FRAUD EXAMINATION ALBRECHT, ALBRECHT, & ALBRECHT Liability, Asset & Inadequate Disclosure Frauds Chapter 13

Learning Objectives Identify fraudulent schemes that understate liabilities. Understand the understatement of liabilities fraud. Identify fraudulent schemes that overstate assets. Understand the overstatement of assets fraud.

Learning Objectives Identify fraudulent schemes that inadequately disclose financial statement information. Understand the inadequate disclosure fraud.

What Makes It Hard for Auditors to Detect Fraud? Collusion Forgery Complex Audit Trails Lies Normal Looking Transactions Silence Off-Book Frauds Misleading Documents Small Frauds First Time Fraudsters

How is Liability and Revenue Fraud Committed? Liabilities UNDERSTATED Revenues OVERSTATED

How is Liability Fraud Committed? Don’t Record Purchase or Record in the Next Accounting Period Overstate Purchase Returns & Allowances Make It Appear that Liabilities Are Paid or Forgiven

Discuss Ways Liability Fraud is Committed. Fraudulent recording of payments Don’t record accrued liabilities Don’t record warranty liabilities or service Record deposits as revenues Borrow against equities in assets Write off liabilities as forgiven Don’t record contingent liabilities that are probable

What are Accrued Liabilities? Liabilities incurred, Used goods or services, but not recorded because paperwork not received, Often estimated

How Are Unearned Revenues Abused? Instead of recording as a liability the revenue is recognized & recorded EXPLAIN By not recording as a debt, debts (liabilities) are understated & revenues overstated - results in not disclosing debt By claiming debt forgiven or paid By claiming debt as personal, not business, debt

Define a Contingent Liability. Liabilities are not incurred but have some probability of being incurred RECORD if probable & estimable DISCLOSE in footnote if reasonably possible DO NOTHING if remotely probable How are they abused? Underestimate amount or probability

What Are Some Analytical Symptoms of Liability Fraud? Balances appear to be too small Purchase Returns & Allowances seem too large Unearned Revenues, payroll taxes, payroll deductions, accrued liabilities, warranty balances appear to be too small Compare with Prior Period Balances

What Symptoms Appear in Documents? Large purchases recorded at the beginning of the period Photocopied records instead of originals Strange differences between balances & confirmations Not recorded timely Unsupported or unauthorized balances Last minute adjustments Missing records Denied access to records, facilities, vendors or people

What Are Some Other Clues to Liabilities Fraud? ●Unrecorded Liens ●No payments to Govt. ●No Payroll Withholdings ●Capitalization of Wages ●Interest with NO Recorded Debt

Period-to-Period Changes Complete The Chart. Analysis of Period-to-Period Changes Liability Account Balances Focus on changes in statement numbers Study Statement of Cash Flow Use horizontal analysis With Industry Competitors Compare statement results with those of similar companies Compare company’s trends with those of similar companies Liability Relationships Examine changes in relevant ratios Use vertical analysis With Real-World Numbers Compare statement amounts with the assets they are supposed to represent

What is a Recommended Process for Examining for Liabilities Fraud? Ask what kind of fraud could be occurring. Identify what symptoms those frauds would generate. Determine whether those symptoms exist. Follow up to determine if the symptom signals fraud, or an abnormality caused by something else.

List Ratios that Are Used to Detect These Types of Fraud. Under recording Accounts Payable (A/P) Acid-test Current A/P to Purchases A/P to COGS A/P to Total Liabilities A/P to Inventory Under recording Accrued Liabilities Various Accruals to Number of days to accrue compared to same ratio in prior years Various Accruals to Related Expenses Under recording Unearned Revenues Unearned Revenue to Revenue

List Ratios that Are Used to Detect These Types of Fraud. Under recording Service Liabilities Warranty Expense to Sales Under recording Various Liabilities Interest Expense to Notes Payable Long-Term Debt to Stockholders’ Equity Various Types of Debt to Assets Total Liabilities to Total Assets Pension Expenses to Salary Expense Lease Expense to Total Fixed Assets Not Recording Contingent Liabilities Generally no ratios to help you, you must look for documentary evidence.

Define Improper Capitalization or Expensing. Recording something as an asset when it should be expensed. This changes the time period when the expense is charged against income. Computer Science Corporation (CSC)

List Five Common Ways to Overstate Assets. Overstate Receivables and Inventory Overstate Fixed Assets Overstate Cash, Short-term Investments and Marketable Securities Overstate Assets though Mergers and Acquisitions Overstate Intangible or Deferred Assets

List Some Ways Fixed Assets Are Overstated. Record at Fair Market Value Under Depreciate Record Fully Depreciated Assets Record Non-Existing Assets

What Does Publicly Traded Mean? Stocks the General Public Can Purchase Stocks Not Traded on Regular Exchanges Are Easily Mistated in Value

List Some Symptoms of Asset Fraud. Deferred Interest Size of Deferred Charges Year-End Reclassification or JEs that reduce expenses & increase deferred charges Detect by Comparing Deferred Charges Ratios

Discuss & Define Inadequate Disclosure Fraud. Creating or Misleading By Providing Incorrect Information or Not Providing Information Statements of Omission Statements of Commission

How Are Footnotes Made Misleading? Missing Confusing Contingent Liabilities Contractual Obligations Significant Events

Marketable Securities Terms Match Purchase something, one company by another Mortgage Long-term loan secured by real property Acquisition Rent asset, do not own, make periodic payments Merger Stocks, bonds and other non-cash assets Lease Combining two businesses into one business Marketable Securities

Terms Match Deferred Asset Asset that is not tangible, can’t touch Fixed Asset Retirement benefits paid to former employees Intangible Asset Capitalized expenditure to be expensed in future Property, Plant & Equipment Pension Recording expenditure as an asset Capitalization

Terms Match Assets are recorded at higher values than they should be Liability Frauds Disclosure Frauds Agreement to buy back something already sold Issuing financial statements with inadequate disclosure Asset Frauds Repurchase Agreement Liabilities are understated