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Financial Statement Fraud McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

14-3 Financial Statement Fraud: Overview Financial statement fraud (FSF) is any undisclosed intentional or grossly negligent violation of generally accepted accounting principles (GAAP) that materially affects the information in any financial statement. COSO reported various general areas for FSF schemes: Improper revenue recognition. Overstatement of assets (other than accounts receivable related to revenue fraud). Understatement of expenses/liabilities. Misappropriation of assets. Inappropriate disclosure. Other miscellaneous techniques. About half of all FSFs involve overstating revenues/assets.

14-4 Revenue Schemes Sham sales Premature revenue recognition Recognition of conditional sales Abuse of cutoff date of sales Misstatement of the percentage of completion\ Unauthorized shipments or channel stuffing Consignment sales

14-5 Schemes Involving Overstating Assets Inventories The most common inventory fraud involves the overstatement of assets. Accounts receivable Accounts receivable are overstated by understating allowances for bad debts or falsifying accounts balances. Property, plant, and equipment In this scheme, depreciation is not taken when it should be or property, plant, and equipment is simply overstated. A corresponding overstatement is made to the revenues. Other overstatements These involve other accounts such as loans/notes receivables, cash, investments, and so on.

14-6 Schemes Involving Improper Accounting Treatment Recording an asset at market value or some other incorrect value rather than cost. Failing to charge proper depreciation or amortization against income. Capitalizing an asset when it should be expensed. Improperly recording transfers of goods from related companies as sales. Not recording liabilities to keep them off the balance sheet. Omitting contingent liabilities (e.g., pending product liability lawsuits, pending government fines, and so on) from the financial statements.

14-7 Other Schemes Fictitious and Fraudulent Transactions Recording sham transactions and legitimate transactions improperly. Fraudulent Transaction Processing Intentionally misprocessing transactions to produce fraudulent account balances. For example, accounting software is modified to incorrectly total sales and accounts receivables so that all transactions in the account are real but the total is overstated. Direct Falsification of Financial Statements Producing false financial statements when management ignores account balances.

14-8 Characteristics of Financial Statement Fraud The median amount of the fraud is approximately 25 percent of the median total assets. Most frauds span multiple fiscal periods with the average fraud time being approximately two years. The majority of fraud involves overstating revenues by recording them fictitiously or prematurely. FSF is much more likely to occur in companies whose assets are less than $100 million. FSF is much more likely to occur in companies with decreased earnings, earnings problems, or a downward trend in earnings.

14-9 Characteristics of Financial Statement Fraud In a large majority of cases, either the CFO or CEO is involved in the fraud. In many cases, the board of directors has no audit committee or one that seldom meets, or none of the audit committee members has the required skills to perform as intended. The members of the board are frequently dominated by insiders (even related to managers) or by those with financial ties to the company. Auditor changes occurred about one-fourth of the time in and around the time of the fraud.

14-10 Characteristics of Financial Statement Fraud Nearly half of audit reports indicate some type of anomaly, such as a change of auditors, doubts about the company’s ability to continue as a going concern, a change in accounting principle, or a litigation issue. Problems with departures from GAAP seldom occur, however. The size of the audit firm does not seem to matter. FSF occurs frequently in companies audited by both large and small audit firms. Nearly one-third of the enforcement action cases that name individuals allege wrongdoing on the part of the external auditor. About half the time, the auditor is accused of participating in a fraud; the other half the time the auditor is accused of negligence.

14-11 Motives for FSF Poor Income Performance Impaired Ability to Acquire Capital. Product Marketing General Business Opportunities Compliance with Bond Covenants Generic Greed Theft, Bribery, or Other Illegal Activities

14-12 Prevention of Financial Statement Fraud The general philosophy behind SOX is to minimize FSF by promoting strong corporate governance and organizational oversight through the oversight of the following six organizational groups. Board of directors Audit committee Management Internal auditor External auditor Public Oversight Bodies

14-13 Prevention of Financial Statement Fraud

14-14 Red Flags: Indications of Possible Financial Statement Fraud Lack of Independence, Competence, Oversight, or Diligence Weak Internal Control Processes Management Style Personnel-Related Practices Accounting Practices Company’s Financial Condition Industry Environment and Conditions

14-15 Management Discretion, Earnings Management, And Earnings Manipulation Management Discretion. With respect to accounting discretion, its legitimate use does not violate any ethics guidelines although some individuals complain about its use and would like it eliminated. Managers also make use of economic discretion. The term earnings management is used frequently confused with earnings manipulation. The term earnings management refers to management’s routine use of nonfraudulent accounting and economic discretion. Earnings manipulation has a more nebulous meaning. It can refer either to the legitimate or aggressive use, or fraudulent abuse, of discretion. By definition, then, earnings management is legitimate, and earnings manipulation can be legitimate, marginally ethical, unethical, or illegal, depending on its extent.

14-16 Earnings Smoothing and Earnings Management Earnings smoothing is the manipulation of earnings to reduce their volatility. In simple terms, this means using manipulations to increase earnings in years when they are weak and to lower them in years when they are strong. It’s very well known on Wall Street that investors prefer steadily increasing earnings that consistently meet or exceed financial analyst expectations. This stems from the general economic principle that investors are risk averse. In financial terms, risk aversion is associated with earnings volatility.

14-17 Cookie Jar and Big Bath Accounting Cookie Jar Accounting One type of earnings management and earnings manipulation. The practice treats the balance sheet as a cookie jar: In good years, the company stores cookies (reserves) in the cookie jar (the balance sheet) so that it can take them out and eat them (place them on the income statement) when management is hungry (needs extra income to look good). Big-Bath Accounting When a company makes a large one- time write off, it is said to take a big bath to improve future earnings. Many companies take a big bath (often in the form of restructuring or inventory write-downs) when earnings performance is already poor.

14-18 Cases Of Financial Statement Fraud And Manipulation McKesson & Robbins: Financial Statement Fraud 101. The Great Salad Oil Swindle Equity Funding: They Made a Movie about It Cedant Corporation: Manufacturing Revenues Zzzz Best: The Teenager Who Fooled Wall Street Sunbeam Corp.: Channel Stuffing Nortel: The Ultimate Big Bath WorldCom: Boosting Earnings in a Big Way Enron: Lessons in Creative Accounting Qwest and Global Crossing: Swap Sales