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Fraudulent Financial Statement Schemes. Pop Quiz. Name at least three of the five principle financial statement fraud schemes . Financial Statement Fraud Defined. Deliberate misstatements or omissions deceive users. Specifically. Falsification, alteration, or manipulation

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pop quiz
Pop Quiz

Name at least three of the five principle financial statement fraud schemes.

financial statement fraud defined
Financial Statement Fraud Defined
  • Deliberate
  • misstatements or omissions
  • deceive users
  • Falsification, alteration, or manipulation
  • Material intentional omissions or misrepresentations
  • Deliberate misapplication of accounting principles, policies, and procedures
  • Intentional omissions of or inadequate disclosures or presentation
costs i
Costs I
  • More than 50% of U.S. corporations are victims of fraud with losses of more than $500,000
  • Investors, employees, pensioners
  • Enron, WorldCom, Quest,Global Crossing, and Tyco’s
  • What might some other fraud costs be?
costs ii
Costs II
  • Financial reporting process undermined
  • Integrity of auditing profession
  • Capital markets lose confidence
  • Capital markets less efficient
costs iii
Costs III
  • Economic growth and prosperity
  • Litigation costs
  • Destroys careers
  • Bankruptcy or substantial economic losses
costs iv
Costs IV
  • intervention
  • Inefficiency
  • Doubts re: audits
  • Public confidence and trust
  • Fictitious revenues
  • Timing differences
  • Improper asset valuations
  • Concealed liabilities and expenses
  • Improper disclosures
fictitious revenues
Fictitious Revenues
  • Fake sales, customers
  • Legitimate customers
  • Conditional sales
red flags fictitious revenues
Red Flags – Fictitious Revenues
  • Rapid growth
  • unusual profitability
  • Negative CFO with positive NI
  • Related party/SPE transactions
red flags fictitious revenues12
Red Flags – Fictitious Revenues
  • Complex transactions
  • ↑ number of days’ sales in receivables
  • Sales to unknown entities
  • An unusual surge in sales
timing differences
Timing Differences
  • Improper periods
  • Shifting revenues or expenses
  • Matching revenues with expenses
  • Premature revenue recognition
    • Long-term contracts
    • Channel stuffing
red flags timing differences
Red Flags – Timing Differences
  • Rapid growth or unusual profitability
  • Negative CFO with positive NI
  • Complex transactions
  • ↑ number of days’ sales in receivables
  • ↓ number of days’ purchases in accounts payable
concealed liabilities
Concealed Liabilities
  • Liability/expense omissions
  • Capitalized expenses
  • Warranties
  • Contingencies
red flags concealed liabilities
Red Flags – Concealed Liabilities
  • Negative CFO with positive NI
  • Significant estimates
  • CEO obsession with GAAP selections
  • Unusual ↑ in gross margin
  • Unusual SRA, warranty claims
  • ↓ the number of days’ purchases in accounts payable
  • Out of line with competitors
improper disclosures
Improper Disclosures
  • Liability omissions
  • Subsequent events
  • Management fraud
  • Related-party transactions
  • Accounting changes
red flags improper disclosures
Red Flags – Improper Disclosures
  • Domination of management
  • Ineffective board of directors
  • Tone at the top
  • Rapid growth or unusual profitability
red flags improper disclosures19
Red Flags – Improper Disclosures
  • Significant, unusual, or highly complex transactions,
  • Significant related-party transactions
  • tax haven bank accounts
  • Overly complex organizational structure
red flags improper disclosures20
Red Flags – Improper Disclosures
  • Known history of violations
  • Materiality justifications
  • Limitation of auditor access
improper asset valuation
Improper Asset Valuation
  • Inventory valuation
  • Accounts receivable
  • Business combinations
  • Fixed assets
red flags improper asset valuation
Red Flags – Improper Asset Valuation
  • negative cash flows with positive earnings.
  • Declining business/economy
  • Lots of assets based on estimates
  • CEO obsession on GAAP choices
  • Gross margin ↑ compared to industry
red flags improper asset valuation23
Red Flags – Improper Asset Valuation
  • ↑ the number of days’ sales in receivables
  • ↑ number of days’ purchases in inventory
  • ↓Allowances for bad debts, inventory
  • Unusual change in the relationships
  • Increasing assets when competitors are reducing
detection of fraudulent financial statement schemes
Detection of Fraudulent Financial Statement Schemes
  • SAS 99 – Consideration of Fraud in a Financial Statement Audit
  • “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.”
sas 99
SAS 99
  • Two major types of fraud
  • Professional skepticism
  • Discussion of risk
sas 9926
SAS 99
  • Obtaining information needed to identify risks of material misstatement due to fraud
    • Inquiries of management
    • Unusual or unexpected relationships
    • Fraud risk factors exist.
    • Other information
sas 9927
SAS 99
  • Identifying risks that may result in material misstatement due to fraud
    • Type
    • Significance
    • Likelihood
    • Pervasiveness
  • Assessing the identified risks after taking into account an evaluation of the entity’s programs and controls
    • Specific controls
    • Broader programs
sas 9928
SAS 99
  • Responding to the results of the assessment
    • Overall responses
    • nature, timing, and extent of procedures
    • risk of management override of controls
    • Examining journal entries and other adjustments
    • Reviewing accounting estimates
    • Evaluating the business rationale
sas 9929
SAS 99
  • Evaluating audit evidence
    • Assessing risks of material misstatement
    • Evaluating analytical procedures
    • at or near the completion of fieldwork
    • misstatements that may be the result of fraud
sas 9930
SAS 99
  • Communicating about fraud to management, the audit committee, and others
    • even if considered inconsequential
    • Internal controls  management
    • Disclosing possible fraud to outside parties
sas 96 audit documentation
SAS 96 – Audit Documentation
  • list of factors
  • new requirements
  • Retains much of the ownership/record retention guidance of SAS 41
  • Contains amendments adding specific documentation requirements to other SASs
financial statement analysis
Financial Statement Analysis
  • Vertical analysis
  • Horizontal analysis
  • Ratio analysis
deterrence of financial statement fraud
Deterrence of Financial Statement Fraud
  • Reduce pressures
  • Reduce the opportunity
  • Reduce rationalization
reduce pressures to commit financial statement fraud
Reduce Pressures to Commit Financial Statement Fraud
  • “tone at the top”.
  • Unachievable goals.
  • excessive pressure.
  • Recognize changing market
  • Fair compensation systems
  • excessive external expectations
  • Remove operational obstacles blocking effective performance.
reduce the opportunity to commit financial statement fraud
Reduce the Opportunity to Commit Financial Statement Fraud
  • internal accounting records.
  • monitor the business transactions and interpersonal relationships
  • physical security system.
  • Accurate personnel records.
  • Strong supervisory and leadership relationships.
  • Clear and uniform accounting procedures
reduce rationalization of financial statement fraud
Reduce Rationalization of Financial Statement Fraud
  • Tone @ the top.
  • Strong policies.
  • Training
  • Anonymous tip procedure
  • Communications
  • Walk the talk