Financial Statement Fraud * Flashcards
ABC Corporation guaranteed a large personal loan taken out by its chief financial officer. ABC will only be liable if the CFO defaults on the loan. To date, the CFO has made all scheduled loan payments on time. The loan term runs for two more years. ABC does NOT have to disclose this loan arrangement in its financial statements.
T/F?
False
Typical liability omissions include the failure to disclose loan covenants or contingent liabilities. Loan covenants are agreements, in addition to or as part of a financing arrangement, that a borrower has promised to keep as long as the financing is in place. The agreements can contain various types of covenants, including certain financial ratio limits and restrictions on other major financing arrangements.
Contingent liabilities are potential obligations that will materialize only if certain events occur in the future. A corporate guarantee of personal loans taken out by an officer or a private company controlled by an officer is an example of a contingent liability. This liability must be disclosed if it is material.
Laura, the sales manager of Sam Corp., is afraid sales revenue for the period is not going to meet company goals. To make up for the shortfall, she decides to mail invoices to fake customers and credit (increase) revenue on the books for these sales. What account will she most likely debit to balance these fictitious revenue entries and conceal her scheme?
Fictitious or fabricated revenues involve the recording of sales of goods or services that did not occur. Fictitious sales most often involve fake or phantom customers, but can also involve legitimate customers. At the end of the accounting period, the sale will be reversed (as will all revenue accounts), which will help to conceal the fraud.
Recording the sales revenue is easy, but the challenge for the fraudster is how to balance the other side of the entry. A credit to revenue increases the revenue account, but the corresponding debit in a legitimate sales transaction typically either goes to cash or accounts receivable. Since no cash is received in a fictitious revenue scheme, increasing accounts receivable is the easiest way to get away with completing the entry. Unlike revenue accounts, however, accounts receivable are not reversed at the end of the accounting period. They stay on the books as an asset until collected. If the outstanding accounts never get collected, they will eventually need to be written off as bad debt expense. Mysterious accounts receivable on the books that are long overdue are a common sign of a fictitious revenue scheme.
Financial statement fraud is
Financial statement fraud is the deliberate misrepresentation of the financial condition of an enterprise accomplished through the intentional misstatement or omission of amounts or disclosures in the financial statements to deceive financial statement users.
Failure to record corresponding revenues and expenses in the same accounting period will result in an understatement of net income in the period when the revenue is recorded and an overstatement of net income in the period in which the corresponding expenses are recorded.
T/F?
False
According to generally accepted accounting principles, revenue and corresponding expenses should be recorded or matched in the same accounting period. The timely recording of expenses is often compromised due to pressures to meet budget projections and goals, or due to lack of proper accounting controls. As the expensing of certain costs is pushed into periods other than the ones in which they actually occur, they are not properly matched against the income that they help produce. For example, revenue might be recognized on the sale of certain items, but the cost of goods and services that went into the items sold might intentionally not be recorded in the accounting system until the subsequent period. This might make the sales revenue from the transaction almost pure profit, inflating earnings. In the next period, earnings would be depressed by a similar amount.
A company must disclose all contingent liabilities in the financial statements, regardless of the liabilities’ materiality.
T/F?
False
Contingent liabilities are potential obligations that will materialize only if certain events occur in the future. A corporate guarantee of personal loans taken out by an officer or a private company controlled by an officer is an example of a contingent liability. Such a liability must be disclosed if it is material.
Early revenue recognition is classified as what type of financial fraud scheme?
Timing Differences
Financial statement fraud might involve timing differences—that is, the recording of revenues or expenses in improper periods. This can be done to shift revenues or expenses between one period and the next, increasing or decreasing earnings as desired. Early revenue recognition is a common type of timing difference scheme since companies are often trying to make themselves look as profitable as possible. This practice is also referred to as “income smoothing.”
In a financial statement fraud scheme in which capital expenditures are recorded as expenses rather than assets, the transactions will have the following effect on the organization’s assets?
Total assets will be understated
Typically, a fraudster’s goal when committing a financial statement fraud scheme is to make the entity look stronger and more profitable. This goal is often achieved by concealing liabilities and/or expenses. To do this, he might fraudulently understate liabilities or improperly capitalize a cost that should be expensed.
Just as capitalizing expenditures that should be expensed is improper, so is expensing costs that should be capitalized. Improperly expensing costs will result in a lower net income, as well as understated assets. There are several reasons an entity might want to make itself look worse than it actually is. For example, the organization might want to minimize its net income due to tax considerations. Expensing an item that should be depreciated over a period of time would help accomplish just that—net income would be lower and so would taxes. The result for the current accounting period is that total assets will be understated and expenses will be overstated.
Related-party transactions is
Related-party transactions occur when a company does business with another entity whose management or operating policies can be controlled or significantly influenced by the company or by some other party in common. There is nothing inherently wrong with related-party transactions, as long as they are fully disclosed. If the transactions are not fully disclosed, the company might injure shareholders by engaging in economically harmful dealings without their knowledge. The financial interest that a company official might have might not be readily apparent. For example, common directors of two companies that do business with each other, any corporate general partner and the partnerships with which it does business, and any controlling shareholder of the corporation with which he/she/it does business are all illustrations of related parties. Family relationships can also be considered related parties, such as all lineal descendants and ancestors, without regard to financial interests. Related-party transactions are sometimes referred to as “self-dealing.”
The quick ratio is used to determine the efficiency with which a company uses its assets? T/F
False
The quick ratio compares the most liquid assets to current liabilities. This calculation divides the total of cash, securities, and receivables by current liabilities to yield a measure of a company’s ability to meet sudden cash requirements. The quick ratio is a conservative measurement of liquidity that is often used in turbulent economic times to provide an analyst with a worst-case scenario of a company’s working capital situation.
The asset turnover ratio is used to determine the efficiency with which asset resources are used by the entity.
The debt-to-equity ratio is computed by dividing current liabilities by total equity.
T/F?
False
The debt-to-equity ratio is computed by dividing total liabilities by total equity. This ratio is one that is heavily considered by lending institutions. It provides a clear picture of the comparison between the long-term and short-term debt of the company and the owner’s financial injection plus earnings to date. Debt-to-equity requirements are often included as borrowing covenants in corporate lending agreements.
The asset turnover ratio is used to assess a company’s ability to meet sudden cash requirements.
T/F?
False
The asset turnover ratio (net sales divided by average total assets) is used to determine the efficiency with which asset resources are used by the entity. The asset turnover ratio is one of the more reliable indicators of financial statement fraud. A sudden or continuing decrease in this ratio is often associated with improper capitalization of expenses, which increases the denominator without a corresponding increase in the numerator.
The quick ratio is used to assess a company’s ability to meet sudden cash requirements. This ratio compares the most liquid assets to current liabilities by dividing the total of cash, securities, and receivables by current liabilities. The quick ratio is a conservative measurement of liquidity that is often used in turbulent economic times to provide an analyst with a worst-case scenario of a company’s working capital situation.
Financial statement fraud is the intentional or erroneous misrepresentation of the financial condition of an enterprise.
T/F?
False
Financial statement fraud is the deliberate misrepresentation of the financial condition of an enterprise accomplished through the intentional misstatement or omission of amounts or disclosures in the financial statements to deceive financial statement users.
Note that financial statement fraud, much like all types of fraud, is an intentional act. As stated in the AICPA’s Auditing Standard AU 240, Consideration of Fraud in a Financial Statement Audit, “misstatements in the financial statements can arise from either fraud or error. The distinguishing factor between fraud and error is whether the underlying action that results in the misstatement of the financial statements is intentional or unintentional.”
Like most other types of fraud, the motivation for financial statement fraud almost always involves personal gain.
T/F
False
Unlike some other types of fraud (such as embezzlement), the motivation for financial statement fraud does not always involve personal gain. Most commonly, financial statement fraud is used to make a company’s earnings look better on paper. Financial statement fraud occurs through a variety of methods, such as valuation judgments and manipulating the timing of transaction recording. These more subtle types of fraud are often dismissed as either mistakes or errors in judgment and estimation. Some of the more common reasons why people commit financial statement fraud include:
To encourage investment through the sale of stock
To demonstrate increased earnings per share or partnership profits interest, thus allowing increased dividend/distribution payouts
To cover inability to generate cash flow
To dispel negative market perceptions
To obtain financing, or to obtain more favorable terms on existing financing
To receive higher purchase prices for acquisitions
To demonstrate compliance with financing covenants
To meet company goals and objectives
To receive performance-related bonuses
Vertical analysis is
Vertical analysis is a technique for analyzing the relationships between items on an income statement or balance sheet by expressing all components as percentages of a specified base value. When performing vertical analysis on an income statement, net sales is assigned 100 percent. On the balance sheet, total assets is assigned 100 percent and total liabilities and equity is assigned 100 percent. All other items on the statements are then expressed as a percentage of these two numbers.
Vertical analysis vs horizontal analysis vs ratio analysis
Vertical analysis is the expression of the relationship or percentage of component items to a specific base item on the income statement or balance sheet. Horizontal analysis is a technique for analyzing the percentage change in individual financial statement items from one accounting period to the next. Ratio analysis is a means of measuring the relationship between any two different financial statement amounts. The relationship and comparison are the keys to any of these types of financial analyses.
