EXHIBIT 12-1

LEARNING OBJECTIVES

After studying this chapter, you should be able to:

12-1	Define financial statement fraud and related schemes
12-2	Understand and identify the five classifications of financial statement fraud
12-3	Explain how fictitious revenues schemes are committed, as well as the motivation for, and result of, committing such fraud
12-4	Explain how timing difference schemes are committed, as well as the motivation for, and result of, committing such fraud
12-5	Describe the methods by which concealed liabilities and expenses are used to fraudulently improve a company's balance sheet
12-6	Understand how improper disclosures may be used to mislead potential investors, creditors, or other users of the financial statements
12-7	Recognize how improper asset valuation may inflate the current ratio
12-8	Identify detection and deterrence procedures that may be instrumental in dealing with fraudulent financial statement schemes
12-9	Understand financial statement analysis for detecting fraud
12-10	Identify and characterize current professional and legislative actions that have sought to improve corporate governance, enhance the reliability and quality of financial reports, and foster credibility and effectiveness of audit functions

OVERVIEW

Financial statement fraud has been a hot subject in the press for many years, and it does not appear to be slowing down anytime soon. High-profile scandals have challenged the corporate responsibility and integrity of major companies, prompting U.S. legislation such as the Sarbanes–Oxley Act and the Dodd–Frank Wall Street Reform and Consumer Protection Act. Financial statement fraud isn't limited to the United States, however. In 2009, the chairman of a leading Indian outsourcing company, Satyam Computer Services, revealed significant financial statement fraud had been taking place for the past several years. He claimed that the company's assets were inflated by $1.04 billion and revenues were overstated by 20 percent. In 2011, newly appointed CEO of Olympus Corporation in Japan, Michael Woodford, exposed one of the biggest and longest-running accounting frauds in Japanese corporate history. Woodford was fired from the company less than two months after becoming CEO for questioning the company's accounting practices. For one, a scheme was set up to conceal $1.7 billion in investment losses, and almost $700 million in M&A fees were paid to the company's financial advisors.

It wasn't too long ago that companies, including Sunbeam, Enron, WorldCom, Global Crossing, Adelphia, Qwest, Tyco, HealthSouth, and AIG, also graced the headlines for fraudulently misstating their financial position. Top management teams, including chief executive officers (CEOs) and chief financial officers (CFOs), of these companies, and of many more, have been accused of cooking the books. Ongoing occurrences of financial statement fraud by high-profile companies have raised concerns about the integrity, transparency, and reliability of the financial reporting process and have challenged the role of corporate governance and audit functions in deterring and detecting financial statement fraud.

DEFINING FINANCIAL STATEMENT FRAUD

The definition of financial statement fraud can be found in a number of authoritative reports (e.g., The Treadway Commission's Report of the National Commission on Fraudulent Financial Reporting (1987) and the AICPA's Statement on Auditing Standards No. 99 (henceforth referred to as the Generally Accepted Auditing Standard AU 240, “Consideration of Fraud in a Financial Statement Audit”). Financial statement fraud is defined as deliberate misstatements or omissions of amounts or disclosures of financial statements to deceive financial statement users, particularly investors and creditors. Financial statement fraud may involve the following schemes:

• 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 (Rezaee 2002)

Generally Accepted Auditing Standard AU 240, entitled “Consideration of Fraud in a Financial Statement Audit,” issued by the Auditing Standards Board (ASB) of the American Institute of Certified Public Accountants (AICPA), defines two types of misstatements relevant to an audit of financial statements and auditors' consideration of fraud (AICPA 2012). The first type is misstatements arising from fraudulent financial reporting, which are defined as “intentional misstatements, including omissions of amounts or disclosures in financial statements to deceive financial statement users” (AICPA 2012). The second type is misstatements arising from misappropriation of assets, which are commonly referred to as theft or defalcation. The primary focus of this chapter is on misstatements arising from fraudulent reporting that directly causes financial reports to be misleading and deceptive to investors and creditors. Fraudulent financial statements can be used to unjustifiably sell stock, obtain loans or trade credit, and/or improve managerial compensation and bonuses. The important issues addressed in this chapter are how to effectively and efficiently deter, detect, and correct financial statement fraud.

COSTS OF FINANCIAL STATEMENT FRAUD

Published statistics on the possible costs of financial statement fraud—including those from the 2011 Global Fraud Survey that were included in the previous chapter—are estimates, at best. It is impossible to determine the actual total costs because not all fraud is detected, not all detected fraud is reported, and not all reported fraud is legally pursued. Nonetheless, it is safe to say that the full impact of financial statement fraud is astonishing. In addition to the direct economic losses resulting from such manipulations are legal costs; increased insurance costs; loss of productivity; adverse impacts on employees' morale, customers' goodwill, and suppliers' trust; and negative stock market reactions. Another important indirect cost of financial statement fraud is the loss of productivity due to dismissal of the fraudsters and their replacements. While these indirect costs cannot possibly be estimated, they should be taken into consideration when assessing the consequences of financial statement fraud. Loss of public confidence in quality and reliability of financial statements caused by the alleged fraudulent activities is the most damaging and costly effect of fraud.

Financial statement fraud is harmful in many ways. It:

• Undermines the reliability, quality, transparency, and integrity of the financial reporting process. Executives at Beazer Homes USA (Beazer), a former Fortune 500 company located in Charlotte, North Carolina, encouraged the manipulation of corporate earnings to meet financial goals. In this fraud, Beazer executives manipulated the company's financial statements by reducing net income during strong financial periods and providing it with excess balances and reserves, allowing it to “smooth earnings” during times of underperformance. In 2009, Beazer entered into a deferred prosecution agreement, acknowledging culpability, and agreed to pay restitution of $50 million. In 2009, General Electric (GE) agreed to pay a $50 million fine to the SEC to settle charges that it misled investors through fraudulent accounting practices in 2002 and 2003. Prior to the 2009 settlement, GE had already restated some of its financial statements for the years 2001 through 2008. In the wake of scandals such as those involving General Electric, Enron, WorldCom, Adelphia, and Tyco, these types of high-profile financial restatements and enforcement actions by the SEC against big corporations for alleged financial statement fraud severely undermine public confidence in the veracity of financial reports.
• Jeopardizes the integrity and objectivity of the auditing profession, especially of auditors and auditing firms. Auditing firms are considered “public watchdogs.” They are tasked with determining whether clients' financial statements are free of material misstatement, whether due to error or fraud. When a large-scale fraud happens under the watchful eye of an auditor, however, the auditor's credibility is shattered. Arthur Andersen, one of the former “Big Five” CPA firms, dismantled its international network and allowed officers to join rival firms after it became embroiled in a scandal involving its shredding of documents related to its audit work for Enron. Although the Supreme Court ultimately overturned Andersen's conviction for obstruction of justice, the accounting firm had already irreparably crumbled in the wake of the document destruction debacle.
• Diminishes the confidence of the capital markets, as well as market participants, in the reliability of financial information. The capital market and market participants, including investors, creditors, employees, and pensioners, are affected by the quality and transparency of financial information they use in making investment decisions.
• Makes the capital markets less efficient. Auditors reduce the information risk that may be associated with the published financial statements and thus make them more transparent. The information risk is the likelihood that financial statements are inaccurate, false, misleading, biased, and deceptive. By applying the same financial standards to diverse businesses and by reducing the information risk, accountants contribute to the efficiency of our capital markets.
• Adversely affects the nation's economic growth and prosperity. Accountants are expected to make financial statements among corporations more comparable by applying the same set of accounting standards to diverse businesses. This enhanced comparability makes business more transparent, the capital markets more efficient, the free enterprise system possible, and the economy more vibrant and prosperous. The efficiency of our capital markets depends on receiving objective, reliable, and transparent financial information. Thus, the accounting profession, especially practicing auditors, plays an important role in our free enterprise system and capital markets. However, many of the recent accounting scandals provide evidence that the role of accountants can be compromised.
• Results in huge litigation costs. Corporations and their auditors are being sued for alleged financial statement fraud and related audit failures by a diverse group of litigants including small investors in class action suits and the U.S. Justice Department. Investors are also given the right to sue and recover damages from those who aided and abetted securities fraud.
• Destroys careers of individuals involved in financial statement fraud. In 2011, the former chief accounting officer of Beazer Homes was convicted on seven of eleven counts of fraud for the use of false information to finance and sell homes and to manipulate corporate earnings. Top executives are being held personally accountable for the integrity of their company's financial statements. Convicted fraudsters are barred from serving on the boards of directors of any public companies, and auditors are being barred from the practice of public accounting.
• Causes bankruptcy or substantial economic losses by the company engaged in financial statement fraud. WorldCom and Enron make up two of the ten largest bankruptcies in U.S. history. Total assets at the time of filing were $104 billion for WorldCom and $66 billion for Enron.
• Encourages regulatory intervention. Regulatory agencies (e.g., the SEC) considerably influence the financial reporting process and related audit functions. Past perceived crises in the financial reporting process and audit functions ultimately encouraged lawmakers to establish accounting reform legislation in the form of the Sarbanes–Oxley Act. This Act was intended to drastically change the self-regulating environment of the accounting profession to a regulatory framework under the SEC oversight function.
• Causes devastation in the normal operations and performance of alleged companies. Even if a company manages to escape bankruptcy as a result of financial statement fraud, it won't likely do so without experiencing immense financial and reputational damage. Normal operations and performance are bound to suffer as the company faces stock price volatility, difficulties in raising capital, layoffs, fines, legal fees, diminished sales, and other negative consequences.
• Raises serious doubt about the efficacy of financial statement audits. The financial community is demanding high-quality audits, and auditors need to effectively address this issue to produce the desired assurance.
• Erodes public confidence and trust in the accounting and auditing profession. One message that comes through loud and clear these days in response to the increasing number of financial restatements and alleged financial statement fraud is that the public confidence in the financial reporting process and related audit functions is substantially eroded.

FICTITIOUS REVENUES

Fictitious or fabricated revenue schemes involve the recording of sales of goods or services that did not occur. Fictitious sales most often involve fake or phantom customers, but can also involve legitimate customers. For example, a fictitious invoice can be prepared (but not mailed) for a legitimate customer although the goods are not delivered or the services are not rendered. At the beginning of the next accounting period, the sale might be reversed to help conceal the fraud, but this may lead to a revenue shortfall in the new period, creating the need for more fictitious sales. Another method is to use legitimate customers and artificially inflate or alter invoices reflecting higher amounts or quantities than actually sold.

Generally speaking, revenue is recognized when it is (1) realized or realizable and (2) earned. The Securities and Exchange Commission (SEC) issued Staff Accounting Bulletin (SAB) Topic 13, “Revenue Recognition” (codified in FASB ASC 605, “Revenue Recognition”), to provide additional guidance on revenue recognition criteria and to rein in some of the inappropriate practices that had been observed. FASB ASC 605 states that revenue is typically considered realized or realizable, and earned, when all of the following criteria are met:

• Persuasive evidence of an arrangement exists
• Delivery has occurred or services have been rendered
• The seller's price to the buyer is fixed or determinable
• Collectibility is reasonably assured

FASB ASC 605 concedes that revenue may be recognized in some circumstances where delivery has not occurred, but sets out strict criteria that limit the ability to record such transactions as revenue.

Properly accounting for revenue is one of the most important and complicated challenges facing companies today. Revenue recognition has always been one of the top accounting and auditing areas of risk. The current conceptual guidelines for revenue recognition are found in FASB Concepts Statement No. 5, “Recognition and Measurement in Financial Statements of Business Enterprises” and FASB Concepts Statement No. 6, “Elements of Financial Statements.” Concepts Statement No. 6 defines revenue as “inflows or other enhancements of assets of an entity or settlements of its liabilities (or a combination of both) from delivering or producing goods, rendering services, or other activities that constitute the entity's ongoing major or central operations.” However, because conflicts can arise between the guidance contained in the two applicable Concepts Statements, the FASB is currently working to develop coherent conceptual guidance on revenue recognition to eliminate existing inconsistencies and to provide a basis for a comprehensive accounting standard on revenue recognition.

As part of this initiative, the FASB and the International Accounting Standards Board (IASB) have partnered on a project to tackle the issue of revenue recognition with the goal of promoting convergence of international accounting standards. The Boards' current perspective on this subject concentrates on “changes in assets and liabilities.” The concept of realization or completion of the earnings processes is not an integral part of their focus in this regard. This is consistent with FASB Concepts Statement No. 6. Although the Boards have arrived at several tentative decisions as part of the project, these decisions do not change current accounting policy until they have gone through extensive due process and deliberations.

Case 1760 details a typical example of fictitious revenue. In this example, a publicly traded company engineered sham transactions for more than seven years in order to inflate their financial standing. The company's management utilized several shell companies, supposedly making a number of favorable sales. The sales transactions were fictitious, as were the supposed customers. As the amounts of the sales grew, so did the suspicions of internal auditors. The sham transactions included the payment of funds for assets while the same funds were returned to the parent company as receipts on sales. The management scheme went undetected for so long that the company's books were eventually inflated by more than $80 million. The perpetrators were finally discovered and prosecuted in both civil and criminal courts.

An example of a sample entry from this type of case is detailed below. To record a purported purchase of fixed assets, a fictional entry is made by debiting fixed assets and crediting cash for the amount of the alleged purchase:

A fictitious sales entry is then made for the same amount as the false purchase, debiting accounts receivable and crediting the sales account. The cash outflow that supposedly paid for the fixed assets is “returned” as payment on the receivable account, though in practice the cash might never have moved if the fraudsters hadn't bothered to falsify that extra documentary support.

The result of the completely fabricated sequence of events is an increase in both company assets and yearly revenue. The debit could alternatively be directed to other accounts, such as inventory or accounts payable, or it could simply be left in accounts receivable if the fraud were committed close to year-end and the receivable could be left outstanding without attracting undue attention.

Sales with Conditions

Sales with conditions are a form of a fictitious revenue scheme in which a sale is booked even though some terms have not been completed and the rights and risks of ownership have not passed to the purchaser. These transactions do not qualify for recording as revenue, but they may nevertheless be recorded in an effort to fraudulently boost a company's revenue. These types of sales are similar to schemes involving the recognition of revenue in improper periods since the conditions for sale may become satisfied in the future, at which point revenue recognition would become appropriate. Premature recognition schemes will be discussed later in this chapter in the section on timing differences.

Pressures to Boost Revenues

External pressures to succeed that are placed on business owners and managers by analysts, bankers, stockholders, families, and even communities often provide the motivation to commit fraud. For example, in addition to other charges, General Electric (GE) was alleged by the SEC to have manipulated earnings for two years in a row in order to meet performance targets by recording $381 million in “sales” of locomotives to financial partners. Since GE hadn't ceded ownership of the assets and had agreed to maintain and secure them on its property, the transactions were, in reality, more like loans than sales. GE settled the SEC's charges in 2009 for $50 million, neither admitting nor denying guilt.

In a different case, the former Chairman of Satyam Computer Services, B. Ramalinga Raju, resigned from the board after revealing that he had systematically falsified accounts as the company expanded. He admitted to inflating cash balances and overstating revenues by 20 percent. In 2011 Satyam, now called Mahindra Satyam Ltd, and its auditor, PricewaterhouseCoopers, agreed to pay $125 million and $25.5 million, respectively, to settle claims filed by shareholders. That same year, Satyam and PwC agreed to pay a combined $17.5 million to settle claims made by the SEC and the PCAOB.

In another example, in Case 2303, a real estate investment company arranged for the sale of shares that it held in a nonrelated company. The sale occurred on the last day of the year and accounted for 45 percent of the company's income for that year.

A 30 percent down payment was recorded as received, with a corresponding receivable recorded for the balance. With the intent to show a financially healthier company, the details of the sale were made public in an announcement to the press, but the sale of the stock was completely fabricated. To cover the fraud, off-book loans were made in the amount of the down payment. Other supporting documents were also falsified. The $40 million misstatement was ultimately uncovered, and the real estate company owner faced criminal prosecution.

In a similar instance, Case 710, a publicly traded textile company engaged in a series of false transactions designed to improve its financial image. Receipts from the sale of stock were returned to the company in the form of revenues. The fraudulent management team even went so far as to record a bank loan on the company books as revenue. At the time that the scheme was uncovered, the company books were overstated by some $50,000, a material amount to this particular company.

The pressures to commit financial statement fraud may also come from within a company. Departmental budget requirements including income and profit goals can create situations in which financial statement fraud is committed. In Case 1664, the accounting manager of a small company misstated financial records to cover its financial shortcomings. The financial statements included a series of entries made by the accounting manager designed to meet budget projections and to cover up losses in the company's pension fund. Influenced by dismal financial performance in recent months, the accountant also consistently overstated period revenues. To cover his scheme, he debited liability accounts and credited the equity account. The perpetrator finally resigned, leaving a letter of confession. He was later prosecuted in criminal court.

Red Flags Associated with 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
• 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

As we mentioned earlier, financial statement fraud may also involve timing differences—that is, the recording of revenue or expenses in improper periods. This can be done to shift revenues or expenses between one period and the next, increasing or decreasing earnings as desired.

Matching Revenues with Expenses

Remember, according to generally accepted accounting principles, revenue and corresponding expenses should be recorded or matched in the same accounting period; failing to do so violates GAAP's matching principle. For example, suppose a company accurately records sales that occurred in the month of December, but fails to fully record expenses incurred as costs associated with those sales until January—in the next accounting period. The effect of this error would be to overstate the net income of the company in the period in which the sales were recorded and also to understate net income in the subsequent period when the expenses are reported.

The following example depicts a sales transaction in which the cost of sales associated with the revenue is not recorded in the same period. A journal entry is made to record the billing of a project, which is not complete. Although a contract has been signed for this project, goods and services for this project have not been delivered, and the project is not even scheduled to start until January. In order to boost revenues for the current year, the following sales transaction is recorded fraudulently before year-end:

In January, the project is started and completed. The entries below show accurate recording of the $15,500 of costs associated with the sale:

If recorded correctly, the entries for the recognition of revenue and the costs associated with the sales would be recorded in the accounting period in which they actually occurred: January. The effect on the income statement for the company is shown on the next page.

This example depicts exactly how failure to adhere to GAAP's matching principle can cause material misstatement in yearly income statements. When the income and expenses were stated in error, year 1 yielded a net income of $17,000 while year 2 produced a loss ($13,400). Correctly stated, revenues and expenses are matched and recorded together within the same accounting period showing a net income of $0 for year 1 and $3,600 for year 2.

Premature Revenue Recognition

Generally, revenue should be recognized in the accounting records when a sale is complete—that is, when title is passed from the seller to the buyer. This transfer of ownership completes the sale and is usually not final until all obligations surrounding the sale are complete and the four criteria set out in FASB ASC 605 have been satisfied. As mentioned previously, those four criteria are:

• Persuasive evidence of an arrangement exists
• Delivery has occurred or services have been rendered
• The seller's price to the buyer is fixed or determinable
• Collectibility is reasonably assured

Case 861 details how early recognition of revenue not only leads to financial statement misrepresentation, but also can serve as a catalyst to further fraud. A retail drugstore chain's management got ahead of itself in recording income. In a scheme that was used repeatedly, management enhanced its earnings by recording unearned revenue prematurely, resulting in the impression that the drugstores were much more profitable than they actually were. When the situation came to light and was investigated, several embezzlement schemes, false expense report schemes, and instances of credit card fraud were also uncovered.

In Case 2639, the president of a not-for-profit organization was able to illicitly squeeze the maximum amount of private donations by cooking the company books. To enable the organization to receive additional funding, which was dependent on the amounts of already-received contributions, the organization's president recorded promised donations before they were actually received. By the time the organization's internal auditor discovered the scheme, the fraud had been perpetrated for more than four years.

When managers recognize revenues prematurely, one or more of the criteria set forth in FASB ASC 605 is typically not met. Examples of common problems with premature revenue recognition are set out below.

Persuasive Evidence of an Arrangement Does Not Exist

• No written or verbal agreement exists
• A verbal agreement exists, but a written agreement is customary
• A written order exists, but is conditional upon sale to end users (such as a consignment sale)
• A written order exists, but contains a right of return
• A written order exists, but a side letter alters the terms in ways that eliminate the required elements for an agreement
• The transaction is with a related party, but this fact has not been disclosed

Delivery Has Not Occurred or Services Have Not Been Rendered

• Shipment has not been made and the criteria for recognizing revenue on “bill-and-hold” transactions set out in FASB ASC 605 have not been met
• Shipment has been made not to the customer, but to the seller's agent, to an installer, or to a public warehouse
• Some but not all of the components required for operation were shipped
• Items of the wrong specification were shipped
• Delivery is not complete until installation and customer testing and acceptance has occurred
• Services have not been provided at all
• Services are being performed over an extended period, and only a portion of the service revenues should have been recognized in the current period
• The mix of goods and services in a contract has been misstated in order to improperly accelerate revenue recognition

The Seller's Price to the Buyer Is Not Fixed or Determinable

• The price is contingent on some future events
• A service or membership fee is subject to unpredictable cancellation during the contract period
• The transaction includes an option to exchange the product for others
• Payment terms are extended for a substantial period and additional discounts or upgrades may be required to induce continued use and payment instead of switching to alternative products

Collectibility Is Not Reasonably Assured

• Collection is contingent on some future events (e.g., resale of the product, receipt of additional funding, or litigation)
• The customer does not have the ability to pay (e.g., it is financially troubled, it has purchased far more than it can afford, or it is a shell company with minimal assets)

Long-Term Contracts

Long-term contracts pose special problems for revenue recognition. Long-term construction contracts, for example, use either the completed contract method or the percentage of completion method, depending partly on the circumstances. The completed contract method does not record revenue until the project is 100 percent complete. Construction costs are held in an inventory account until completion of the project. The percentage of completion method recognizes revenues and expenses as measurable progress on a project is made, but this method is particularly vulnerable to manipulation. Managers can often easily manipulate the percentage of completion and the estimated costs to complete a construction project in order to recognize revenues prematurely and conceal contract overruns.

Channel Stuffing

Another difficult area of revenue recognition is “channel stuffing,” which is also known as “trade loading.” This refers to the sale of an unusually large quantity of a product to distributors, who are encouraged to overbuy through the use of deep discounts and/or extended payment terms. This practice is especially attractive in industries with high gross margins (cigarettes, pharmaceuticals, perfume, soda concentrate, and branded consumer goods) because it can increase short-term earnings. The downside is that stealing from the next period's sales makes it harder to achieve sales goals in the next period, sometimes leading to increasingly disruptive levels of channel stuffing and ultimately a restatement.

Although orders are received in a channel-stuffing scheme, the terms of the order might raise some question about the collectibility of accounts receivable, and there may be side agreements that grant a right of return, effectively making the sales consignment sales. There may be a greater risk of returns for certain products if they cannot be sold before their shelf life expires. This is particularly a problem for pharmaceuticals, because retailers will not accept drugs that have a short shelf life remaining. As a result, channel stuffing should be viewed skeptically as in certain circumstances it may constitute fraud.

Recording Expenses in the Wrong Period

The timely recording of expenses is often compromised due to pressures to meet budget projections and goals, or due to lack of proper accounting controls. As the expensing of certain costs is pushed into periods other than the ones in which they actually occur, they are not properly matched against the income that they help produce. Consider Case 1370, in which supplies were purchased and applied to the current-year budget but were actually used in the following accounting period. A manager at a publicly traded company completed eleven months of operations remarkably under budget when compared to total-year estimates. He therefore decided to get a head start on the next year's expenditures. In order to spend all current-year budgeted funds allocated to his department, the manager bought $50,000 in unneeded supplies. The supplies expense transactions were recorded against the current year's budget. Staff auditors noticed the huge leap in expenditures, however, and inquired about the situation. The manager came clean, explaining that he was under pressure to meet budget goals for the following year. Because the manager was not attempting to keep the funds for himself, no legal action was taken.

The correct recording of the above transactions would be to debit supplies inventory for the original purchase and subsequently expense the items out of the account as they are used. The example journal entries below detail the correct method of expensing the supplies over time.

Similar entries should be made monthly, as the supplies are used, until they are consumed and $50,000 in supplies expense is recorded.

Red Flags Associated with 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 AND EXPENSES

As previously discussed, understating liabilities and expenses is one of the ways that financial statements can be manipulated to make a company appear more profitable. Because pretax income will increase by the full amount of the expense or liability not recorded, this financial statement fraud method can have a significant impact on reported earnings with relatively little effort by the fraudster. This method is much easier to commit than falsifying many sales transactions. Missing transactions are generally harder for auditors to detect than improperly recorded ones, because there is no audit trail.

There are three common methods for concealing liabilities and expenses:

• Liability/expense omissions
• Capitalized expenses
• Failure to disclose warranty costs and liabilities

Liability/Expense Omissions

The preferred and easiest method of concealing liabilities/expenses is to simply fail to record them. Multimillion-dollar judgments against the company from a recent court decision might be conveniently ignored. Vendor invoices might be thrown away (they'll send another later) or stuffed into drawers rather than being posted into the accounts payable system, thereby increasing reported earnings by the full amount of the invoices. In a retail environment, debit memos might be created for chargebacks to vendors, supposedly to claim permitted rebates or allowances but sometimes just to create additional income. These items may or may not be properly recorded in a subsequent accounting period, but that does not change the fraudulent nature of the current financial statements. One of the highest-profile liability omission cases of recent vintage involved Adelphia Communications. John Rigas, Adelphia's founder, purchased a small cable company in Coudersport, Pennsylvania for the sum of $300 in 1952. By 2002, it had grown to the nation's sixth-largest cable television company, with more than five million subscribers and $10 billion in assets.

Rigas, of Greek heritage, named his company Adelphia Communications Corporation, after the Greek word for “brothers.” He and his brother Gus ran the company as their own—a style that came back to haunt him after the company went public. Later, his three sons Tim, Michael, and James—along with son-in-law Peter Venetis—became active in Adelphia's management. The family controlled the majority of the company's voting stock and constituted the majority on the board of directors. Accordingly, the family used Adelphia's money as their own. They also used company assets as their own. Three corporate jets took family members on exotic vacations, including African safaris. John Rigas was particularly egregious in his spending. At one time, he racked up personal debt of $66 million, forcing his son, Timothy, to put his father on a “budget” of $1 million a month in personal draws.

Adelphia CFO Timothy Rigas engineered the financial manipulations. He was in charge of manipulating the books to inflate the stock price in order to meet analysts' expectations. Investigators later discovered that the family members had looted the company to the tune of some $3 billion. The money transfers were made by journal entries that gave Adelphia debt that hadn't been disclosed. Among other things, the Rigas family used the funds to:

• Acquire other cable companies not owned by Adelphia
• Pay debt service on investments
• Purchase a controlling interest in the Buffalo Sabres Hockey Team
• Pay $700,000 in country club memberships
• Buy luxury vacation homes in Cancun, Beaver Creek (Colorado), and Hilton Head Island, as well as two apartments in Manhattan
• Purchase a $13 million golf course

The Rigas family's problems started with overexpansion in the late 1990s when they purchased Century Communications for the sum of $5.2 billion. By 2002, Adelphia's stock had fallen to historic lows and the company was unable to make payments on the debt it incurred to make acquisitions.

In July 2002, the SEC charged Adelphia with, among other things, fraudulently excluding over $2.3 billion in bank debt from its consolidated financial statements. According to the complaint filed by the SEC, Adelphia's founder and his three sons fraudulently excluded the liabilities from the company's annual and quarterly consolidated financial statements by deliberately shifting those liabilities onto the books of Adelphia's off–balance sheet unconsolidated affiliates. Failure to record this debt violated GAAP requirements and precipitated a series of misrepresentations about those liabilities by Adelphia and the defendants. This included the creation of (1) sham transactions backed by fictitious documents to give the false appearance that Adelphia had actually repaid debts when, in truth, it had simply shifted them to unconsolidated entities controlled by the founder and (2) misleading financial statements that, in their footnotes, gave the false impression that liabilities listed in the company's financials included all outstanding bank debt. This led to a freefall of Adelphia's stock; less than three months later, the company filed for bankruptcy.

Often, perpetrators of liability and expense omissions believe they can conceal their fraud in future periods. They often plan to compensate for their omitted liabilities with visions of other income sources such as profits from future price increases.

Just as they are easy to conceal, omitted liabilities are probably one of the most difficult financial statement schemes to uncover. A thorough review of all post-financial statement-date transactions, such as accounts payable increases and decreases, can aid in the discovery of omitted liabilities in financial statements, as can a computerized analysis of expense records. Additionally, if the auditor requested and was granted unrestricted access to the client's files, a physical search could turn up concealed invoices and unposted liabilities. Probing interviews of accounts payable and other personnel can reveal unrecorded or delayed items, too.

Capitalized Expenses

Capital expenditures are costs that provide a benefit to a company over more than one accounting period. Manufacturing equipment is an example of this type of expenditure. Revenue expenditures or expenses, on the other hand, directly correspond to the generation of current revenue and provide benefits for only the current accounting period. An example of expenses is labor costs for one week of service. These costs correspond directly with revenues billed in the current accounting period.

Capitalizing revenue-based expenses is another way to increase income and assets, since they are amortized over a period of years rather than expensed immediately. If expenditures are capitalized as assets and not expensed during the current period, income will be overstated. As the assets are depreciated, income in subsequent periods will be understated.

The improper capitalization of expenses was one of the key methods of financial statement fraud that was allegedly used by WorldCom, Inc., in its high-profile fraud, which came to light in early 2002. The saga of WorldCom, at one time the second-largest long-distance carrier in America (behind AT&T), began in 1983, when Bernie Ebbers drew a business plan on the back of a napkin at a coffee shop in Hattiesburg, Mississippi. Ebbers and his partners, attempting to benefit from the breakup of AT&T, decided to purchase long-distance time and sell it to local companies on a smaller scale. They named the fledgling business Long Distance Discount Service (LDDS).

Up until that time, Ebbers didn't know much about the telecommunications industry. He graduated from a small Mississippi college with a degree in physical education. He'd previously owned a small garment factory and several motels.

But LDDS turned out to be a success. The company was buying and selling a commodity—long-distance service—but it didn't have to invest in the costs of buying and installing expensive telephone lines. Along the way, LDDS acquired a half-dozen other communications companies.

In 1995, the business was renamed WorldCom, and the new company went on an acquisition rampage, purchasing over sixty companies. WorldCom's crown jewel was a $37 billion merger in 1997 with MCI, a much larger company. The following year, it bought Brooks Fiber Properties and CompuServe. In 1999, it attempted to acquire rival Sprint in a $115 billion merger, but the Federal Communications Commission blocked the deal to prevent breach of antitrust laws.

Because of increasing competition in the telecommunications industry, WorldCom's spectacular growth started slowing dramatically resulting in a precipitous drop in its stock price. To reverse declining margins, the company started reducing the reserves it had established to cover the undisclosed liabilities of companies it had acquired. Between 1998 and 2000, this amounted to $2.8 billion.

However, in the opinion of management, the reduction in reserves was insufficient. Scott Sullivan, the CFO, directed certain WorldCom staffers to reclassify as assets $3.35 billion in fees paid to lease phone networks from other companies and $500 million in computer expenses, both operating costs. Rather than suffering a $2.5 billion loss in 2001, the company reported a $1.4 billion profit. Andersen LLP, WorldCom's external auditors, uncovered none of these machinations.

In 2002, Sullivan directed a WorldCom employee to classify another $400 million in expenses as assets. The employee complained to Cynthia Cooper, CFE, WorldCom's internal auditor, who directed her staff to conduct an investigation. Cooper's team first discovered that the $500 million in computer expenses reclassified as assets had no documentation to support the expenditures. Then they uncovered another $2 billion in questionable entries.

Internal auditors met with the audit committee in June 2002 to explain their findings. On June 25, WorldCom made a public announcement that it had inflated revenues by $3.8 billion over the previous five quarters. Within three weeks, the company had filed for bankruptcy. Subsequent investigations would show that WorldCom had overstated its profits and income by about $11 billion.

These improper accounting practices were designed to, and did, inflate income to correspond with estimates by Wall Street analysts and to support the price of WorldCom's stock. As a result, several former WorldCom Executives, including former CEO Bernie Ebbers, former CFO Scott Sullivan, former Controller David F. Meyers, and former Director of General Accounting Buford “Buddy” Yates, Jr., were charged with multiple criminal offenses and received prison sentences ranging from one to twenty-five years for their participation in the scheme.

Expensing Capital Expenditures

Just as capitalizing expenses is improper, so is expensing costs that should be capitalized. An organization may want to minimize its net income due to tax considerations or to increase earnings in future periods. Expensing an item that should be depreciated over a period of time helps accomplish just that—net income is lower and so are taxes.

Returns and Allowances and Warranties

Improper recording of sales returns and allowances occurs when a company fails to properly record or present the expense associated with sales returns and customer allowances stemming from customer dissatisfaction. It is inevitable that a certain percentage of products sold will, for one reason or another, be returned. When this happens, management must record the related expense in a contra-sales account, which reduces the amount of net sales presented on the company's income statement.

Likewise, when a company offers a warranty on product sales, it must estimate the amount of warranty expense it reasonably expects to incur over the warranty period and accrue a liability for that amount. In warranty liability fraud, the warranty liability is usually either omitted or substantially understated. Another similar area is the liability resulting from defective products (product liability).

Red Flags Associated with Concealed Liabilities and Expenses

• 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
• Nonfinancial 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
• 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 DISCLOSURES

As we discussed earlier, accounting principles require that financial statements and notes include all the information necessary to prevent a reasonably discerning user of the financial statements from being misled. The notes should include narrative disclosures, supporting schedules, and any other information required to avoid misleading potential investors, creditors, or any other users of the financial statements.

Management has an obligation to disclose all significant information appropriately in the financial statements and in management's discussion and analysis. In addition, the disclosed information must not be misleading. Improper disclosures relating to financial statement fraud usually involve the following:

• Liability omissions
• Subsequent events
• Management fraud
• Related-party transactions
• Accounting changes

Liability Omissions

Typical omissions include the failure to disclose loan covenants or contingent liabilities. Loan covenants are agreements, in addition to or part of a financing arrangement, which a borrower has promised to keep as long as the financing is in place. The agreements can contain various types of covenants, including certain financial ratio limits and restrictions on other major financing arrangements. Contingent liabilities are potential obligations that will materialize only if certain events occur in the future. A corporate guarantee of personal loans taken out by an officer or a private company controlled by an officer is an example of a contingent liability. The company's potential liability, if material, must be disclosed.

Subsequent Events

Events occurring or becoming known after the close of the period may have a significant effect on the financial statements and should be disclosed. Fraudsters often avoid disclosing court judgments and regulatory decisions that undermine the reported values of assets, that indicate unrecorded liabilities, or that adversely reflect on management integrity. Public record searches can reveal this information.

Management Fraud

Management has an obligation to disclose to the shareholders significant fraud committed by officers, executives, and others in positions of trust. Withholding such information from auditors would likely also involve lying to auditors, an illegal act in itself.

Related-Party Transactions

Related-party transactions occur when a company does business with another entity whose management or operating policies can be controlled or significantly influenced by the company or by some other party in common. There is nothing inherently wrong with related-party transactions, as long as they are fully disclosed. If the transactions are not conducted on an arm's-length basis, the company may suffer economic harm, injuring stockholders.

The financial interest that a company official might have may not be readily apparent. For example, common directors of two companies that do business with each other, any corporate general partner and the partnerships with which it does business, and any controlling shareholder of the corporation with which he/she/it does business may be related parties. Family relationships can also be considered related parties. These relationships include all lineal descendants and ancestors, without regard to financial interests. Related-party transactions are sometimes referred to as “self-dealing.” While these transactions are sometimes conducted at arm's length, they often are not.

In the highly publicized Tyco fraud case, which broke in 2002, the SEC charged former top executives of the company, including its former CEO, L. Dennis Kozlowski, with failing to disclose to shareholders hundreds of millions of dollars of low-interest and interest-free loans they took from the company. Moreover, Kozlowski forgave $50 million in loans to himself and another $56 million for fifty-one favored Tyco employees. Tyco's board approved none of the charges.

Kozlowski also engaged in undisclosed non-arm's-length real estate transactions with Tyco or its subsidiaries and received undisclosed compensation and perks, including rent-free use of large New York City apartments and personal use of corporate aircraft at little or no cost. The SEC complaint alleged that three former executives, including Kozlowski, also sold restricted shares of Tyco stock valued at $430 million dollars while their self-dealing remained undisclosed.

In addition, Kozlowski participated in numerous improper transactions to fund an extravagant lifestyle. In January 2002, several empty boxes arrived at Tyco's headquarters in Exeter, New Hampshire. They were supposed to contain art worth at least $13 million to decorate the modest, two-story facility. In fact, the art—consisting of original works by Renoir and Monet—was actually hanging on the walls in Kozlowski's lavish Fifth Avenue corporate apartment; the empty-box ruse had been staged in an effort to avoid New York State sales tax of 8.25 percent.

Less than six months later, Kozlowski resigned just before he was accused of evading payment of taxes on the art. But the art, paid for by Tyco, was just the tip of the iceberg. A subsequent investigation would accuse Kozlowski and CFO Mark Schwartz of systematically looting their employer for more than $170 million. Both men were later found guilty of twenty-two charges and sentenced to up to twenty-five years in prison.

Most of the stolen money was simply charged to Tyco even though it personally benefited Kozlowski. For example, his compensation was reported at $400 million, but, in addition, Tyco paid for such outrageous charges as:

• A $16.8 million apartment in New York City for Kozlowski
• $13 million in original art
• A $7 million apartment for Kozlowski's ex-wife
• An umbrella stand that cost $15,000
• A $17,000 traveling toilette box
• $5,960 for two sets of sheets
• A $6,300 sewing basket
• A $6,000 shower curtain
• Half of a $2.1 million birthday party for his wife
• Up to $80,000 a month in personal credit card charges

Although Kozlowski's embezzlements were not material to the financial statements as a whole, they were nonetheless substantial and vividly portray the ultimate in corporate greed.

Accounting Changes

FASB ASC 250, “Accounting Changes and Error Corrections,” describes three types of accounting changes that must be disclosed to avoid misleading the user of financial statements: accounting principles, estimates, and reporting entities. Although the required treatment for each type of change is different, they are all susceptible to manipulation by determined fraudster. For example, fraudsters may fail to properly retroactively restate the financial statements for a change in accounting principle if the change causes the company's financial statements to appear weaker. Likewise, they may fail to disclose significant changes in estimates such as the useful lives and estimated salvage values of depreciable assets or the estimates underlying the determination of warranty or other liabilities. They may even secretly change the reporting entity, by adding entities owned privately by management or excluding certain company-owned units, in order to improve reported results.

Red Flags Associated with 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
• 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
• 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

IMPROPER ASSET VALUATION

Generally accepted accounting principles require that most assets be recorded at their historical (acquisition) cost. Under the “lower of cost or market value” rule, where an asset's cost exceeds its current market value (as happens often with obsolete technology), it must be written down to market value. With the exception of certain securities, asset values are not increased to reflect current market value. It is often necessary to use estimates in accounting. For example, estimates are used in determining the residual value and the useful life of a depreciable asset, the uncollectable portion of accounts receivable, or the excess or obsolete portion of inventory. Whenever estimates are used, there is an additional opportunity for fraud by manipulating those estimates.

Many schemes are used to inflate current assets at the expense of long-term assets. The net effect is seen in the current ratio. The misclassification of long-term assets as current assets can be of critical concern to lending institutions that often require the maintenance of certain financial ratios. This is of particular consequence when the loan covenants are on unsecured or undersecured lines of credit and other short-term borrowings. Sometimes these misclassifications are referred to as “window dressing.”

Most improper asset valuations involve the fraudulent overstatement of inventory or receivables. Other improper asset valuations include manipulation of the allocation of the purchase price of an acquired business in order to inflate future earnings, misclassification of fixed and other assets, or improper capitalization of inventory or start-up costs. Improper asset valuations usually fall into one of the following categories:

• Inventory valuation
• Accounts receivable
• Business combinations
• Fixed assets

Inventory Valuation

Since inventory must be valued at the acquisition cost except when the cost is determined to be higher than the current market value, inventory should be written down to its current value, or written off altogether if it has no value. Failing to write down inventory results in overstated assets and the mismatching of cost of goods sold with revenues. Inventory can also be improperly stated through the manipulation of the physical inventory count, by inflating the unit costs used to price out inventory, by failing to relieve inventory for costs of goods sold, or by other methods. Fictitious inventory schemes usually involve the creation of fake documents such as inventory count sheets, receiving reports, and similar items. Companies have even programmed special computer reports of inventory for auditors that incorrectly added up the line item values so as to inflate the overall inventory balance. Computer-assisted audit techniques can significantly help auditors to detect many of these inventory fraud techniques. Case 2481 involved an inventory valuation scheme in which the fraud was committed through tampering with the inventory count. During a routine audit of a publicly traded medical supply company, the audit team found a misstatement of the inventory value that could hardly be classified as routine. The client's inventory was measured in metric volumes, and apparently as the count was taken, an employee arbitrarily moved the decimal unit. This resulted in the inventory being grossly overstated. The discovery forced the company to restate its financial statements, resulting in a write-down of the inventory amount by more than $1.5 million.

One of the most popular methods of overstating inventory is through fictitious (phantom) inventory. For example, in Case 1666 a CFE conducting a systems control review at a large cannery and product wholesaler in the Southwest observed a forklift driver constructing a large façade of finished product in a remote location of the warehouse. The inventory was cordoned off and a sign indicated that it was earmarked for a national food processor. The cannery was supposedly warehousing the inventory until requested by the customer. When the CFE investigated, he discovered that the inventory held for the food processor was later resold to a national fast-food supplier.

A review of the accounts receivable aging report indicated sales of approximately $1.2 million to this particular customer in prior months, and the aging also showed that cash receipts had been applied against those receivables. An analysis of ending inventory failed to reveal any improprieties because the relief of inventory had been properly recorded with cost of sales. Copies of all sales documents to this particular customer were then requested. The product was repeatedly sold free on board (FOB) shipping point, and title had passed. But bills of lading indicated that only $200,000 of inventory had been shipped to the original purchaser. There should have been a million dollars of finished product on hand for the food processor. However, there was nothing behind the façade of finished products. An additional comparison of bin numbers on the bill of lading with the sales documents revealed that the same product had been sold twice.

The corporate controller was notified and the plant manager questioned. He explained that “he was doing as he was told.” The vice president of marketing and the vice president of operations both knew of the situation, but felt there was “no impropriety.” The CFO and president of the company felt differently, and fired the vice presidents. The company eventually was forced into bankruptcy.

Accounts Receivable

Accounts receivable are subject to manipulation in the same manner as sales and inventory, and in many cases, the schemes are conducted together. The two most common schemes involving accounts receivable are fictitious receivables and failure to write off accounts receivable as bad debts (or failure to establish an adequate allowance for bad debts). Fictitious receivables commonly arise from fictitious revenues, discussed earlier. Accounts receivable should be reported at net realizable value—that is, the amount of the receivable less amounts expected not to be collected.

Fictitious Accounts Receivable Fictitious accounts receivable are common among companies with financial problems, as well as with managers who receive a commission based on sales. The typical entry under fictitious accounts receivable is to debit (increase) accounts receivable and credit (increase) sales. Of course, these schemes are more common around the end of the accounting period, since accounts receivable should be paid in cash within a reasonable time. Fraudsters commonly attempt to conceal fictitious accounts receivable by providing false confirmations of balances to auditors. They get the audit confirmations because the mailing address they provide for the phony customers is typically either a mailbox under their control, a home address, or the business address of a co-conspirator. Such schemes can be detected by using satellite imaging software, business credit reports, public records, or even the telephone book to identify significant customers who have no physical existence or no apparent business need for the product sold to them.

Failure to Write Down Companies are required to accrue losses on uncollectible receivables when the criteria in FASB ASC 450, “Contingencies,” are met, and to record impairment of long-lived assets and goodwill under FASB ASC 350, “Intangibles—Goodwill and Other.” Companies struggling for profits and income may be tempted to omit the recognition of such losses because of the negative impact on income.

Business Combinations

Companies are required to allocate the purchase price they have paid to acquire another business to the tangible and intangible assets of that business. Any excess of the purchase price over the value of the acquired assets is treated as goodwill. Changes in goodwill accounting have decreased the incentive for companies to allocate an excessive amount to purchased assets, to minimize the amount allocated to goodwill that previously should have been amortized and which reduced future earnings. However, companies may still be tempted to overallocate the purchase price to in-process research and development assets, in order to then write them off immediately. Or they may establish excessive reserves for various expenses at the time of acquisition, intending to quietly release those excess reserves into earnings at a future date.

Fixed Assets

Fixed assets are subject to manipulation through several different schemes. Some of the more common schemes are:

• Booking fictitious assets
• Misrepresenting asset valuation
• Improperly capitalizing inventory and start-up costs

Booking Fictitious Assets One of the easiest methods of asset misrepresentation is in the recording of fictitious assets. This false creation of assets affects account totals on a company's balance sheet. The corresponding account commonly used is the owners' equity account. Because company assets are often physically found in many different locations, this fraud can sometimes be easily overlooked. One of the most common fictitious asset schemes is to simply create fictitious documents. For example, in Case 376 a real estate development and mortgage financing company produced fraudulent statements that included fictitious and inflated asset amounts and illegitimate receivables. The company also recorded expenses that actually were for personal, instead of business, use. To cover the fraud, the company raised cash through various illegal securities offerings, guaranteeing over $110 million with real estate projects. It subsequently defaulted. The company declared bankruptcy shortly before the owner passed away.

In other instances, equipment is leased, not owned, yet that fact is not disclosed during the audit of fixed assets. Bogus fixed assets can sometimes be detected because the fixed asset addition makes no business sense.

Misrepresenting Asset Value Fixed assets should be recorded at cost. Although assets may appreciate in value, this increase in value generally should not be recognized on company financial statements. Many financial statement frauds have involved the reporting of fixed assets at market values instead of the lower acquisition costs, or at even higher inflated values with phony valuations to support them. Further, companies may falsely inflate the value of fixed assets by failing to record impairments of long-lived assets and of goodwill as required by FASB ASC 350, “Intangibles—Goodwill and Other.” Misrepresentation of asset values frequently goes hand in hand with other schemes.

One of the most high-profile asset-valuation fraud cases of recent years involved the collapse of Enron, the energy-trading company. Enron was created in 1985 as a merger between Houston Natural Gas and InterNorth, a Nebraska pipeline company. Although Enron began as a traditional natural gas supplier, under the lead of employee Jeffrey Skilling it quickly developed a new and innovative strategy to make money: the creation of a “gas bank,” whereby the company would buy gas from a network of suppliers and sell to a network of consumers. Its profits would be derived from contractually guaranteeing both the supply and the selling price, charging a fee for its services.

This new business segment required Enron to borrow enormous amounts of money, but by 1990, the company was the market leader. Kenneth Lay, Enron's CEO, created Enron Finance Corp. (EFC) to handle the new business and picked Skilling to run it. Based on the initial success of EFC, and assisted by Skilling's new protégé, Andrew Fastow, the company's “gas bank” concept was expanded to include trading in a wide variety of areas: electricity, and futures contracts in coal, paper, water, steel, and other commodities.

Since Enron was either a buyer or a seller in every transaction, the company's credit was crucial. Eventually, in 2000, Enron expanded into the telecommunications business by announcing that it planned to build a high-speed broadband network and to trade network capacity (bandwidth) in the same way it traded other commodities. Enron sunk hundreds of millions of dollars in borrowed money for this new venture, which quickly failed to produce the intended profits.

The money that Enron borrowed to finance its various ventures was kept off of its balance sheet by Fastow, using an accounting treatment called special-purpose entities (SPEs). Under accounting rules in place at the time, Enron could contribute up to 97 percent of an SPE's assets or equity. Then the SPE could borrow its own money, which would not show up on Enron's financial statements. But Enron could claim its profits (or losses).

In most of the SPEs established by Enron, the asset contributed was company stock. But since the stock contributed would have diluted earnings per share, Enron used another treatment, “mark-to-market accounting,” to boost profits. Mark-to-market accounting required a company to book both realized and unrealized gains and losses on energy-related or other “derivative” contracts at the end of each quarter. Because there were no hard-and-fast rules on how to value such contracts, Enron consistently valued them to show gains, which would offset the effect of issuing more stock to fund the SPEs. Moreover, the accounting treatment that allowed Enron to keep the debt off of its balance sheet also allowed the company to claim the income from unrealized holding gains, which increased the return on assets. By 1999, Enron derived more than half of its $1.4 billion pretax net income from unrealized holding gains.

Fastow became the master of the SPE, eventually creating thousands of them for various purposes. However, when the economic boom of the 1990s started to wane, Enron's unrealized holding gains on its “derivative” contracts started turning into losses. To keep these losses from showing up on Enron's income statement, Fastow created SPEs to hide them. And in the process of creating SPEs, Fastow paid himself over $30 million in management fees; his wife was paid another $17 million.

One of the six transactions in the SEC's complaint against Fastow involved a special-purpose entity named Raptor I and a public company called Avici Systems, Inc. According to the complaint, Enron and the Fastow-controlled partnership, LJM2, engaged in complex transactions with Raptor I to manipulate Enron's balance sheet and income statement, as well as to generate profits for LJM2 and Fastow, at Enron's expense. In September 2000, Fastow and others used Raptor I to effectuate a fraudulent hedging transaction and thus avoid a decrease in the value of Enron's investment in the stock of Avici Systems, Inc. Specifically, Fastow and others back-dated documents to make it appear that Enron locked in the value of its investment in Avici in August 2000, when Avici's stock was trading at its all-time-high price.

The various deals that Enron cooked up should have been properly disclosed in footnotes to its financial statements. But a number of analysts questioned the transparency of those disclosures. One said, “The notes just don't make any sense, and we read notes for a living.”

As in other cases involving profits built on paper and risky deals, Enron was unable to continue without massive infusions of cash. When that didn't materialize, Enron, in October 2001, was forced to disclose it was taking a $1 billion charge to earnings to account for poorly performing business segments. It also had to reverse $1.2 billion in assets and equities booked as a result of the failed SPEs. Later that month, it announced restatements that added $591 million in losses and $628 million in liabilities for the year ended in 2000.

The bubble had burst: On December 2, 2001, Enron filed for bankruptcy. Enron's auditor, Andersen & Co., closed its doors on August 30, 2002, for failing to discover the fraud. In the end, sixteen people pled guilty to crimes related to the scandal; five more were convicted at trial. Many of the company's top executives were sentenced to jail time for their part in the fraud, including Fastow, Skilling, and former treasurer Ben Glisan, Jr. Ken Lay was also found guilty of six counts of fraud, but died of a heart attack before sentencing.

Understating Assets In some cases, as with some government-related or government-regulated companies in which additional funding is often based on asset amounts, it may be advantageous to understate assets. This understatement can be done directly or through improper depreciation. In Case 507, for example, the management of the company falsified its financial statements by manipulating the depreciation of the fixed assets. The depreciation reserve was accelerated by the amount of $2.9 million over a six-month period. The purpose of the scheme was to avoid cash contributions to a central government capital asset acquisition account.

Capitalizing Non-Asset Cost Excluded from the cost of a purchased asset are interest and finance charges incurred in the purchase. For example, as a company finances a capital equipment purchase, monthly payments include both principal liability reduction and interest payments. On initial purchase, only the original cost of the asset should be capitalized. The subsequent interest payments should be charged to interest expense and not to the asset. Without reason for intensive review, fraud of this type can go unchecked. In Case 921, a new investor in a closely held corporation sued for rescission of purchase of stock, alleging that the company compiled financial information that misrepresented the financial history of the business. A fraud examination uncovered assets that were overvalued due to capitalization of interest expenses and other finance charges. Also discovered was the fact that one of the owners was understating revenue by $150,000 and embezzling the funds. The parties subsequently settled out of court.

Misclassifying Assets In order to meet budget requirements, and for various other reasons, assets are sometimes misclassified into general ledger accounts in which they don't belong. The manipulation can skew financial ratios and help comply with loan covenants or other borrowing requirements. In Case 2106, a purchasing employee at a retail jewelry firm feared being called to the carpet on some bad jewelry purchases. Instead of taking the blame for bad margins on many items, the employee arbitrarily redistributed costs of shipments to individual inventory accounts. The cover-up did not take; the company's CFO detected the fraud after he initiated changes to control procedures. When the CFO created a separation of duties between the buying function and the costing activities, the dishonest employee was discovered and terminated.

Red Flags Associated with 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
• Nonfinancial 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
• 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 that are otherwise out of line with those of 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

AU 240—Consideration of Fraud in a Financial Statement Audit

In response to the high-profile financial frauds that occurred in 2001 and 2002, the Auditing Standards Board of the AICPA replaced the preexisting fraud audit standard—SAS No. 82—with SAS No. 99 (eventually codified as Generally Accepted Auditing Standard AU 240), to give expanded guidance to auditors for detecting material fraud. The standard was issued as part of an effort to “restore investor confidence in U.S. capital markets and re-establish audited financial statements as a clear picture window into Corporate America.”

AU 200, “Overall Objectives of the Independent Auditor and the Conduct of an Audit in Accordance With Generally Accepted Auditing Standards,” states, “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.” The purpose of AU 240 is to “establish standards and provide guidance to auditors in fulfilling that responsibility.” It is divided into ten main sections:

• Description and characteristics of fraud
• Importance of exercising professional skepticism
• Discussion among engagement personnel regarding risk of material misstatement due to fraud
• Obtaining information needed to identify risks of material misstatement due to fraud
• Identifying risks that may result in material misstatement due to fraud
• Assessing the identified risks after taking into account an evaluation of the entity's programs and controls
• Responding to the assessed risks of material misstatement due to fraud
• Evaluating audit evidence
• Communicating about fraud to management, the audit committee, those charged with governance, regulatory authorities, and others
• Documenting the auditor's consideration of fraud

  Following is a brief description of each of these sections.

Description and Characteristics of Fraud This section emphasizes that the auditor should be interested in acts that result in a material misstatement of the financial statements. Misstatements can be the result of fraud or error depending on whether the misstatement was intentional or unintentional.

Two types of misstatements are considered relevant for audit purposes:

• Misstatements arising from fraudulent financial reporting
• Misstatements arising from misappropriation of assets

Misstatements Arising from Fraudulent Financial Reporting This category is defined as intentional misstatements or omissions of amounts or disclosures in financial statements that are “designed to deceive financial statement users.” Fraudulent financial reporting may be accomplished by the following:

• Manipulation, falsification, or alteration of accounting records or supporting documents
• Misrepresentation or intentional omission of events, transactions, or other significant information
• Intentional misapplication of accounting principles relating to amounts, classification, manner of presentation, or disclosure

Misstatements Arising from Misappropriation of Assets Also referred to as theft or defalcation, this category includes the theft of an entity's assets such that the effect of the theft causes the financial statements, in all material respects, not to be in conformity with GAAP.

This section cautions the auditor that, by definition, fraud often is concealed, and management is in a position to perpetrate fraud more easily, because managers are in the position of being able to directly or indirectly manipulate accounting records. Auditors cannot obtain absolute assurance that material misstatements are not present, but auditors should be aware of the possibility that fraud may be concealed and that employees may be in collusion with each other or with outside vendors. If the auditor notices records that seem unusual, the auditor should at least consider the possibility that fraud may have occurred.

Importance of Exercising Professional Skepticism AU 200 states that due professional care requires the auditor to exercise professional skepticism. Because of the characteristics of fraud, the auditor should conduct the engagement “with a mindset that recognizes the possibility that a material misstatement due to fraud could be present.” It also requires an “ongoing questioning” of whether information the auditor obtains could suggest a material misstatement due to fraud.

Discussion among Engagement Personnel Regarding Risk of Material Misstatement Due to Fraud Prior to or in conjunction with the information-gathering procedures discussed below, the members of the audit team should discuss the potential for material misstatements due to fraud. The discussion should include brainstorming among the audit team members about the following:

• How and where they believe the entity's financial statement might be susceptible to fraud
• How management could perpetrate or conceal fraud
• How assets of the entity could be misappropriated

This discussion should also include a consideration of known external and internal factors affecting the entity that might:

• Create incentives/pressures for management and others to commit fraud
• Provide the opportunity for fraud to be perpetrated
• Indicate a culture or environment that enables management and others to rationalize committing fraud

The discussion should also emphasize the need to maintain “a questioning mind” in gathering and evaluating evidence throughout the audit and to obtain additional information if necessary.

Obtaining Information Needed to Identify Risks of Material Misstatement Due to Fraud AU 300, “Planning an Audit,” provides guidance on how the auditor obtains knowledge about the entity's business and industry. As part of that process, the auditor should perform the following procedures to obtain information to use in identifying the risks of material misstatement due to fraud:

• Make inquiries of management and others within the entity to obtain their views 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

Making Inquiries of Management about the Risks of Fraud and How They Are Addressed This step involves asking management about a number of issues, including:

• Whether management has knowledge of fraud or suspected fraud
• Management's understanding of the risk of fraud
• Programs and controls the entity has established to help prevent, deter, or detect fraud
• Whether and how management communicates to employees its views on business practices and ethical behavior

The auditor should also question the audit committee directly about its views concerning the risk of fraud and whether the committee has knowledge of fraud or suspected fraud. The same should be done with the company's internal audit department.

Additionally, the auditor may need to conduct similar inquiries of the entity's other personnel if the auditor believes they may have additional information about the risks of fraud.

Considering the Results of Analytical Procedures Performed in Planning the Audit AU 240 requires that analytical procedures be performed in planning the audit with an objective of identifying the existence of unusual transactions or events, and amounts, ratios, and trends that might indicate matters “that have financial statement and audit planning implications.” If the results of these procedures yield unusual or unexpected relationships, the auditor should consider the results in identifying the risks of material misstatement due to fraud.

Considering Fraud Risk Factors As discussed above, even though fraud is concealed, the auditor may identify events or conditions that indicate incentives or pressures to commit fraud, opportunities to carry out fraud, or attitudes and rationalizations to justify fraudulent conduct. These events and conditions are referred to as “fraud risk factors.” The auditor should consider whether one or more of the fraud risk factors are present and should be considered in identifying and assessing the risks of material misstatement due to fraud. The appendix to AU 240 contains a list of examples of fraud risk factors.

Considering Other Information in Identifying Risks of Material Misstatement Due to Fraud Finally, the auditor should also consider any other information that he may feel would be helpful in identifying the risks of material misstatement.

Identifying Risks That May Result in Material Misstatement Due to Fraud After gathering the information as discussed previously, the auditor should consider the information in the context of the three conditions present when fraud occurs—incentives/pressures, opportunities, and attitudes/rationalizations. Auditors should consider:

• The type of risk that may exist (i.e., whether it involves fraudulent financial reporting or misappropriation of assets)
• The significance of the risk (i.e., whether it is of a magnitude that could result in a possible material misstatement)
• The likelihood of the risk (i.e., the likelihood that it will result in a material misstatement)
• The pervasiveness of the risk (i.e., whether the potential risk is pervasive to the financial statement as a whole or is specifically related to a particular assertion, account, or class of transactions)

Assessing the Identified Risks after Taking into Account an Evaluation of the Entity's Programs and Controls Auditors must obtain an understanding of each of the five components of internal controls sufficient to plan the audit. As part of this step, the auditor should evaluate whether the entity's programs and controls that address identified risks of fraud have been suitably designed and placed in operation. These programs and controls may involve:

• Specific controls designed to mitigate specific risks of fraud (e.g., controls to prevent misappropriation of particular, susceptible assets)
• Broader programs designed to deter and detect fraud (e.g., ethics policies)

Responding to the Assessed Risks of Material Misstatement Due to Fraud Once the auditor has gathered the information and assessed the risk of fraud, he must determine what impact the assessment will have on how the audit is conducted. For example, the auditor may need to design additional or different auditing procedures to obtain more reliable evidence in support of account balances, transactions, and so forth, or obtain additional corroboration of management's explanations and representations concerning material matters (such as third-party confirmation, documentation from independent sources, use of a specialist, analytical procedures, etc.).

Overall Responses to the Risk of Material Misstatement Judgments about the risk of material misstatement due to fraud have an overall effect on how the audit is conducted in several ways:

• Assignment of personnel and supervision. The auditor may need to consult with specialists in a particular field.
• Accounting principles. The auditor should consider management's selection and application of significant accounting principles, particularly those related to subjective measurements and complex transactions.
• Predictability of auditing procedures. The auditor should incorporate an “element of unpredictability” in the selection of auditing procedures to be performed, such as using differing sampling methods at different locations or auditing on an unannounced basis.

Responses Involving the Nature, Timing, and Extent of Procedures to Be Performed to Address the Identified Risks This section notes that the auditing procedures performed in response to identified risks will vary depending on the type of risks identified. Such procedures may involve both substantive tests and tests of the operating effectiveness of the entity's programs and controls. However, because management may have the ability to override controls that may otherwise appear to be operating effectively, it is unlikely that the audit risk can be reduced appropriately by performing only tests of controls.

Therefore, the auditor's response to specifically identified risks of fraud should include the following:

• Changing the nature of the auditing procedures to obtain more reliable or additional corroborative information (such as through independent sources or physical inspection).
• Changing the timing of substantive tests. For example, the auditor may conduct substantive tests at or near the end of the reporting period.
• The extent of the procedures should also reflect the assessment of the risk of fraud, such as increasing the sample sizes or performing analytical procedures at a more detailed level.

Examples of Responses to Identified Risks of Misstatement Arising from Fraudulent Financial Reporting AU 240 provides a number of examples of responses the auditor may take in regard to risks of misstatement arising from both fraudulent financial reporting and asset misappropriation.

Some examples concerning fraudulent financial reporting include:

• Revenue recognition—performing substantive analytical procedures relating to revenue using disaggregated data (for example, comparing revenue reported by month and by product line during the current reporting period with comparable prior periods), confirming with customers relevant contract terms, or questioning staff about shipments near the end of a period
• Inventory quantities—examining inventory records to identify locations or items that require specific attention during or after the physical inventory count, more rigorous examination of the count such as by examining contents of boxed items, or additional testing of count sheets, tags, or other records
• Management estimates—depending on the situation, engaging a specialist or developing an independent estimate for comparison to management's estimate; gathering further information may help the auditor evaluate the reasonableness of management's estimates and underlying assumptions

Examples of Responses to Identified Risks of Misstatement Arising from Misappropriation of Assets If the auditor identifies a risk of material misstatement due to fraud relating to misappropriation of assets, the auditor may wish to include additional procedures. For example, if a particular asset is highly susceptible to misappropriation, the auditor may wish to conduct further testing of the controls to detect and deter such misappropriation.

Responses to Further Address Risk of Management Override of Controls Because management is in a unique position to override existing controls, if such a risk is identified, the auditor may need to perform further procedures to further address the risk of management override of controls.

Examining Journal Entries and Other Adjustments for Evidence of Possible Material Misstatement Due to Fraud Material misstatements of financial statements often involve recording inappropriate or unauthorized journal entries or making adjustments to amounts reported in the financial statements that are not reflected in journal entries (such as consolidating adjustments or reclassifications). Therefore, the auditor should design procedures to test the appropriateness of journal entries recorded in the general ledger and other adjustments (such as entries posted directly to financial statement drafts).

Reviewing Accounting Estimates for Biases That Could Result in Material Misstatement Due to Fraud In preparing financial statements, management is responsible for making a number of judgments or assumptions that affect significant accounting estimates. Fraudulent financial reporting is often accomplished through intentional misstatement of these estimates. In performing the audit, the auditor should consider whether the differences between estimates supported by the audit evidence and the estimates included in the financial statements indicate a possible bias on the part of management. If so, the auditor should perform a retrospective review of significant accounting estimates of the prior year. This should provide the auditor with additional information about whether management may have a bias in presenting the current-year estimates.

Evaluating the Business Rationale for Significant Unusual Transactions During the course of the audit, the auditor may become aware of significant transactions that are outside the normal course of the entity's business or appear unusual given the auditor's understanding of the entity's operations. The auditor should gain an understanding of the business rationale for these transactions and whether the rationale (or lack thereof) suggests that the transactions may have been entered into to engage in fraudulent financial reporting or to conceal misappropriation of assets. Some factors the auditor should consider include:

• Are the transactions overly complex?
• Has management discussed the transactions with the board of directors and audit committee?
• Has management placed more emphasis on the need for a particular accounting treatment than on the underlying economics of the particular transaction?
• Do the transactions involve unconsolidated, unrelated parties (including special-purpose entities) or parties that do not have the substance or financial strength to support the transaction?

Evaluating Audit Evidence

Assessing Risks of Material Misstatement Due to Fraud throughout the Audit During the performance of the audit, the auditor may identify conditions that either change or support a judgment regarding the assessment of risks. Examples include:

• Discrepancies in the accounting records (such as transactions that are not recorded, unsupported or unauthorized balances or transactions, or last-minute adjustments)
• Conflicting or missing evidential matter (such as missing or altered documents/records, unexplained items or reconciliations, or missing inventory)
• Problematic or unusual relationships between the auditor and management (such as denial of access to records, facilities, employees, or customers; complaints by management about the conduct of the audit team; unusual delays in providing information; or unwillingness to add or revise disclosures)

Evaluating Whether Analytical Procedures Indicate a Previously Unrecognized Risk of Fraud Analytical procedures performed during the audit may result in identifying unusual or unexpected relationships that should be considered in assessing the risk of material misstatement due to fraud. Determining whether a particular trend or relationship is a risk of fraud requires professional judgment. Unusual relationships involving year-end revenue and income often are particularly relevant and might include (1) uncharacteristically large amounts of income reported in the last week or two of the reporting period from unusual transactions and (2) income that is inconsistent with trends in cash flow from operations.

Analytical procedures are useful because management or employees generally are unable to manipulate all the information necessary to produce normal or expected relationships. AU 240 provides several examples, including:

• The relationship of net income to cash flows from operations may appear unusual because management recorded fictitious revenues and receivables but was unable to manipulate cash
• Changes in inventory, accounts payable, sales, or costs of sales from the prior period to the current period may be inconsistent, indicating a possible theft of inventory because the employee was unable to manipulate all of the related accounts
• An unexpected or unexplained relationship between sales volume as determined from the accounting records and production statistics maintained by operations personnel (which is more difficult for management to manipulate) may indicate a possible misstatement of sales

Evaluating Risks of Material Misstatement at or near the Completion of Fieldwork At or near the completion of fieldwork, the auditor should evaluate whether the accumulated results of auditing procedures and other observations affect the assessment of risk of material misstatements due to fraud made earlier. Such an evaluation may identify whether there is a need to perform further audit procedures.

Responding to Misstatements That May Be the Result of Fraud If the auditor believes that misstatements are or may be the result of fraud but the effect of the misstatements is not material to the financial statements, the auditor nevertheless should evaluate the implications, especially those dealing with the “organizational position” of the person involved, which may require a reevaluation of the assessment of the risk of material misstatement. An example is theft of cash from a small petty cash fund. The amount of the theft generally would not be of significance to the auditor, but if higher-level management perpetrated the theft, it may be indicative of a more pervasive problem, such as management integrity.

If the auditor believes that a misstatement is or may be the result of fraud, and either has determined that the effect of the misstatement is material to the financial statements, or has been unable to evaluate whether the effect is material, the auditor should:

• Attempt to obtain additional evidence to determine whether material fraud occurred and its effect on the financial statements
• Consider the implications for other aspects of the audit
• Discuss the matter and the approach for further investigation with an appropriate level of management that is at least one level above those involved, and with senior management and the audit committee
• If appropriate, suggest the client consult with legal counsel

Communicating about Possible Fraud to Management, the Audit Committee, and Others AU 240 states, “Whenever an auditor has determined that there is evidence that fraud may exist, the matter should be brought to the attention of an appropriate level of management.” It is considered appropriate to do so even if the matter might be considered inconsequential. Fraud involving senior management and fraud (by anyone) that causes a material misstatement should be reported directly to the audit committee.

If the auditor has identified risks of material misstatement due to fraud that have continuing control implications, the auditor should also consider whether these risks should be communicated to senior management and the audit committee. Conversely, the auditor should also consider whether the absence of controls to detect or deter fraud should also be reported.

The disclosure of possible fraud to parties other than the client's senior management and its audit committee is ordinarily not part of the auditor's responsibility and may be precluded by the auditor's legal or ethical obligations of confidentiality unless the matter is reflected in the auditor's report.

However, AU 240 points out that there may be a duty to disclose the information to outside parties in the following circumstances:

• To comply with certain legal and regulatory requirements (such as SEC rules)
• To a successor auditor pursuant to generally accepted auditing standards
• In response to a subpoena
• To a funding agency or other specified agency in accordance with the requirements for audits of entities that receive governmental financial assistance

Documenting the Auditor's Consideration of Fraud AU 240 concludes by requiring that auditors document the following:

• Discussion among engagement personnel regarding the susceptibility of the entity's financial statements to material misstatement due to fraud (including how and when the discussion occurred, the team members who participated, and the subject matter discussed)
• Procedures performed to obtain information necessary to identify and assess the risks of material misstatement due to fraud
• Specific risks of material misstatement due to fraud that were identified
• If the auditor has not identified improper revenue recognition as a risk, the reasons supporting the auditor's conclusion
• The results of the procedures performed to further address the risk of management override of controls
• Other conditions and analytical relationships that caused the auditor to believe that additional auditing procedures or other responses were required to address such risks
• The nature of the communication about fraud made to management, the audit committee, or others

Financial Statement Analysis

Comparative financial statements provide information for current and past accounting periods. Accounts expressed in whole-dollar amounts yield a limited amount of information. The conversion of these numbers into ratios or percentages allows the reader of the statements to analyze them based on their relationship to each other, as well as to major changes in historical totals. In fraud detection and investigation, the determination of the reasons for relationships and changes in amounts can be important. These determinations are the red flags that point an examiner in the direction of possible fraud. If large enough, a fraudulent misstatement will affect the financial statements in such a way that relationships between the numbers become questionable. Many schemes are detected because the financial statements, when analyzed closely, do not make sense. Financial statement analysis includes the following:

• Vertical analysis
• Horizontal analysis
• Ratio analysis

Percentage Analysis—Vertical and Horizontal Traditionally, there are two methods of percentage analysis of financial statements. Vertical analysis is a technique for analyzing the relationships between the items on an income statement, balance sheet, or statement of cash flows by expressing components as percentages. This method is often referred to as “common sizing” financial statements. In the vertical analysis of an income statement, net sales is assigned 100 percent; for a balance sheet, total assets is assigned 100 percent on the asset side, and total liabilities and equity is expressed as 100 percent. All other items in each of the sections are expressed as a percentage of these numbers.

Horizontal analysis is a technique for analyzing the percentage change in individual financial statement items from one year to the next. The first period in the analysis is considered the base, and the changes to subsequent periods are computed as a percentage of the base period. If more than two periods are presented, each period's changes are computed as a percentage of the preceding period. Like vertical analysis, this technique will not work for small, immaterial frauds.

The following is an example of financial statements that are analyzed by both vertical and horizontal analysis:

Vertical Analysis Discussion Vertical analysis is the expression of the relationship or percentage of an item on a financial statement to a specific base item. In the above example, vertical analysis of the income statement includes net sales as the base amount, and all other items are then analyzed as a percentage of that total. Vertical analysis emphasizes the relationship of statement items within each accounting period. These relationships can be used with historical averages to determine statement anomalies.

In the above example, we can observe that accounts payable is 29 percent of total liabilities. Historically we may find that this account averages slightly over 25 percent.

In year 2, accounts payable increased to 51 percent. Although the change in the account total may be explainable through a correlation with a rise in sales, this significant rise might be a starting point in a fraud examination. Source documents should be examined to determine the cause of this percentage increase. With this type of examination, fraudulent activity may be detected. The same type of change can be seen as selling expenses decline as a part of sales in year 2 from 20 to 17 percent. Again, this change may be due to higher-volume sales or another bona fide situation. But close examination may possibly point a fraud examiner to uncover fictitious sales, since accounts payable rose significantly without a corresponding increase in selling expenses.

Horizontal Analysis Discussion Horizontal statement analysis uses percentage comparison from one accounting period to the next. The percentage change is calculated by dividing the amount of increase or decrease for each item by the base period amount. It is important to consider the amount of change as well as the percentage in horizontal comparisons. A 5 percent change in an account with a very large dollar amount may actually be much more of a change than a 50 percent change in an account with much less activity.

In the above example, it is very obvious that the 80 percent increase in sales has a much greater corresponding increase in cost of goods sold, which rose 140 percent. These accounts are often used to hide fraudulent expenses, withdrawals, or other illegal transactions.

Ratio Analysis Ratio analysis is a means of measuring the relationship between two different financial statement amounts. The relationship and comparison are the keys to the analysis, which allows for internal evaluations using financial statement data. Traditionally, financial statement ratios are used in comparisons to an entity's industry average. They can be very useful in detecting red flags for a fraud examination. As the financial ratios highlight a significant change in key areas of an organization from one year to the next, or over a period of years, it becomes obvious that there may a problem. As in all other analyses, specific changes can often be explained by changes in the business operations. Changes in key ratios are not, in and of themselves, proof of any wrongdoing. Whenever a change in specific ratios is detected, the appropriate source accounts should be researched and examined in detail to determine whether fraud has occurred. For instance, a significant decrease in a company's current ratio may have resulted from an increase in current liabilities or a reduction in assets, both of which could be used to conceal fraud. Like the statement analysis discussed previously, the analysis of ratios is limited by its inability to detect fraud on a smaller, immaterial scale. Some of key financial ratios include:

• Current ratio
• Quick ratio
• Receivable turnover
• Collection ratio
• Inventory turnover
• Average number of days inventory is in stock
• Debt-to-equity ratio
• Profit margin
• Asset turnover

There are many other kinds of financial ratios that are analyzed in industry-specific situations, but the nine listed previously are ratios that may lead to discovery of fraud.

The following calculations are based on the sample financial statements presented earlier:

Interpretation of Financial Ratios

The current ratio—current assets divided by current liabilities—is probably the most-used ratio in financial statement analysis. This comparison measures a company's ability to meet present obligations from its liquid assets. The number of times that current assets exceed current liabilities has long been a quick measure of financial strength.

In detecting fraud, this ratio can be a prime indicator of manipulation of accounts. Embezzlement will cause the ratio to decrease. Liability concealment will cause a more favorable ratio.

In the case example, the drastic change in the current ratio from year 1 (2.84) to year 2 (1.70) should cause an examiner to look at these accounts in more detail. For instance, a billing scheme will usually result in a decrease in current assets—cash—that will in turn decrease the ratio.

The quick ratio, often referred to as the acid-test ratio, compares assets that can be immediately liquidated. In this calculation, the total of cash, securities, and receivables is divided by current liabilities. This ratio is a measure of a company's ability to meet sudden cash requirements. In turbulent economic times, it is used more prevalently, giving the analyst a worst-case look at the company's working capital situation.

An examiner will analyze this ratio for fraud indicators. In year 1 of the example, the company balance sheet reflects a quick ratio of 2.05. This ratio drops in year 2 to 1.00. In this situation, a fraud affecting the quick ratio might be fictitious accounts receivable that have been added to inflate sales in one year. The ratio calculation will be abnormally high, and there will not be an offsetting current liability.

Receivable turnover is defined as net sales divided by average net receivables. It measures the number of times accounts receivable is turned over during the accounting period. In other words, it measures the time between on-account sales and collection of funds. This ratio is one that uses both income statement and balance sheet accounts in its analysis. If the fraud involves fictitious sales, this bogus income will never be collected. As a result, the turnover of receivables will decrease.

Accounts receivable aging is measured by the collection ratio. This ratio divides 365 days by the receivable turnover ratio to arrive at the average number of days to collect receivables. In general, the lower the collection ratio, the faster receivables are collected. A fraud examiner may use this ratio as a first step in detecting fictitious receivables or larceny and skimming schemes. Normally, this ratio will stay fairly consistent from year to year, but changes in billing policies or collection efforts may cause a fluctuation. The example shows a favorable reduction in the collection ratio from 226.3 in year 1 to 170.33 in year 2. This means that the company is collecting its receivables more quickly in year 2 than in year 1.

The relationship between a company's cost of goods sold and average inventory is shown through the inventory turnover ratio. This ratio measures the number of times inventory is sold during the period and is a good determinant of purchasing, production, and sales efficiency. In general, a higher inventory turnover ratio is considered more favorable. For example, if cost of goods sold has increased due to theft of inventory (ending inventory has declined, but not through sales), then this ratio will be abnormally high. In the case example, inventory turnover increases in year 2, signaling the possibility that an embezzlement is buried in the inventory account. An examiner should look at the changes in the components of the ratio to determine a direction in which to discover possible fraud.

The ratio of the average number of days inventory is in stock is a restatement of the inventory turnover ratio, expressed in days. This rate is important for several reasons. An increase in the number of days that inventory stays in stock causes additional expenses, including storage costs, risk of inventory obsolescence, and market price reductions, as well as interest and other expenses incurred due to tying up funds in inventory stock. Inconsistency or significant variance in this ratio is a red flag for fraud investigators. Examiners may use this ratio to examine inventory accounts for possible larceny schemes. Purchasing and receiving inventory schemes can also affect the ratio, and false debits to cost of goods sold will result in an increase in the ratio. Significant changes in the inventory turnover ratio are good indicators of possible fraudulent inventory activity.

The debt-to-equity ratio is computed by dividing total liabilities by total equity. This ratio is one that is heavily considered by lending institutions. It provides a clear picture of the comparison between the long-term and short-term debt of the company and the owner's financial injection plus earnings-to-date. This balance of resources provided by creditors and what the owners provide is crucial when analyzing the financial status of a company. Debt-to-equity requirements are often included as borrowing covenants in corporate lending agreements. The example displays a year 1 ratio of 0.89 and a year 2 ratio of 1.83. The increase in the ratio corresponds with the rise in accounts payable. Sudden changes in this ratio may signal an examiner to look for fraud.

Profit margin ratio is defined as net income divided by net sales. This ratio is often referred to as the efficiency ratio because it reveals profits earned per dollar of sales. The ratio of net income to sales relates not only to the effects of gross margin changes, but also charges to sales and administrative expenses. As fraud is committed, artificially inflated sales will not have a corresponding increase to cost of goods sold, net income will be overstated, and the profit margin ratio will be abnormally high. False expenses and fraudulent disbursements will cause an increase in expenses and a decrease in the profit margin ratio. Over time, this ratio should be fairly consistent.

Net sales divided by average operating assets is the calculation used to determine the asset turnover ratio. This ratio is used to determine the efficiency with which asset resources are utilized. The case example reflects a greater use of assets in year 2 than in year 1.

DETERRENCE OF FINANCIAL STATEMENT FRAUD

Deterring financial statement fraud is more complex than deterring asset misappropriation and other frauds. Adding traditional internal controls is unlikely to be effective. As we saw earlier, the COSO study indicated that either the CEO or the CFO was involved in 89 percent of the financial statement frauds studied. People at this high level can use their authority to override most internal controls, so those controls will often be of limited value in preventing financial statement fraud. A different approach is needed.

Following the principles of the fraud triangle, introduced in Chapter 1, a general approach to reducing financial statement fraud is to:

• 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 that 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
• Divide important functions among employees, separating total control of one area
• 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
• 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; dishonest acts by management, even if they are directed at someone outside the organization, create a dishonest environment that can spread to other business activities and other employees, internal and external
• The consequences of violating the rules, and the punishment of violators, should be clearly communicated

SUMMARY

Financial statement fraud has become daily press, challenging the corporate governance and accountability of public companies as well as the professional responsibility and integrity of these companies' boards of directors, senior executives, and auditors. Financial statement fraud is defined as the deliberate misstatement or omission of amounts or disclosures to deceive financial statement users, particularly investors and creditors.

There are a variety of financial statement fraud schemes. The first is fictitious revenues, which includes using fictitious sales involving fake, phantom, and legitimate customers, and inflating or altering invoices for legitimate customers to increase assets and annual revenue. The motivation to commit this fraud comes from pressures that are placed on owners by bankers, stockholders, their families, and communities for the companies to succeed. Pressure also comes from departmental budget requirements, especially income and profit goals.

The second category is timing differences. These methods include not matching revenues with expenses, early revenue recognition, and recording expenses in the wrong period.

The third category is concealed liabilities and expenses. The three common methods for concealing liabilities and expenses are (1) liability/expense omissions, (2) capitalizing expenses, and (3) failure to disclose warranty costs and liabilities. Since pretax income will increase by the full amount of the expense or liability not recorded, this fraud method can have a significant impact on reported earnings.

The fourth category is improper disclosures. This includes liability omission, significant events, management fraud, related-party transactions, and accounting changes.

The fifth category is improper asset valuation. The company's fraudulent overstatement of inventory or accounts receivable, booking fictitious assets, misrepresenting asset value, or mis-classifying assets may cause inflation of the current ratio at the expense of long-term assets.

This chapter examines the incentives and opportunities to commit financial statement fraud and the rationalization and consequences of engaging in this type of fraud. It also presents financial statement fraud detection and deterrence recommendations, including the responsibilities of management, internal auditors, and external auditors as specified in AU 240. Detection and deterrence of financial statement fraud is the responsibility of all corporate governance participants as well as those involved with the financial statements' supply chain, including the board of directors, the audit committee, management, internal auditors, and external auditors.

ESSENTIAL TERMS

Financial statement fraud Intentional misstatements or omissions of amounts or disclosures of financial statements to deceive investors, creditors, and other users of financial statements.

Fictitious revenue Recording of sales of goods or services that never occurred.

Liability/expense omissions Deliberate attempts to conceal liabilities and expenses already incurred.

Capitalized expenses When expenditures are capitalized as assets and not expensed off during the current period, income will be overstated. As the assets are depreciated, income in subsequent periods will be understated.

Related-party transactions Transactions that occur when a company does business with another entity whose management or operating policies can be controlled or significantly influenced by the company or by some other party in common. There is nothing inherently wrong with related-party transactions, so long as they are fully disclosed.

Improper asset valuation Generally accepted accounting principles require that most assets be recorded at their historical (acquisition) cost with some exceptions. This type of fraud usually involves the fraudulent overstatement of inventory or receivables or the misclassification of fixed assets.

Horizontal analysis A technique for analyzing the percentage change in individual financial statement items from one year to the next.

Vertical analysis The expression of the relationship or percentage of component part items to a specific base item.

Ratio analysis A means of measuring the relationship between two different financial statement amounts.

REVIEW QUESTIONS

12-1 (Learning objective 12-1) What is financial statement fraud?

12-2 (Learning objective 12-2) List five different ways in which financial statement fraud can be committed.

12-3 (Learning objective 12-3) What are the two methods of engaging in fictitious revenues?

12-4 (Learning objective 12-3) What are the two most common pressures and motivations for committing financial statement fraud?

12-5 (Learning objective 12-4) List three methods of engaging in timing differences.

12-6 (Learning objective 12-4) What is the motivation for violating the generally accepted accounting principle of matching revenues with expenses? What is the result of committing this fraud?

12-7 (Learning objective 12-4) What is the motivation for early revenue recognition? What is the result of engaging in this type of fraud?

12-8 (Learning objective 12-5) List the three common methods for concealing liabilities and expenses.

12-9 (Learning objective 12-5) What is the motivation for concealing liabilities and expenses?

12-10 (Learning objective 12-6) List five common categories of improper disclosures.

12-11 (Learning objective 12-7) What are the four common forms of improper asset valuation?

12-12 (Learning objective 12-7) What is the likely result of committing an improper asset valuation?

12-13 (Learning objective 12-8) What is the difference between fraudulent financial reporting and misappropriation of assets?

12-14 (Learning objective 12-9) Describe three analytical techniques for financial statement analysis.

DISCUSSION ISSUES

12-1 (Learning objective 12-3) What is the most effective way to prevent fictitious revenue from being fraudulently reported in the financial statements?

12-2 (Learning objective 12-3) How can fictitious revenue be created through the use of false sales to shell companies? Discuss the method and result of committing this fraud.

12-3 (Learning objective 12-4) How might a company use timing differences to boost revenues for the current year? Discuss and analyze the method and result of committing the fraud.

12-4 (Learning objective 12-4) In the case study, “The Importance of Timing,” what kind of fraud did the accountant commit? How could this fraud have been discovered?

12-5 (Learning objective 12-5) Liability/expense omission is the preferred and easiest method of concealing liabilities/expenses. Why? Discuss how to detect this type of fraud.

12-6 (Learning objective 12-7) What internal control activities and related test procedures can detect or deter overstated inventory?

12-7 (Learning objective 12-9) What financial reporting analysis techniques can help to detect fraudulent financial statement schemes?

12-8 (Learning objectives 12-3, 12-5, and 12-7) In the case study “That Way Lies Madness,” what kind of fraud did Eddie Antar commit? How was the fraud committed? How could such fraud be discovered?

12-9 (Learning objective 12-10) During the audit of financial statements, an auditor discovers that financial statements might be materially misstated due to the existence of fraud. Describe (1) the auditor's responsibility according to AU 240 for discovering financial statement fraud, (2) what the auditor should do if he is precluded from applying necessary audit procedures to discover the suspected fraud, and (3) what the auditor should do if he finds that the fraud materially affects the integrity of the financial statements.