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Forensic Accounting > Financial St. Fraud > Flashcards

Financial St. Fraud Flashcards

0
Q

3 elements of legal definition of fraud

A

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

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1
Q

Financial statement fraud (FSF)

A

Any undisclosed or grossly negligent violation of GAAP that

Materially affects the info in any financial statement

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2
Q

Aside from recording inaccurate info, fraud also includes?

A

Undisclosed material

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3
Q

Which organization studies financial statement fraud schemes?

A

Committee of Sponsoring Organizations (COSO)

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4
Q

6 most common financial fraud schemes?

A 
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
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5
Q

Overstating revenues: sham sales

A

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

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6
Q

Overstating revenues: premature revenue recognition

A

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

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7
Q

Overstating revenues: Recognition of conditional sales

A

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

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8
Q

Overstating revenues: abuse of cutoff date of sales

A

Sales that occur after closing date of reporting period,

and included in current period’s income statement

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9
Q

Overstating revenues: misstatement of percentage of completion

A

Employees overstate percentage of project completed
Thus overstating revenues

Ex. Overstating percentage completed of construction projects

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10
Q

Overstating revenues: unauthorized shipments

A

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

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11
Q

Overstating revenues: channel stuffing

A

Company ships unsold goods to distributor and records sales

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12
Q

Overstating revenues: consignment sales fraud

A

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

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13
Q

Overstating Assets: Inventory Fraud, most common type?

2) Why is it overstated?

A

Most commonly involves overstatement of ending inventories

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14
Q

Why is ending inventory overstated?

A

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

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15
Q

Inventory equation and variables

A

BI + P - EI = COGS

BI = beginning inventory
P = inventory purchases during current period
EI = ending inventory
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16
Q

Why is beginning inventory not subject to fraud?

A

Because Beginning inventory must match ending inventory

amount from Previous period

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17
Q

How does a company overstate current period purchasing inventory?

A

Company must create fictitious purchase entries

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

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18
Q

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

A

A/R overstated by understating allowances for bad debts or

Falsifying account balances

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19
Q

Overstating Assets: Property, plant and equipment

A

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

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20
Q

Overstating Assets: other over statements

A

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

In some cases expenses may be understated

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21
Q

Overstating Assets: 6 common cases of Improper Accounting Treatment

A

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

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22
Q

Overstating Assets: fictitious and fraudulent transactions

A

Recording sham transactions and legitimate transactions

Improperly

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23
Q

Overstating Assets: fraudulent transaction processing

A

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

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24
Q

Overstating Assets: direct falsification of financial statements

A

Producing false financial statements when management simply

Ignores account balances

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25
Q

Median amount of misappropriation of assets for fraud?

A

Fraud is approximately 25% of median total assets

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26
Q

What is the average time span for fraud to occur?

A

2 years

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27
Q

Overstated revenues are frequently accompanied by what?

A

Overstatement if assets (inventory, property plant, equipment,
A/R after allowances for bad debts)

In some cases fictitious assets are created

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28
Q

Accounting and Auditing Enforcement Releases (AAERs)

A

SEC publishes its enforcement actions on its website

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29
Q

FSF

A

Financial statement fraud

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30
Q

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

A

Less than $100 million

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31
Q

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

A

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

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32
Q

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

A

CFO or CEO

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33
Q

FSF and audit committee

A

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

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34
Q

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

A

Insiders (even related to managers)

Or by those with financial ties to the company

35
Q

FSF and the size of the financial firm performing the audit

A

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

36
Q

FSF and external auditor

A

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

37
Q

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

A

25%

38
Q

Motives for management to commit fraud

A 
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
39
Q

Management FSF motives: product marketing

A

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

40
Q

Management FSF motives: compliance with Bond Covenants

A

Fraud is performed to hide company’s inability to meet bond

Or other covenant conditions

41
Q

Fraud created insider information period (FCIIP)

A

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

42
Q

Most cases of fraud involve management withholding…

A

Bad news

43
Q

Many cases of fraud occur when management fraudulently creates…

A

Good news

44
Q

The stock market can be viewed as a mechanism that…

A

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

45
Q

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

A

Supply of valuable services and products that are available to
society

46
Q

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

A

By selling shares 1 day before they publish bad news

47
Q

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

A

File special SEC reports

And comply with special SEC rules

48
Q

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

A

Strong corporate governance and organizational oversight

49
Q

SOX: corporate governance and organizational oversight, 6 organizations

A 
1 Board of directors
2 audit committee
3 management
4 internal auditor
5 external auditor
6 public oversight bodies
50
Q

SOX requirements for: board of directors

A

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

51
Q

SOX requirements for: audit committee, who should they work closely with?

2) for what purpose?

A

Internal auditors, external auditors and management

Ensure integrity of external audit processes

52
Q

SOX requirements for: managment

A

CEO and CFO have primary responsibility for implementing enterprise wide internal control processes and ethics management

Both must stay actively involved

53
Q

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

A

So audit committee can serve as independent check on top
Management

And independently ensure quality of internal control processes
And compliance

54
Q

SOX requirements for: external auditors

A

Should be independent of company in both fact and appearance

SOX prohibits nonaudit services from external auditors

55
Q

Most critical group of the 6 organizations in SOX?

A

Audit committee

56
Q

3 primary responsibilities of audit committee?

A

Selecting, hiring and communicating with external auditor

57
Q

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

A

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

58
Q

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

A

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

59
Q

Red flags for FSF: weak internal control process 2

A

1 management fails to actively develop and oversee internal
Control

2 lack of corporate code of conduct with no related employee
Training and awareness

60
Q

Red flags for FSF: management style 7

A

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

61
Q

Red flags for FSF: personnel related practices 5

A

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

62
Q

Red flags for FSF: accounting practices 11

A

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

63
Q

Red flags for FSF: company’s financial condition 15

A

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

64
Q

Red flags for FSF: industry environment and conditions 2

A

1 volatility, especially when firms in same industry have problems

2 one product company in declining industry

65
Q

Management discretion: GAAP

A

Gives management wide degree of latitude in financial reporting

66
Q

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

A

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

67
Q

Management can’t switch depreciation methods or accounting methods from one year to the next without…

A

Generating notation in auditors report

68
Q

Auditors report regarding change in accounting method

A

Notation is likely to occur only in year change occurs

Although it effects income in future years

69
Q

In times of rising prices LIFO results in…

2) FIFO results in…

A

Higher cost of goods sold and lower income

2) lower cost of goods sold and higher income

70
Q

2 common examples of discretion in making economic choices by managment

A

1 deferred expenses

2 accelerated revenues

71
Q

Deferred expenses

A

Management can boost EPS by deferring one year’s expenses

To the next year

72
Q

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

A

1 marketing campaigns
2 maintenance
3 research and development
4 training

73
Q

Accelerated revenues, define and give examples

A

Management can boost EPS by accelerating revenues

Ex. Offering end of year discounts, inventory liquidations, other promotions

74
Q

Matching principle

A

Requires revenues to be matched with related expenses in

Income statement

75
Q

Real economic income is…

2) and accrual accounting decides only the…

A

Cashflow

2) timing of recognition of that cashflow

76
Q

Earnings managment

A

Management’s routine use of non fraudulent accounting and

Economic discretion

77
Q

Earnings manipulation

A

Refer to either legitimate or aggressive use of discretion

Or fraudulent use of discretion

78
Q

Aggressive accounting technique example

A

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

79
Q

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

A

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

80
Q

Earnings smoothing

A

Manipulation of earnings to reduce their volatility

Using manipulation to increase EPS when they are weak and
Lower EPS when they are strong

81
Q

Earnings smoking functions are based on…

A

Accounting so fundamental law of conservation

82
Q

Accounting’s fundamental law of conservation

A

GAAP-compliant accounting manipulations neither create nor
Destroy earnings

They merely shift them from one period to another

83
Q

Cookie jar accounting

A

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

84
Q

Reserve accounts

A

Used to charge anticipated future costs to current income

Costs are debited to current expense and credited to reserve
Account (which acts as liability)

85
Q

Big bath accounting

A

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)

Forensic Accounting (10 decks)

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