HOW TO DETECT AND PREVENT FINANCIAL STATEMENT FRAUD
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HOW TO DETECT AND PREVENT FINANCIAL STATEMENT FRAUD TABLE OF CONTENTS I. INTRODUCTION Trends in Financial Statement Fraud ..................................................................................................................... 1 The COSO Study on Financial Statement Fraud .......................................................................................... 2 About This Course ................................................................................................................................................... 3 Course Overview................................................................................................................................................ 3 Video Supplement.............................................................................................................................................. 4 Practical Problems CD-ROM .......................................................................................................................... 4 Review Questions and Final Examination ..................................................................................................... 4 II. FINANCIAL STATEMENT FRAUD OVERVIEW Financial Statement Fraud Defined ....................................................................................................................... 7 Management’s Role................................................................................................................................................... 7 The Victims of Financial Statement Fraud ........................................................................................................... 7 Financial Statement Fraud Triangle ....................................................................................................................... 8 Pressures to Commit Financial Statement Fraud .......................................................................................... 8 Video .................................................................................................................................................................... 9 Opportunity for Financial Statement Fraud ................................................................................................10 Rationalizations for Financial Statement Fraud...........................................................................................10 Financial Statement Fraud Red Flags...................................................................................................................11 Introduction to Financial Statement Fraud Schemes and Examinations .......................................................12 Review Questions ...................................................................................................................................................13 III. EXAMINING FOR FINANCIAL STATEMENT FRAUD The Role of the Certified Fraud Examiner .........................................................................................................15 Fraud Examination Methodology ........................................................................................................................15 Predication ........................................................................................................................................................16 Fraud Theory Approach .................................................................................................................................16 Financial Statement Fraud Examination Techniques ........................................................................................19 Document Examination ..................................................................................................................................20 Interviewing Witnesses and Conspirators ....................................................................................................21 Auditing Procedures ........................................................................................................................................23 Review Questions ...................................................................................................................................................26 IV. FRAUD PREVENTION AND DETECTION RESPONSIBILITIES Prevention of Financial Statement Fraud ............................................................................................................29 Reducing Fraud Risk........................................................................................................................................30 Detection of Financial Statement Fraud .............................................................................................................35 The Tone at the Top .......................................................................................................................................35 Video ..................................................................................................................................................................36 Internal Audit Function ..................................................................................................................................36 Independent Audit Committee ......................................................................................................................37 External Auditors .............................................................................................................................................38 The Ethical Environment for Fraud Prevention and Detection .....................................................................40 The COSO Reports .........................................................................................................................................40 Video ..................................................................................................................................................................42
How to Detect and Prevent Financial Statement Fraud
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HOW TO DETECT AND PREVENT FINANCIAL STATEMENT FRAUD IV. FRAUD PREVENTION AND DETECTION RESPONSIBILITIES (CONT.) The Legal Environment for Fraud Prevention and Detection ........................................................................46 The Sarbanes-Oxley Act .................................................................................................................................46 Securities and Exchange Commission ..........................................................................................................59 Private Securities Litigation Reform Act of 1995........................................................................................60 External Auditors’ Responsibilities for Prevention and Detection of Financial Statement Fraud .............61 AU Section 240 ................................................................................................................................................62 PCAOB Auditing Standard No. 5 .................................................................................................................72 Statement of Standards for Attestation Engagements No. 15 ..................................................................75 Risk-Based Audit Approach ...........................................................................................................................75 PCAOB Auditing Standard No. 3 .................................................................................................................76 AU Section 230 ................................................................................................................................................77 Internal Auditors’ Responsibilities for Prevention and Detection of Financial Statement Fraud ..............78 Standard 1210—Proficiency ...............................................................................................................................78 Standard 1220—Due Professional Care.............................................................................................................79 Standard 2060—Reporting to Senior Management and the Board ......................................................................79 Standard 2110—Governance .............................................................................................................................80 Standard 2120—Risk Management...................................................................................................................80 Standard 2130—Control ...................................................................................................................................80 Standard 2210—Engagement Objectives ............................................................................................................81 The IIA’s IPPF—Practice Guide: Internal Auditing and Fraud ........................................................................81 Review Questions ...................................................................................................................................................84 V. ACCOUNTING BASICS Introduction .............................................................................................................................................................89 Accounting as a Language .....................................................................................................................................89 The Development of the Language...............................................................................................................89 The Concept of Debits and Credits ..............................................................................................................90 Accounting Methods ..............................................................................................................................................91 Accounting Principles ............................................................................................................................................92 Definition ..........................................................................................................................................................93 Underlying Principles of U.S. GAAP............................................................................................................93 Financial Statements Explained ............................................................................................................................94 The Balance Sheet ............................................................................................................................................95 The Income Statement ................................................................................................................................. 101 The Cash Flow Statement ............................................................................................................................ 106 The Statement of Retained Earnings ......................................................................................................... 111 Notes to the Financial Statements and Management’s Discussion ....................................................... 113 Video ............................................................................................................................................................... 114 Using Financial Statements to Get the Full Picture ................................................................................. 114 Review Questions ................................................................................................................................................ 116 VI. GENERAL TECHNIQUES FOR FINANCIAL STATEMENT ANALYSIS Financial Statement Analysis .............................................................................................................................. 119 Comparative Techniques ............................................................................................................................. 120 Financial Relationships ................................................................................................................................. 121 Unexpected Relationships............................................................................................................................ 122 Analytical Procedures .......................................................................................................................................... 122
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How to Detect and Prevent Financial Statement Fraud
HOW TO DETECT AND PREVENT FINANCIAL STATEMENT FRAUD VI. GENERAL TECHNIQUES FOR FINANCIAL STATEMENT ANALYSIS (CONT.) Percentage Analysis—Vertical and Horizontal......................................................................................... 123 Financial Ratio Analysis ............................................................................................................................... 125 Cash Flow Analysis ....................................................................................................................................... 129 Video ............................................................................................................................................................... 133 Data Analytics ...................................................................................................................................................... 133 Textual Analytics ........................................................................................................................................... 135 Visual Analytics ............................................................................................................................................. 135 Review Questions ................................................................................................................................................ 137 VII. SCHEMES AND SCENARIOS: AN INTRODUCTION Financial Statement Fraud Schemes.................................................................................................................. 139 Video ............................................................................................................................................................... 143 Methods of Detection ......................................................................................................................................... 143 VIII. FICTITIOUS REVENUE Fabricating Revenue ............................................................................................................................................ 149 Detecting Fabricated Revenues................................................................................................................... 150 Improper Recording of Sales Returns, Allowances, and Discounts ............................................................ 155 Sales Returns and Allowances ..................................................................................................................... 155 Sales Discounts .............................................................................................................................................. 156 Detecting Improper Recording of Sales Returns and Allowances and Discounts .............................. 156 Improper Recording of Sales with Conditions ................................................................................................ 157 Conditional Sales ........................................................................................................................................... 157 Consignment Sales ........................................................................................................................................ 158 Detecting Sales with Conditions ................................................................................................................. 158 Review Questions ................................................................................................................................................ 160 IX. TIMING DIFFERENCES Revenue Recognition Schemes .......................................................................................................................... 164 Recording Revenue When Goods or Services Are Still Due.................................................................. 165 Shipping Merchandise Before the Sale Is Finalized ................................................................................. 165 Holding the Books Open ............................................................................................................................. 166 Long-Term Contracts ................................................................................................................................... 166 Multiple Deliverables .................................................................................................................................... 167 Channel Stuffing............................................................................................................................................ 167 Detecting Premature Revenue Recognition .............................................................................................. 168 Recording Expenses in the Wrong Period ....................................................................................................... 170 Delayed Expense Recognition .................................................................................................................... 170 Premature Expense Recognition ................................................................................................................ 174 Video ............................................................................................................................................................... 176 Review Questions ................................................................................................................................................ 177 X. CONCEALED LIABILITIES AND EXPENSES Video ............................................................................................................................................................... 179 Failure to Record Liabilities or Expenses......................................................................................................... 179 Omitting Liabilities or Expenses ................................................................................................................ 180 Reporting Revenue Rather Than a Liability When Cash Is Received ................................................... 182
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HOW TO DETECT AND PREVENT FINANCIAL STATEMENT FRAUD X. CONCEALED LIABILITIES AND EXPENSES (CONT.) Omission of Contingent Liabilities for Warranties, Products, or Environmental Impacts ...................... 183 Failure to Record Contingencies................................................................................................................. 183 Omission of Warranty Liabilities ................................................................................................................ 184 Omission of Product Liabilities .................................................................................................................. 185 Omission of Environmental Liabilities ...................................................................................................... 185 Using Off-Balance Sheet Entities to Conceal Expenses and Liabilities ...................................................... 187 Detecting Improper Off-Balance Sheet Accounting Arrangements ..................................................... 189 Review Questions ................................................................................................................................................ 190 XI. IMPROPER DISCLOSURES Sarbanes-Oxley Required Disclosures .............................................................................................................. 193 Pro Forma Financial Information .............................................................................................................. 194 Disclosures in Periodic Reports .................................................................................................................. 194 Transactions Involving Management and Principal Stockholders......................................................... 194 Management Assessment of Internal Controls ........................................................................................ 194 Codes of Ethics for Senior Financial Officers.......................................................................................... 194 Audit Committee Financial Expert ............................................................................................................ 195 Real-Time Disclosures.................................................................................................................................. 195 Detecting Improper Sarbanes-Oxley Disclosures .................................................................................... 195 Accounting Methods and Changes ................................................................................................................... 195 Pensions, Compensation, and Other Benefits Disclosures .................................................................... 196 Backdating Stock Options ........................................................................................................................... 196 Detecting Improper Disclosure of Accounting Methods and Changes ............................................... 198 Liability-Related Disclosures .............................................................................................................................. 199 Loan Covenant and Default Omissions .................................................................................................... 199 Contingency and Commitment Omission ................................................................................................. 200 Significant Events ................................................................................................................................................ 200 Detecting Undisclosed Significant Events ................................................................................................ 201 Prior Management Fraud .................................................................................................................................... 201 Detecting Undisclosed Prior Management Fraud .................................................................................... 202 Related-Party Transactions ................................................................................................................................. 202 Detecting Undisclosed Related-Party Transactions ................................................................................. 203 Video ............................................................................................................................................................... 203 Review Questions ................................................................................................................................................ 204 XII. IMPROPER ASSET VALUATION Video ............................................................................................................................................................... 207 Inventory Valuation ............................................................................................................................................. 207 Improper Estimates for Obsolete or Slow-Moving Goods.................................................................... 208 Fictitious Inventory and the Manipulation of Count Sheets .................................................................. 209 Failure to Record the Purchase of Inventory............................................................................................ 211 Improper Inventory Capitalization ............................................................................................................. 212 Accounts Receivable............................................................................................................................................ 213 Fictitious Accounts Receivable ................................................................................................................... 213 Failure to Write Down Accounts Receivable for Bad Debts ................................................................. 215 Fixed and Intangible Assets................................................................................................................................ 218 Booking Fictitious Long-Term Assets ....................................................................................................... 219
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How to Detect and Prevent Financial Statement Fraud
HOW TO DETECT AND PREVENT FINANCIAL STATEMENT FRAUD XII. IMPROPER ASSET VALUATION (CONT.) Misrepresenting Asset Value ....................................................................................................................... 219 Improper Capitalization ............................................................................................................................... 221 Misclassification of Assets ........................................................................................................................... 221 Business Combinations ....................................................................................................................................... 222 Improper Valuation of Goodwill................................................................................................................ 222 Inflating Value of Assets to Provide Cheap Capital for Takeovers ....................................................... 223 Assets Related to Pensions and Other Post-Retirement Benefits ................................................................ 224 Detecting Improper Accounting for Pensions and Post-Retirement Benefits .................................... 226 Review Questions ................................................................................................................................................ 227 XIII. THE CRAZY EDDIE FRAUD Video ............................................................................................................................................................... 231 Under-Reporting Income—Skimming ............................................................................................................. 231 Video ............................................................................................................................................................... 237 Fictitious Revenues .............................................................................................................................................. 237 The Panama Pump........................................................................................................................................ 238 The Zazy Check Scheme.............................................................................................................................. 238 The Falsification of Warranty Claims ........................................................................................................ 240 Video ............................................................................................................................................................... 240 Concealed Liabilities Fraud ................................................................................................................................ 240 The Use of Fraudulent Post-Dated Invoices to Understate Accounts Payable .................................. 240 The Phony Debit Memo Scheme ............................................................................................................... 241 The “Reeps” Return Scheme....................................................................................................................... 243 Video ............................................................................................................................................................... 243 Inventory Fraud Schemes ................................................................................................................................... 243 Fraudulent Inventory Inflation Schemes ................................................................................................... 243 Notes to the Financial Statements .............................................................................................................. 244 The Fraudulent Inflation of Inventory with Borrowed Merchandise ................................................... 245 Video ............................................................................................................................................................... 245 Disclosure of False and Fraudulent Financial Information to the Public ................................................... 245 Concealment of the Fraudulent Schemes......................................................................................................... 245 Comparative Techniques .................................................................................................................................... 246 Analytical Techniques.......................................................................................................................................... 246 Horizontal Analysis....................................................................................................................................... 247 Vertical Analysis ............................................................................................................................................ 249 Key Ratio Analysis ........................................................................................................................................ 251 Selling-Off Stock .................................................................................................................................................. 252 Red Flags ............................................................................................................................................................... 253 The End of the Story........................................................................................................................................... 254 XIV. THE SICK CASE OF HEALTHSOUTH’S ACCOUNTING FRAUDS The Rise and Fall ................................................................................................................................................. 257 Cooking the Books .............................................................................................................................................. 257 Video ............................................................................................................................................................... 258 Fictitious Revenues and Overvalued Assets ............................................................................................. 258 Video ............................................................................................................................................................... 259 Notes to the Financial Statements .............................................................................................................. 260
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HOW TO DETECT AND PREVENT FINANCIAL STATEMENT FRAUD XIV. THE SICK CASE OF HEALTHSOUTH’S ACCOUNTING FRAUDS (CONT.) Fooling the Experts ............................................................................................................................................. 261 Waving the Red Flag ........................................................................................................................................... 262 Analytical Techniques.......................................................................................................................................... 263 Horizontal Analysis....................................................................................................................................... 263 Vertical Analysis ............................................................................................................................................ 265 Ratio Analysis ................................................................................................................................................ 267 Financial Statement Analysis ....................................................................................................................... 267 Warning Signs ....................................................................................................................................................... 268 The End of the Story........................................................................................................................................... 268 XV. CONCLUSION ........................................................................................................................................ 271 XVI. PRACTICAL PROBLEMS Practical Problem 1 .............................................................................................................................................. 273 Practical Problem 2 .............................................................................................................................................. 276 Practical Problem 3 .............................................................................................................................................. 278 Practical Problem 4 .............................................................................................................................................. 283 Practical Problem 5 .............................................................................................................................................. 287 Practical Problem 6 .............................................................................................................................................. 289 Practical Problem 7 .............................................................................................................................................. 291 Practical Problem 8 .............................................................................................................................................. 293 Practical Problem 9 .............................................................................................................................................. 296 Practical Problem 10............................................................................................................................................ 299 Practical Problem 11............................................................................................................................................ 304 Practical Problem 12............................................................................................................................................ 305 Practical Problem 13............................................................................................................................................ 306 Practical Problem 14............................................................................................................................................ 308 Practical Problem 15............................................................................................................................................ 310 Practical Problem 16............................................................................................................................................ 311 Practical Problem 17............................................................................................................................................ 312 XVII. APPENDIX A: CRAZY EDDIE INC. ........................................................................................... 313 XVIII. APPENDIX B: VIDEO TRANSCRIPTS .................................................................................... 393 XIX. SOLUTIONS TO REVIEW QUESTIONS II. Financial Statement Fraud Overview .......................................................................................................... 417 III. Examining for Financial Statement Fraud ................................................................................................ 422 IV. Fraud Prevention and Detection Responsibilities .................................................................................... 425 V. Accounting Basics........................................................................................................................................... 435 VI. General Techniques for Financial Statement Analysis ............................................................................ 439 VIII. Fictitious Revenue ..................................................................................................................................... 444 IX. Timing Differences ....................................................................................................................................... 449 X. Concealed Liabilities and Expenses ............................................................................................................. 453 XI. Improper Disclosures ................................................................................................................................... 457 XII. Improper Asset Valuation .......................................................................................................................... 461
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HOW TO DETECT AND PREVENT FINANCIAL STATEMENT FRAUD XX. SOLUTIONS TO PRACTICAL PROBLEMS Practical Problem 1 .............................................................................................................................................. 467 Practical Problem 2 .............................................................................................................................................. 469 Practical Problem 3 .............................................................................................................................................. 472 Practical Problem 4 .............................................................................................................................................. 477 Practical Problem 5 .............................................................................................................................................. 480 Practical Problem 6 .............................................................................................................................................. 482 Practical Problem 7 .............................................................................................................................................. 484 Practical Problem 8 .............................................................................................................................................. 486 Practical Problem 9 .............................................................................................................................................. 488 Practical Problem 10............................................................................................................................................ 489 Practical Problem 11............................................................................................................................................ 492 Practical Problem 12............................................................................................................................................ 494 Practical Problem 13............................................................................................................................................ 495 Practical Problem 14............................................................................................................................................ 497 Practical Problem 15............................................................................................................................................ 499 Practical Problem 16............................................................................................................................................ 500 Practical Problem 17............................................................................................................................................ 501 XXI. FINAL EXAMINATION .................................................................................................................... E-1 XXII. INDEX....................................................................................................................................................... I-1
How to Detect and Prevent Financial Statement Fraud
