1. Chapter 11: Financial Statement Fraud
Fraud Examination, 4E
Chapter 11: Financial Statement Fraud

2. Learning Objectives
Discuss the role that financial statements play in capital markets.
Understand the nature of financial statement fraud.
Become familiar with financial statement fraud statistics.
See how financial statement frauds occur and are concealed.
Outline the framework for detecting financial statement fraud.
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3. Learning Objectives Identify financial statement fraud exposures.
Explain how information regarding a company’s management and directors, nature of organization, operating characteristics, relationship with others, and financial results can help assess the likelihood of financial statement fraud.
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4. Role of Financial Statements
Financial statements play a very important role in keeping capital markets efficient.
Financial statements are based on generally accepted accounting principles (GAAP), which guide the accounting for transactions.
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5. Financial Statement Fraud
Financial statements are sometimes prepared in ways that intentionally misstate the financial position and performance of an organization.
Misstatement of financial statements can result from manipulating, falsifying, or altering accounting records.
Misleading financial statements cause serious problems in the market and the economy.
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6. Financial Statement Fraud
Misleading financial statements cause serious problems:
large losses by investors
lack of trust in the market and accounting systems
litigation and embarrassment for individuals and organizations associated with financial statement fraud
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7. Examples of Financial Statement Fraud
Misstated financial statements and “cooking the books.”
Examples:
Qwest
Enron
Global Crossing
WorldCom
Xerox
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8. Examples of Financial Statement Fraud
Inappropriate executive loans and corporate looting.
Examples:
John Rigas (Adelphia)
Dennis Kozlowski (Tyco)
Bernie Ebbers (WorldCom)
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9. Examples of Financial Statement Fraud
Insider trading scandals
Example:
Martha Stewart and Sam Waksal, both used insider information to profit from trading ImClone stock
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10. Why These Frauds Occurred
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11. Elements of the Perfect Fraud Storm
A Booming Economy
Decay of Moral Values
Misplaced Incentives
High Analysts’ Expectations
High Debt Levels
Focus on Accounting Rules Rather Than Principles
Lack of Auditor Independence
Greed
Educator Failures
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12. Nature of Financial Statement Fraud
Involves intentional deceit
Involves attempted concealment
Rarely seen
Many false red flags
Conviction is very difficult
Because of the difficulty of detecting and proving fraud , investigators must exercise
extreme care when performing fraud examinations, quantifying fraud, or performing
other types of fraud-related engagements.
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13. Fraud Statistics (Between 1987 – 1997)
The average fraud last about two years
Improper revenue recognition, overstatement of assets, and understatement of expenses were the most common frauds
Cumulative average magnitude of fraud was $25 million ($4.1 million median)
CEO perpetrated the fraud in 72 percent of the cases
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14. Fraud Statistics (Between 1987 – 1997)
Fraudulent companies’ size: Average assets were $532 million ($16 million median) and $232 million average revenues ($13 million median)
Severe consequences were usually associated with companies having fraudulent financial statements
Most of these firms had no audit committee, or one that met only once per year
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15. Fraud Statistics (Between 1987 – 1997)
Boards of directors were dominated by insiders and “grey” directors
Some companies were experiencing net losses or were close to break-even positions
25% of the companies changed auditors during the fraud period
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16. Detecting Financial Statement Fraud
Strategic Reasoning
The ability to anticipate a fraud perpetrator’s likely method
of concealing a fraud
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17. Detecting Financial Statement Fraud
Strategic Reasoning
Questions to ask:
What types of fraud schemes is management likely to use to commit financial statement fraud?
What typical tests are used to detect these schemes?
How could management conceal the scheme of interest from the typical test?
How could the typical test be modified so as to detect the concealed scheme?
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18. Detecting Financial Statement Fraud
Financial Statement Analysis
Focus on the changes in reported assets, liabilities,
revenues, and expenses from period to period or by
comparing company performance to industry norms.
Not just general financial statement analysis – think outside the box……
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19. Detecting Financial Statement Fraud
Nonfinancial Performance Measures
Look for a discrepancy between the company’s financial and nonfinancial performance
Example:
Former HealthSouth CEO Richard Scrushy’s
The company’s revenues and assets were increasing while the number of HealthSouth facilities decreased
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20. Detecting Financial Statement Fraud
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21. Management and Directors
Investigate three aspects of management:
Managements’ backgrounds
Managements’ motivations
Managements’ influence in making decisions for the organization
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22. Relationship with Others
Relationships should be examined to determine if they present management fraud opportunities or exposures.
Carefully consider relationships with:
related organizations and individuals
external auditors
lawyers
Investors
regulators
bondholders
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23. Organization and Industry
Some industries are more risky than others.
Attributes of fraud-prone organizations:
unduly complex organizational structure
without an internal audit department
board of directors with no or few outsiders on the board or audit committee
one person or a small group of individuals controls related entities
has offshore affiliates with no apparent business purpose
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24. Financial Results and Operations
Critical questions that must be asked:
Are unrealistic changes or increases present in financial statement account balances?
Are account balances are not realistic given the nature, age, and size of the company?
Do actual physical assets do not exist in the amounts and values indicated on the financial statements?
Have there been significant changes in the nature of the organization’s revenues or expenses?
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