Financial St. Fraud

Question 0

3 elements of legal definition of fraud

Answer 0

1 intentional misrepresentation of fact by perpetrator
2 reliance on misrepresentation by victim
3 injury to victim resulting from reliance on misrepresentation

Question 1

Financial statement fraud (FSF)

Answer 1

Any undisclosed or grossly negligent violation of GAAP that

Materially affects the info in any financial statement

Question 2

Aside from recording inaccurate info, fraud also includes?

Answer 2

Undisclosed material

Question 3

Which organization studies financial statement fraud schemes?

Answer 3

Committee of Sponsoring Organizations (COSO)

Question 4

6 most common financial fraud schemes?

Answer 4

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

Question 5

Overstating revenues: sham sales

Answer 5

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

Question 6

Overstating revenues: premature revenue recognition

Answer 6

Process where company employees record sales after receiving customer orders but before shipping goods

Question 7

Overstating revenues: Recognition of conditional sales

Answer 7

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

Question 8

Overstating revenues: abuse of cutoff date of sales

Answer 8

Sales that occur after closing date of reporting period,

and included in current period’s income statement

Question 9

Overstating revenues: misstatement of percentage of completion

Answer 9

Employees overstate percentage of project completed
Thus overstating revenues

Ex. Overstating percentage completed of construction projects

Question 10

Overstating revenues: unauthorized shipments

Answer 10

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

Question 11

Overstating revenues: channel stuffing

Answer 11

Company ships unsold goods to distributor and records sales

Question 12

Overstating revenues: consignment sales fraud

Answer 12

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

Question 13

Overstating Assets: Inventory Fraud, most common type?

2) Why is it overstated?

Answer 13

Most commonly involves overstatement of ending inventories

Question 14

Why is ending inventory overstated?

Answer 14

Ending inventory overstatement is simple matter because it
Involves miss counting the inventories on hand without creating
Fraudulent transactions

Question 15

Inventory equation and variables

Answer 15

BI + P - EI = COGS

BI = beginning inventory
P = inventory purchases during current period
EI = ending inventory

Question 16

Why is beginning inventory not subject to fraud?

Answer 16

Because Beginning inventory must match ending inventory

amount from Previous period

Question 17

How does a company overstate current period purchasing inventory?

Answer 17

Company must create fictitious purchase entries

These fraudulent entries go into A/P, cash and purchases
Accounts

Question 18

Overstating assets: A/R, how is it overstated?

Answer 18

A/R overstated by understating allowances for bad debts or

Falsifying account balances

Question 19

Overstating Assets: Property, plant and equipment

Answer 19

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

Question 20

Overstating Assets: other over statements

Answer 20

Involve other accounts including loans/ notes receivable, cash,
Investments, etc.

In some cases expenses may be understated

Question 21

Overstating Assets: 6 common cases of Improper Accounting Treatment

Answer 21

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

Question 22

Overstating Assets: fictitious and fraudulent transactions

Answer 22

Recording sham transactions and legitimate transactions

Improperly

Question 23

Overstating Assets: fraudulent transaction processing

Answer 23

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

Question 24

Overstating Assets: direct falsification of financial statements

Answer 24

Producing false financial statements when management simply | Ignores account balances

Question 25

Median amount of misappropriation of assets for fraud?

Answer 25

Fraud is approximately 25% of median total assets

Question 26

What is the average time span for fraud to occur?

Answer 26

2 years

Question 27

Overstated revenues are frequently accompanied by what?

Answer 27

Overstatement if assets (inventory, property plant, equipment, A/R after allowances for bad debts) In some cases fictitious assets are created

Question 28

Accounting and Auditing Enforcement Releases (AAERs)

Answer 28

SEC publishes its enforcement actions on its website

Question 29

FSF

Answer 29

Financial statement fraud

Question 30

FSF is more likely to occur in companies whose assets are...

Answer 30

Less than $100 million

Question 31

When FSF is more likely to occur in regard to a company's earnings?

Answer 31

1 Earnings problems, 2 decreased earnings, 3 downward trend in earnings

Question 32

In a large majority of cases who is involved in fraud?

Answer 32

CFO or CEO

Question 33

FSF and audit committee

Answer 33

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

Question 34

FSF occurs more often when members of the board are frequently dominated by...

Answer 34

Insiders (even related to managers) Or by those with financial ties to the company

Question 35

FSF and the size of the financial firm performing the audit

Answer 35

Size of firm doesn't matter, FSF frequently occurs in companies Audited by both large and small audit firms

Question 36

FSF and external auditor

Answer 36

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

Question 37

In and around the time of the fraud, what percentage of the time do auditor changes occur?

Answer 37

25%

Question 38

Motives for management to commit fraud

Answer 38

``` 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 ```

Question 39

Management FSF motives: product marketing

Answer 39

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

Question 40

Management FSF motives: compliance with Bond Covenants

Answer 40

Fraud is performed to hide company's inability to meet bond | Or other covenant conditions

Question 41

Fraud created insider information period (FCIIP)

Answer 41

Fraud related losses accrue to shareholders between dates the Company publishes the fraudulent info and date it corrects info

Question 42

Most cases of fraud involve management withholding...

Answer 42

Bad news

Question 43

Many cases of fraud occur when management fraudulently creates...

Answer 43

Good news

Question 44

The stock market can be viewed as a mechanism that...

Answer 44

Assigns gains and losses to individual shareholders on a risk- Reward basis

Question 45

The overall effect of financial statement fraud is to reduce the...

Answer 45

Supply of valuable services and products that are available to society

Question 46

How could the CEO and CFO still perpetrate insider trading fraud, when they have already published an honest financial report?

Answer 46

By selling shares 1 day before they publish bad news

Question 47

Insider trading is illegal in the United States, except when done by company officials who do what?

Answer 47

File special SEC reports And comply with special SEC rules

Question 48

The general philosophy behind SOX is to minimize FSF by promoting...

Answer 48

Strong corporate governance and organizational oversight

Question 49

SOX: corporate governance and organizational oversight, 6 organizations

Answer 49

``` 1 Board of directors 2 audit committee 3 management 4 internal auditor 5 external auditor 6 public oversight bodies ```

Question 50

SOX requirements for: board of directors

Answer 50

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

Question 51

SOX requirements for: audit committee, who should they work closely with? 2) for what purpose?

Answer 51

Internal auditors, external auditors and management Ensure integrity of external audit processes

Question 52

SOX requirements for: managment

Answer 52

CEO and CFO have primary responsibility for implementing enterprise wide internal control processes and ethics management Both must stay actively involved

Question 53

SOX requirements for: why should internal auditors report directly to audit committee?

Answer 53

So audit committee can serve as independent check on top Management And independently ensure quality of internal control processes And compliance

Question 54

SOX requirements for: external auditors

Answer 54

Should be independent of company in both fact and appearance SOX prohibits nonaudit services from external auditors

Question 55

Most critical group of the 6 organizations in SOX?

Answer 55

Audit committee

Question 56

3 primary responsibilities of audit committee?

Answer 56

Selecting, hiring and communicating with external auditor

Question 57

If the audit committee does its job well, FSF can only occur if there are...

Answer 57

3 independent failures involving management, the internal auditor and the external auditor

Question 58

Red flags for FSF: lack of independence, competence, oversight or diligence 2

Answer 58

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

Question 59

Red flags for FSF: weak internal control process 2

Answer 59

1 management fails to actively develop and oversee internal Control 2 lack of corporate code of conduct with no related employee Training and awareness

Question 60

Red flags for FSF: management style 7

Answer 60

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

Question 61

Red flags for FSF: personnel related practices 5

Answer 61

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

Question 62

Red flags for FSF: accounting practices 11

Answer 62

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

Question 63

Red flags for FSF: company's financial condition 15

Answer 63

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

Question 64

Red flags for FSF: industry environment and conditions 2

Answer 64

1 volatility, especially when firms in same industry have problems 2 one product company in declining industry

Question 65

Management discretion: GAAP

Answer 65

Gives management wide degree of latitude in financial reporting

Question 66

Use of discretion in making accounting choices: selection of depreciation methods

Answer 66

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

Question 67

Management can't switch depreciation methods or accounting methods from one year to the next without...

Answer 67

Generating notation in auditors report

Question 68

Auditors report regarding change in accounting method

Answer 68

Notation is likely to occur only in year change occurs Although it effects income in future years

Question 69

In times of rising prices LIFO results in... 2) FIFO results in...

Answer 69

Higher cost of goods sold and lower income 2) lower cost of goods sold and higher income

Question 70

2 common examples of discretion in making economic choices by managment

Answer 70

1 deferred expenses 2 accelerated revenues

Question 71

Deferred expenses

Answer 71

Management can boost EPS by deferring one year's expenses | To the next year

Question 72

Deferred expenses: what types of expenses can be deferred 4 examples

Answer 72

1 marketing campaigns 2 maintenance 3 research and development 4 training

Question 73

Accelerated revenues, define and give examples

Answer 73

Management can boost EPS by accelerating revenues Ex. Offering end of year discounts, inventory liquidations, other promotions

Question 74

Matching principle

Answer 74

Requires revenues to be matched with related expenses in | Income statement

Question 75

Real economic income is... 2) and accrual accounting decides only the...

Answer 75

Cashflow 2) timing of recognition of that cashflow

Question 76

Earnings managment

Answer 76

Management's routine use of non fraudulent accounting and | Economic discretion

Question 77

Earnings manipulation

Answer 77

Refer to either legitimate or aggressive use of discretion Or fraudulent use of discretion

Question 78

Aggressive accounting technique example

Answer 78

Purchasing a machine with a 7 year useful life and management Gives it a useful life of 10 years to boost net income

Question 79

3 examples of management's economic discretion that helps firm in short run but hurts it in long run

Answer 79

1 cutting equipment maintenance expenses 2 cutting safety or environmental practices (potential lawsuits) 3 offering large year end product discounts

Question 80

Earnings smoothing

Answer 80

Manipulation of earnings to reduce their volatility Using manipulation to increase EPS when they are weak and Lower EPS when they are strong

Question 81

Earnings smoking functions are based on...

Answer 81

Accounting so fundamental law of conservation

Question 82

Accounting's fundamental law of conservation

Answer 82

GAAP-compliant accounting manipulations neither create nor Destroy earnings They merely shift them from one period to another

Question 83

Cookie jar accounting

Answer 83

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

Question 84

Reserve accounts

Answer 84

Used to charge anticipated future costs to current income Costs are debited to current expense and credited to reserve Account (which acts as liability)

Question 85

Big bath accounting

Answer 85

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)