating Assets: fraudulent transaction processing
Intentional misprocessing transactions to produce fraudulent
Account balances
Ex. Accounting software is modified to incorrectly total sales and A/R
so all transactions in account are real but total is overstated
Overstating Assets: direct falsification of financial statements
Producing false financial statements when management simply
Ignores account balances
Median amount of misappropriation of assets for fraud?
Fraud is approximately 25% of median total assets
What is the average time span for fraud to occur?
2 years
Overstated revenues are frequently accompanied by what?
Overstatement if assets (inventory, property plant, equipment,
A/R after allowances for bad debts)
In some cases fictitious assets are created
Accounting and Auditing Enforcement Releases (AAERs)
SEC publishes its enforcement actions on its website
FSF
Financial statement fraud
FSF is more likely to occur in companies whose assets are…
Less than $100 million
When FSF is more likely to occur in regard to a company’s earnings?
1 Earnings problems,
2 decreased earnings,
3 downward trend in earnings
In a large majority of cases who is involved in fraud?
CFO or CEO
FSF and audit committee
Board of directors has no audit committee or one that seldom
Meets
Or none of the members of the audit committee are qualified
To audit
FSF occurs more often when members of the board are frequently dominated by…
Insiders (even related to managers)
Or by those with financial ties to the company
FSF and the size of the financial firm performing the audit
Size of firm doesn’t matter, FSF frequently occurs in companies
Audited by both large and small audit firms
FSF and external auditor
One third of enforcement action cases name individuals
Allege wrongdoing on part of external auditor
Half the time auditor participates in fraud, the other half the auditor
Is accused of negligence
In and around the time of the fraud, what percentage of the time do auditor changes occur?
25%
Motives for management to commit fraud
1 poor income performance 2 impaired ability to acquire capital 3 product marketing 4 general business opportunities 5 compliance with bond covenants 6 generic greed 7 theft, bribery, or other illegal acts
Management FSF motives: product marketing
Management seeks to hide financial problems to keep buyers
Buyers tend to shy away from companies with financial problems
Or that can go out of business
Management FSF motives: compliance with Bond Covenants
Fraud is performed to hide company’s inability to meet bond
Or other covenant conditions
Fraud created insider information period (FCIIP)
Fraud related losses accrue to shareholders between dates the
Company publishes the fraudulent info and date it corrects info
Most cases of fraud involve management withholding…
Bad news
Many cases of fraud occur when management fraudulently creates…
Good news
The stock market can be viewed as a mechanism that…
Assigns gains and losses to individual shareholders on a risk-
Reward basis
The overall effect of financial statement fraud is to reduce the…
Supply of valuable services and products that are available to
society
How could the CEO and CFO still perpetrate insider trading fraud, when they have already published an honest financial report?
By selling shares 1 day before they publish bad news
Insider trading is illegal in the United States, except when done by company officials who do what?
File special SEC reports
And comply with special SEC rules
The general philosophy behind SOX is to minimize FSF by promoting…
Strong corporate governance and organizational oversight
SOX: corporate governance and organizational oversight, 6 organizations
1 Board of directors 2 audit committee 3 management 4 internal auditor 5 external auditor 6 public oversight bodies
SOX requirements for: board of directors
Board of directors must have competent, experienced members
Who actively participate in company’s governance processes
Should be financially independent from company except for
Board related compensation
SOX requirements for: audit committee, who should they work closely with?
2) for what purpose?
Internal auditors, external auditors and management
Ensure integrity of external audit processes
SOX requirements for: managment
CEO and CFO have primary responsibility for implementing enterprise wide internal control processes and ethics management
Both must stay actively involved
SOX requirements for: why should internal auditors report directly to audit committee?
So audit committee can serve as independent check on top
Management
And independently ensure quality of internal control processes
And compliance
SOX requirements for: external auditors
Should be independent of company in both fact and appearance
SOX prohibits nonaudit services from external auditors
Most critical group of the 6 organizations in SOX?
Audit committee
3 primary responsibilities of audit committee?
Selecting, hiring and communicating with external auditor
If the audit committee does its job well, FSF can only occur if there are…
3 independent failures involving management, the internal auditor
and the external auditor
Red flags for FSF: lack of independence, competence, oversight or diligence 2
1 any lack of independence between managment, internal
auditors and external auditors
2 lack of competence, oversight or diligence by audit committee
Or internal auditor
Red flags for FSF: weak internal control process 2
1 management fails to actively develop and oversee internal
Control
2 lack of corporate code of conduct with no related employee
Training and awareness
Red flags for FSF: management style 7
1 excess pressure for employees to perform
2 excess focus on short term performance
3 excessively authoritarian style causing employees to blindly
agree and participate in fraud
4 excessive decentralization resulting in management oversight
That’s too lax
5 crisis managment
6 missing it poor strategic and operational plan
7 excessive risk taking
Red flags for FSF: personnel related practices 5
1 high employee turnover, especially top management
2 hiring unqualified employees or hiring without background check
3 inexperienced top management
4 inadequate employee compensation
5 low employee morale
Red flags for FSF: accounting practices 11
1 restatements of prior year reports
2 aggressive accounting methods
3 weak audit trails
4 losses of accounting records
5 weak or poorly organized accounting info system
6 overly optimistic or inadequate budgets
7 arguments with auditors or lack of cooperation with auditors
Or audit committee
8 late or last minute financial reports
9 large or unusual end or year accounting adjustments or
transactions
10 frequent changes of external auditor
11 large or frequent accounting errors
Red flags for FSF: company’s financial condition 15
1 deterioration of financial condition associated with large
Percentage of FSF
2 extremely high earnings or sudden increases in earnings
3 declining in net income
4 declining cashflows from operations or low cashflows relative
To net income
5 declining sales or market shares
6 increases in debt leveraging
7 inadequate liquidity
8 product obsolescence
9 lagging collections in A/R
10 tax problems
11 serious legal or contractual problems
12 significant failure to meet analysts earnings and expectations
13 doubt about remaining going concern
14 insider sale of stock shares
15 excess accumulation of inventory relative to sales
Red flags for FSF: industry environment and conditions 2
1 volatility, especially when firms in same industry have problems
2 one product company in declining industry
Management discretion: GAAP
Gives management wide degree of latitude in financial reporting
Use of discretion in making accounting choices: selection of depreciation methods
1 straight line depreciation
2 decline balance (MACRS)
Management can manage income according to depreciation
method it chooses
Management has discretion in deciding useful life of assets
Management can’t switch depreciation methods or accounting methods from one year to the next without…
Generating notation in auditors report
Auditors report regarding change in accounting method
Notation is likely to occur only in year change occurs
Although it effects income in future years
In times of rising prices LIFO results in…
2) FIFO results in…
Higher cost of goods sold and lower income
2) lower cost of goods sold and higher income
2 common examples of discretion in making economic choices by managment
1 deferred expenses
2 accelerated revenues
Deferred expenses
Management can boost EPS by deferring one year’s expenses
To the next year
Deferred expenses: what types of expenses can be deferred 4 examples
1 marketing campaigns
2 maintenance
3 research and development
4 training
Accelerated revenues, define and give examples
Management can boost EPS by accelerating revenues
Ex. Offering end of year discounts, inventory liquidations, other promotions
Matching principle
Requires revenues to be matched with related expenses in
Income statement
Real economic income is…
2) and accrual accounting decides only the…
Cashflow
2) timing of recognition of that cashflow
Earnings managment
Management’s routine use of non fraudulent accounting and
Economic discretion
Earnings manipulation
Refer to either legitimate or aggressive use of discretion
Or fraudulent use of discretion
Aggressive accounting technique example
Purchasing a machine with a 7 year useful life and management
Gives it a useful life of 10 years to boost net income
3 examples of management’s economic discretion that helps firm in short run but hurts it in long run
1 cutting equipment maintenance expenses
2 cutting safety or environmental practices (potential lawsuits)
3 offering large year end product discounts
Earnings smoothing
Manipulation of earnings to reduce their volatility
Using manipulation to increase EPS when they are weak and
Lower EPS when they are strong
Earnings smoking functions are based on…
Accounting so fundamental law of conservation
Accounting’s fundamental law of conservation
GAAP-compliant accounting manipulations neither create nor
Destroy earnings
They merely shift them from one period to another
Cookie jar accounting
Company uses generous reserves from good years against
Losses that might be incurred in bad years
Balance sheet is a cookie jar for storing treats, so management
Can take them out and eat them (on income statement) in bad
Years
Reserve accounts
Used to charge anticipated future costs to current income
Costs are debited to current expense and credited to reserve
Account (which acts as liability)
Big bath accounting
When company makes a large one time write off, it is said to
Take a big bath to improve future earnings when earnings
Performance is poor
Ex. Restructuring or inventory write downs)
