WEEK 5

FINANCIAL STATEMENT FRAUD

5.0 Introduction
The red flags of financial statement fraud are distinctly different from those of asset
misappropriation. Common general red flags of financial statement fraud include:
• Accounting anomalies.
• Unusually rapid revenue and/or profit growth.
• Readily noticeable internal control weaknesses.
• Noticeably “aggressive” financial actions by senior management.
• Personality or character flaws of the CEO and/or other top level executives.
These groups of red flags will be covered in the course of this lecture.
Of these general indicators, top management personality and character are by far the most
compelling with regard to financial statement fraud. Typically, a senior executive who is inclined
to “cook the books” possesses low ethical standards, though this trait may often be difficult to
detect prior to the commission of a crime. However, most executives with ethical weaknesses
also exhibit very noticeable signs of aggressiveness in almost everything they do—including
making critical financial decisions. Examples include:
• Overly domineering, disrespectful or abusive management style vis-à-vis subordinates.
• Actively “steering” internal and external auditors away from financial reports that could reveal
the fraud.
• Secretive or distinctly evasive attitude regarding critical financial information.

Objectives
At the end of this lecture, students should have a good understanding of:-
a) red flags of financial statement fraud
b) detection methods for general financial statement frauds

Pre-Test
1. What is fraud?
2. What is red flag?
3. What is financial statement fraud?

CONTENT
5.1 Detection methods for general financial statement frauds:
• Internal audit is consistently engaged in substantive anti-fraud activities.
• Auditors aggressively apply standards of SAS No. 99.
• Frequent and thorough fraud-oriented ratio analysis—focusing in particular on long-term trends
and on comparisons between business units.
• Surprise audits and/or cash counts.
• Implementation of an anonymous, user-friendly tip hotline for use by employees, vendors and
customers.
• Data mining using one of the common auditing software applications such as ACL or IDEA.

5.2 Specific red flags

As with asset misappropriation, there are also specific red flags of financial statement fraud that
are present in many of the common varieties of such accounting violations. Examples:

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 Complex or unstable organizational structure.
 Unusually intricate or confusing financial transactions with third-party entities.
 Sudden or gradual increase in gross margin compared with the company’s prior performance,
and with industry averages.
 Cash flows that is negative for the first three quarters and suddenly positive for the fourth
quarter—not by just a little, but by more than all losses to date. (This scenario is exactly what
happened at Enron. It is why Sherron Watkins said, after the company’s demise, that if anyone
had been paying attention to the cash flows they would have known that Enron's statements were
suspicious and/or fraudulent.)
 Significant sales to companies or individuals whose identity and business track record are
questionable.
 Sudden above-average profits for specific quarters.
 Executives or board members have direct personal dependence on the company’s
performance.
 Conspicuously lax board oversight of top management.

5.3 Fraud Categories

Also similar to asset misappropriation, financial statement fraud has distinct categories. Each has
its unique red flags and detection methods. Examples include:
1. Revenue recognition or timing schemes—also known as improper treatment of sales
This fraud category is possibly the most common form of financial statement fraud—usually
employed when management seeks to conceal the real numbers for a weak quarter or two.
Red flags:
 If a sale is legitimate, but is posted prematurely, the red flag would be a GAAP violation by
early recording of the sale. Similarly, channel stuffing—where sales are recorded before they’ve
actually been made—would be indicated by an excessive number of subsequent period returns of
merchandise, accompanied by an unusual jump in credits.

2. Fictitious revenue
One of the oldest financial statement schemes around— this involves posting sales that simply
never occurred.
Red flags:
Unusual increase in assets—the other side of the entry to mask fictitious revenues.
“Customer” records are missing key data such as physical address and phone number.
Unusual changes in ratio patterns— such as a spike in revenues with no commensurate
increase in accounts receivable.

3. Concealed liabilities (improper or under-reporting of expenses and other liabilities)

By shifting expenses from one entity to another or reclassifying liabilities as assets, which is
what got WorldCom into trouble when it improperly reported $3.8 billion in expenses as capital
expenditures, management can make the company’s financial condition appear much rosier than
it is.

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Red flags:
Use of different audit firms for different subsidiaries or business entities.
Recurring negative cash flows from operations or an inability to generate cash flows from
operations while reporting earnings growth.
Invoices and other liabilities go unrecorded in the company’s financial records.
Writing off loans to executives or other parties.
Failure to record warranty-related liabilities.
4. Inadequate disclosures
This tactic is used after a financial statement fraud has occurred—in an attempt to cover it up.
Red flags:
Disclosure notes are so complex that it is impossible to determine the actual nature of the
event or transaction.
Discovery of undisclosed legal contingencies.

5. Improper asset valuation

Fraudulently inflating asset valuations is a common form of profit manipulation.
Red flags:
Unusual or unexplained increases in the book value of assets such as inventory, receivables,
long-term assets, etc.
Odd patterns in relationships of assets to other components of the financial report, such as
sudden changes in the ratio of receivables to revenues.
GAAP violations in recording expenses as assets.

5.4 Detection Methods

To reduce the risk of having these frauds occur—or continue undetected— auditors should use
such practices as:
 Horizontally and vertically analyzing all financial reports.
 Conducting frequent ratio analysis, including assessment of trends over periods of several
years.
 Using Bonefish’s Ratios which pinpoint anomalies in year-to-year measures of gross margins,
sales growth, receivables levels and other key accounting ratios.
 Rigorously applying the guidance of SAS 99 to all audit exercises

5.5 Schemes, red flags and questions to ask

While the opportunity for misstatement exists on each line of every financial statement, a
handful of culprits account for the majority of cases. It is incumbent upon managers to be
familiar with these culprits and know which red flags might indicate their presence. Of course,
red flags are not surefire signs of fraud. Rather, they are signs that questions need to be asked
and that reasonable answers need to be found.
To help managers know when to raise eyebrows and start asking questions, the
Association of Certified Fraud Examiners has developed a list of common accounting fraud
schemes and associated red flags. More details are available in the ACFE’s publication

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Fraud and the CPA: Understanding Why Employees Commit Fraud. the ACFE’s schemes and
red flags are listed below, along with a series of questions that managers should ask when the red
flags appear.
1. Overstating revenues
Starting literally at the top of an income statement is always a good idea. Overstating or
improperly recognizing revenues is a common form of financial statement fraud.
Schemes
• Recording gross, rather than net, revenue
• Recording revenues of other companies when acting as a “middleman”
• Recording sales that never took place
• Recording future sales in the current period
• Recording sales of products that are out on consignment

Red flags
• Increased revenues without a corresponding increase in cash flow, especially over time
• Significant, unusual or highly complex transactions, particularly those that are closed near the
end of a financial reporting period
• Unusual growth in the number of days’ sales in receivables
• Strong revenue growth when peer companies are experiencing weak sales

Questions to ask
Why did revenues increase sharply during the end of the period compared with prior-year and
current-year results and the budget forecast?
• How does revenue growth compare with that of peers during the same period? If substantially
higher, does the explanation make sense?
• Did receivables increase due to a particular customer? If so, should a reserve be established?

2. Understating expenses
Another common number-fudging technique is understating expenses, which leads to increased
operating income and net income.
Schemes
• Reporting cost of sales as an operating expense so it does not negatively affect gross margin
• Capitalizing operating expenses, recording them as assets on the balance sheet instead of as
expenses on the income statement
• Not recording some expenses at all, or not recording expenses in the proper period

Red flags
• Unusual increases in income or income in excess of industry peers
• Significant unexplained increases in fixed assets
• Recurring negative cash flows from operations while reporting earnings and earnings growth
• Allowances for sales returns, warranty claims, etc., that are shrinking in percentage terms or are
otherwise out of line with those of industry peers

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Questions to ask
• Why did gross margin (by location, product and geographic area) increase during yearend or
period-end compared with the prior year\ and current-year budget forecast?
Does the explanation make sense?
• How does the company compare to competitors in terms of net income during the same time
period?
• What were the major additions to fixed assets during the year? Is the treatment of recording
assets consistent with that of prior years?

3. Improper asset valuations

Highly publicized asset write-downs following the disclosure of faulty reserve reports should
make all company managers pay special attention to how they report their most important hard
assets.
Schemes
• Manipulating reserves
• Changing useful lives of assets
• Failing to take a write-down when needed
• Manipulating estimates of fair market value

Red flags
• Recurring negative cash flows from operations while reporting earnings and earnings growth
• Significant declines in customer demand and increasing business failures in either the industry
or the overall economy
• Assets, liabilities, revenues or expenses based on significant estimates that involve subjective
judgments or uncertainties that are difficult to corroborate

Questions to ask
• How is the overall economy affecting customer demand and business? Declines in both could
be a signal that there might be an asset impairment issue involving inventory or allowance
reserves.
• For areas where there are significant estimates, what is the method used to determine the
estimate?
• Is this method consistent with that of prior periods?
• What supporting documentation is available to support the calculation?

4. Other common areas for financial statement fraud

The following are also schemes used frequently to “cook the books” and make results look better
than they really are.
Schemes
Smoothing of earnings: • Often referred to as using “cookie jar reserves,” this involves
overestimating liabilities during “good “periods and storing away funds for future use against
declining revenues
• Disclosing information improperly, especially concerning related-party transactions and loans
to management

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• Executing highly complex transactions, particularly those dealing with structured finance,
special-purpose entities and off-balance sheet structures, and unusual counterparties

Red flags
• Domineering management
• Decision to “fix” accounting in the next period
• No apparent business purpose
• “Reality” of transaction differs from accounting or tax result

• Significant related-party transactions

• Counterparts that lack economic substance
• Multiple memos rationalizing an aggressive accounting treatment
Questions to ask
• Is there an overly aggressive push by management to meet previously disclosed revenues or
earnings targets?
• Can management explain the business purpose for entities that are outside the consolidated
financial statements?
• Were there significant adjustments made at the end of the period?
• Has there been an unusual focus on achieving a certain accounting treatment?
• Does the business purpose make sense?
• Does the preferred accounting treatment allow the company to meet certain targets?
• Has there been a change in the method of calculating the reserve estimates for any item from
that used in the prior quarter or prior years? If so, why?

6.6 When fraud is suspected

Ideally, questions that are prompted by red flags will result in answers that make perfect sense.
But when they don’t, it’s time to consider two actions: notifying the audit committee and calling
in the forensic accountants. Forensic accountants are the crime scene investigators of the
financial world. They have extensive experience examining the DNA of financial statements;
sifting through email records, documents and data entries; and conducting extensive interviews
to uncover and explain the most complex financial statement fraud. They are also trained to
uncover and preserve evidence to make it admissible in court should the need arise. When
engaging forensic accountants, it is important to consider three qualifications. The first is
forensic accounting experience. The abundance of corporate scandals in the last few years has
created a forensic accounting boom, and many accountants with backgrounds other than
forensics have established themselves as forensic accountants. It is important for companies
seeking the help of forensic accountants to find out how long they have been practicing forensic
accounting and whether the personnel who will be examining potential red flags have
appropriate credentials .The second qualification is industry experience. A forensic accountant
fluent in financial statements for a manufacturing or retail company might be lost trying to
navigate the engineering and geophysical components of an investigation into the possible
overstatement of oil and gas reserves. The third qualification is the breadth of services offered by
the accounting firm and its global reach. While a forensic accounting specialty shop might be
able to conduct a solid, professional investigation of a small matter, it may not be able to address

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the issues that led to the fraud in the first place — issues like inadequate financial controls,
insufficient or nonexistent processes or weak information technology infrastructure and security.
A full-service firm, on the other hand, can move from a fraud investigation\ to the fraud
prevention initiative that should follow. For energy companies operating internationally, use of a
firm that can operate seamlessly on a global basis is critical to\ make certain that all elements of
activity can be included in the investigation.
Post Tests
1. Outline the detection methods for general financial statement frauds. (5 marks)
2. What are the red flags associated with overstatement of expenses, understatement of
expenses, improper assets valuations, fictitious revenue and concealed liabilities (10
marks).