Financial Statement Fraud

Hanna C Quffa
 Pop Quiz
Name at least three of the
five principle financial
statement fraud schemes.
 
Financial Statement Fraud Defined

 Deliberatemisstatements or
omissions of amounts or
disclosures of financial
statements to deceive financial
statement users, particularly
investors and creditors
Defining Financial Statement Fraud
 Falsification, alteration, or manipulation of material
financial records, supporting documents, or business
transactions
 Material intentional omissions or misrepresentations of
events, transactions, accounts, or other significant
information from which financial statements are
prepared
 Deliberate misapplication of accounting principles,
policies, and procedures used to measure, recognize,
report, and disclose economic events and business
transactions
 Intentional omissions of disclosures or presentation of
inadequate disclosures regarding accounting principles
and policies and related financial amounts
Costs of Financial Statement Fraud
 More than 50% of U.S. corporations are victims of
fraud with losses of more than $500,000
(Albrecht & Searcy 2001)
 Enron lost about $70 billion in market
capitalization to investors, employees, and
pensioners
 Enron, WorldCom, Quest, Global Crossing, and
Tyco’s loss to shareholders was $460 billion
(Cotton 2002)
 Other fraud costs are legal costs, increased
insurance costs, loss of productivity, adverse
impacts on employee morale, customers’
goodwill, suppliers’ trust, and negative stock
market reactions
Frequency of Types of Occupational
Fraud and Abuse

Fraudulent
7.9%
Statements 5.1%

30.1%
Corruption
12.8%

Asset
92.7%
Misappropriation 85.7%

0.0% 20.0% 40.0% 60.0% 80.0% 100.0%

2002 2004
 Median Loss of Types of
Occupational Fraud and Abuse

Fraudulent $1,000,000
Statements
$4,250,000
$250,000
Corruption $530,000

Asset $93,000
$80,000
Misappropriation
$- $500,000 $1,000,000 $1,500,000 $2,000,000 $2,500,000 $3,000,000 $3,500,000 $4,000,000 $4,500,000

2002 2004
Effects of Financial Statement Fraud
 Undermines the reliability, quality,
transparency, and integrity of the
financial reporting process
 Jeopardizes the integrity and objectivity
of the auditing profession, especially
auditors and auditing firms
 Diminishes the confidence of the capital
markets, as well as market participants,
in the reliability of financial information
 Makes the capital markets less efficient
Effects of Financial Statement Fraud
 Adversely affects the nation’s economic
growth and prosperity
 Results in huge litigation costs
 Destroys careers of individuals involved in
financial statement fraud.
 Causes bankruptcy or substantial
economic losses by the company engaged
in financial statement fraud
Effects of Financial Statement Fraud
 Encourages regulatory intervention
 Causes devastation in the normal
operations and performance of alleged
companies
 Raises serious doubt about the efficacy of
financial statement audits
 Erodes public confidence and trust in the
accounting and auditing profession
Who Commits Financial Statement Fraud

 Senior management
 Mid- and lower-level employees

 Organized criminals
Why Do People Commit Financial
Statement Fraud

 To conceal true business

performance
 To preserve personal
status/control
 To maintain personal
income/wealth
Why Senior Management Will
Overstate Business Performance
 To meet or exceed the earnings or
revenue growth expectations of stock
market analysts
 To comply with loan covenants
 To increase the amount of financing
available from asset-based loans
 To meet a lender’s criteria for
granting/extending loan facilities
 To meet corporate performance criteria
set by the parent company
Why Senior Management Will
Overstate Business Performance

 To meet personal performance criteria

 To trigger performance-related
compensation or earn-out payments
 To support the stock price in anticipation
of a merger, acquisition, or sale of
personal stockholding
 To show a pattern of growth to support a
planned securities offering or sale of the
business
Why Senior Management Will
Understate Business Performance
 To defer “surplus” earnings to the next accounting
period.
 To take all possible write-offs in one “big bath”
now so future earnings will be consistently higher.
 To reduce expectations now so future growth will
be better perceived and rewarded.
 To preserve a trend of consistent growth,
avoiding volatile results.
 To reduce the value of an owner-managed
business for purposes of a divorce ­settlement.
 To reduce the value of a corporate unit whose
management is planning a buyout
How Do People Commit Financial
Statement Fraud

 Playing the accounting system

 Beating the accounting system
 Goingoutside the accounting
system
 Conceptual Framework for
Financial Reporting

 Recognition and measurement

concepts
 Assumptions
 Economic entity
 Going concern
 Monetary unit
 Periodicity
Recognition and Measurement Concepts

 Principles
 Historical cost
 Revenue recognition

 Matching

 Full disclosure
Recognition and Measurement Concepts

 Constraints

 Cost-benefit
 Materiality
 Industry practice
 Conservatism
Qualitative Characteristics

 Relevance and reliability

 Comparability and consistency

Responsibility for Financial Statements

 Company management is
responsible for financial statements
 Company’s board of directors and
senior management set the code of
conduct
 Company’s “ethic” – the standard
by which all other employees will
tend to conduct themselves
 Users of Financial Statements
Transaction Accounting Financial
Activity System Statements

Bankers
Investors Information
Balance Sheet
Vendors Users Income Statement
Government Statement of
Management Owner Equity
Statement of
Loan Approval Cash Flows
Financial Investment
Decisions Credit Approval
Operational &
Financial Decisions
Financial Statements
 Balance sheet
 Statement of income or statement
of operations
 Statement of retained earnings
 Statement of cash flows
 Statement of changes in owner’s
equity
 Notes
Financial Statements Other Basis

 Other comprehensive bases of

accounting,
 Government or regulatory agency accounting
 Tax basis accounting
 Cash receipts and disbursements, or modified
cash receipts and disbursements
 Any other basis with a definite set of criteria
applied to all material items, such as the price-
level basis of accounting
Other Financial Data Presentations
 Prospective financial information
 Pro forma financial statements
 Proxy statements
 Interim financial information
 Current value financial representations
 Personal financial statements
 Bankruptcy financial statements
 Registration statement disclosures
Methods of Financial Statement Fraud

 Fictitious
revenues
 Timing differences

 Improper asset valuations

 Concealed liabilities and

expenses
 Improper disclosures
Financial Statement Schemes by
Category

Asset Value
52.5%

Disclosures 47.5%

45.0%
Fict. Rev.

Conceal Liab.
40.0%

Timing Diff.
25.0%

0% 10% 20% 30% 40% 50% 60%

Fictitious Revenues

 Recording of goods or services

that did not occur
 Fake or phantom customers

 Legitimate customers

 Sales with conditions

 Pressures to boost revenues

Red Flags – Fictitious Revenues
 Rapid growth or unusual profitability,
especially compared to that of other
companies in the same industry
 Recurring negative cash flows from
operations or an inability to generate cash
flows from operations while reporting
earnings and earnings growth
 Significant transactions with related
parties or special purpose entities not in
the ordinary course of business or where
those entities are not audited or are
audited by another firm
Red Flags – Fictitious Revenues
 Significant, unusual, or highly complex
transactions, especially those close to
period end that pose difficult “substance
over form” questions
 Unusual growth in the number of days’
sales in receivables
 A significant volume of sales to entities
whose substance and ownership is not
known
 An unusual surge in sales by a minority of
units within a company, or of sales
recorded by corporate headquarters
Timing Differences
 Recording revenue and/or
expenses in improper periods
 Shifts revenues or expenses
between one period and the
next, increasing or decreasing
earnings as desired
Red Flags – Timing Differences
 Rapid growth or unusual profitability, especially
compared to that of other companies in the same
industry
 Recurring negative cash flows from operations or an
inability to generate cash flows from operations while
reporting earnings and earnings growth
 Significant, unusual, or highly complex transactions,
especially those close to period end that pose difficult
“substance over form” questions
 Unusual increase in gross margin or margin in excess
of industry peers
 Unusual growth in the number of days’ sales in
receivables
 Unusual decline in the number of days’ purchases in
accounts payable
Concealed Liabilities

 Liability/expense omissions
 Capitalized expenses

 Failure to disclose warranty

costs and liabilities
Red Flags – Concealed Liabilities
 Recurring negative cash flows from operations or
an inability to generate cash flows from
operations while reporting earnings and earnings
growth
 Assets, liabilities, revenues, or expenses based on
significant estimates that involve subjective
judgments or uncertainties that are difficult to
corroborate
 Non-financial management’s excessive
participation in or preoccupation with the
selection of accounting principles or the
determination of significant estimates
Improper Disclosures
 Liability
omissions
 Subsequent events

 Management fraud

 Related-party transactions

 Accounting changes
Red Flags – Improper Disclosures
 Domination of management by a single person or
small group (in a non-owner managed business)
without compensating controls
 Ineffective board of directors or audit committee
oversight over the financial reporting process and
internal control
 Ineffective communication, implementation,
support, or enforcement of the entity’s values or
ethical standards by management or the
communication of inappropriate values or ethical
standards
 Rapid growth or unusual profitability, especially
compared to that of other companies in the same
industry
Red Flags – Improper Disclosures
 Significant, unusual, or highly complex
transactions, especially those close to period end
that pose difficult “substance over form”
questions
 Significant related-party transactions not in the
ordinary course of business or with related
entities not audited or audited by another firm
 Significant bank accounts or subsidiary or branch
operations in tax haven jurisdictions for which
there appears to be no clear business justification
 Overly complex organizational structure involving
unusual legal entities or managerial lines of
authority
Red Flags – Improper Disclosures
 Known history of violations of securities laws or
other laws and regulations, or claims against the
entity, its senior management, or board members
alleging fraud or violations of laws and regulations
 Recurring attempts by management to justify
marginal or inappropriate accounting on the basis
of materiality
 Formal or informal restrictions on the auditor that
inappropriately limit access to people or
information or the ability to communicate
effectively with the board of directors or audit
committee
Red Flags – Concealed Liabilities
 Unusual increase in gross margin or
margin in excess of industry peers
 Allowances for sales returns, warranty
claims, and so on that are shrinking in
percentage terms or are otherwise out of
line with industry peers
 Unusual reduction in the number of days’
purchases in accounts payable
 Reducing accounts payable while
competitors are stretching out payments
to vendors
Improper Asset Valuation

 Inventory valuation
 Accounts receivable

 Business combinations

 Fixed assets
Red Flags –
Improper Asset Valuation
 Recurring negative cash flows from operations or an
inability to generate cash flows from operations while
reporting earnings and earnings growth
 Significant declines in customer demand and increasing
business failures in either the industry or overall
economy
 Assets, liabilities, revenues, or expenses based on
significant estimates that involve subjective judgments
or uncertainties that are difficult to corroborate
 Non-financial management’s excessive participation in
or preoccupation with the ­selection of accounting
principles or the determination of significant estimates
 Unusual increase in gross margin or margin in excess
of industry peers
Red Flags –
Improper Asset Valuation
 Unusual growth in the number of days’
sales in receivables
 Unusual growth in the number of days’
purchases in inventory
 Allowances for bad debts, excess and
obsolete inventory, and so on that are
shrinking in percentage terms or are
otherwise out of line with industry peers
 Unusual change in the relationship
between fixed assets and depreciation
 Adding to assets while competitors are
reducing capital tied up in assets
Detection of Fraudulent Financial
Statement Schemes

 SAS 99 – Consideration of Fraud in

a Financial Statement Audit as well
as ISA
 “The auditor has a responsibility to
plan and perform the audit to obtain
reasonable assurance about
whether the financial statements
are free of material misstatement,
whether caused by error or fraud.”
Auditing Standards
 Description and characteristics of fraud
 Misstatements arising from fraudulent
financial reporting
 Misstatements arising from misappropriation
of assets
 Importance of exercising professional
skepticism
 Discussion among engagement personnel
regarding risk of material misstatement due
to fraud
 Brainstorming
 Internal and external pressures
Auditing Standards
 Obtaining information needed to identify
risks of material misstatement due to fraud
 Making inquiries of management about the
risks of fraud and how they are addressed
 Consider any unusual or unexpected
relationships that have been identified in
performing analytical procedures in planning
the audit.
 Consider whether one or more fraud risk
factors exist.
 Consider other information that may be helpful
in the identification of risks of material
misstatement due to fraud
Auditing Standards – Audit Documentation
 Contains a list of factors that the auditor should
consider in determining the nature and extent of
the documentation for a particular audit area
 Contains a new requirement for auditors to
document audit findings or issues that in their
judgment are significant, actions taken to address
them
 Retains much of the ownership/record retention
guidance
 Contains amendments adding specific
documentation requirements to other ISA
Financial Statement Analysis
 Vertical analysis
 Analyzes the relationships between the
items on an income statement, balance
sheet, or statement of cash flows by
expressing components as percentages
 Horizontal analysis
 Analyzes the percentage change in
individual financial statement items
 Ratio analysis
 Measures the relationship between two
different financial statement amounts
 Deterrence of Financial Statement
Fraud

 Reduce pressures to commit

financial statement fraud
 Reduce the opportunity to commit
financial statement fraud
 Reduce rationalization of financial
statement fraud
Reduce Pressures to Commit Financial
Statement Fraud
 Establish effective board oversight of the “tone at
the top” created by management.
 Avoid setting unachievable financial goals.
 Avoid applying excessive pressure on employees
to achieve goals.
 Change goals if changed market conditions
require it
 Ensure compensation systems are fair and do not
create too much incentive to commit fraud.
 Discourage excessive external expectations of
future corporate performance.
 Remove operational obstacles blocking effective
performance.
Reduce the Opportunity to Commit
Financial Statement Fraud
 Maintain accurate and complete internal accounting records.
 Carefully monitor the business transactions and interpersonal
relationships of suppliers, buyers, purchasing agents, sales
representatives, and others who interface in the transactions
between financial units.
 Establish a physical security system to secure company
assets, including finished goods, cash, capital equipment,
tools, and other valuable items.
 Maintain accurate personnel records including background
checks on new employees.
 Encourage strong supervisory and leadership relationships
within groups to ensure enforcement of accounting
procedures.
 Establish clear and uniform accounting procedures with no
exception clauses.
Reduce Rationalization of Financial
Statement Fraud

 Promote strong values, based on

integrity, throughout the organization.
 Have policies that clearly define
prohibited behavior with respect to
accounting and financial statement fraud.
 Provide regular training to all employees
communicating prohibited behavior.
Reduce Rationalization of Financial
Statement Fraud
 Have confidential advice and reporting
mechanisms to communicate inappropriate
behavior.
 Have senior executives communicate to
employees that integrity takes priority and that
goals must never be achieved through fraud.
 Ensure management practices what it preaches
and sets an example by promoting honesty in the
accounting area.
 The consequences of violating the rules and the
punishment of violators should be clearly
communicated
Thank You