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Chapter 12

Chapter 12. Fraudulent Financial Statement Schemes. What is Financial Statement Fraud ?. Deliberate misstatements or omissions of amounts or disclosures of financial statements to deceive financial statement users, particularly investors and creditors. Costs of Financial Statement Fraud.

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Chapter 12

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  1. Chapter 12 Fraudulent Financial Statement Schemes

  2. What is Financial Statement Fraud ? • Deliberate misstatements or omissions of amounts or disclosures of financial statements to deceive financial statement users, particularly investors and creditors.

  3. Costs of Financial Statement Fraud • More than 50% of U.S. corporations are victims of fraud with losses of more than $500,000 (Albrecht & Searcy 2001) • Enron lost about $70 billion in market capitalization to investors, employees, and pensioners • Enron, WorldCom, Quest,Global Crossing, and Tyco’s loss to shareholders was $460 billion (Cotton 2002) • Other fraud costs are legal costs, increased insurance costs, loss of productivity, adverse impacts on employee morale, customers’ goodwill, suppliers’ trust, and negative stock market reactions

  4. Costs of Financial Statement Fraud • Undermines • Jeopardizes • Diminishes the confidence • Capital markets • Economic growth and prosperity • litigation • Destroys careers • bankruptcy

  5. Methods of Financial Statement Fraud • Fictitious revenues • Timing differences • Improper asset valuations • Concealed liabilities and expenses • Improper disclosures

  6. Fictitious Revenues • Recording of goods or services that did not occur • Fake or phantom customers • Legitimate customers • Sales with conditions • Pressures to boost revenues

  7. Red Flags – Fictitious Revenues • Rapid growth • negative cash flows • Significant transactions

  8. Red Flags – Fictitious Revenues • unusual transactions, • number of days’ sales in receivables • sales to unknown entities • An unusual surge

  9. Timing Differences • Recording revenue and/or expenses • Shifts revenues or expenses

  10. Timing Differences • Matching • Premature • Long-term contracts • Channel stuffing • wrong period

  11. Red Flags – Timing Differences • Rapid growth or unusual profitability • negative cash flows • Significant complex transactions • Unusual increase in gross margin • number of days’ sales in receivables • number of days’ purchases in accounts payable

  12. Concealed Liabilities • Liability/expense omissions • Capitalized expenses • Failure to disclose warranty costs and liabilities

  13. Red Flags – Concealed Liabilities • negative cash flows from operations • significant estimates • Nonfinancial management’s excessive participation

  14. Red Flags – Concealed Liabilities • Unusual increase in gross margin • Allowances • number of days’ purchases in accounts payable • Reducing accounts payable

  15. Improper Disclosures • Liability omissions • Subsequent events • Management fraud • Related-party transactions • Accounting changes

  16. Red Flags – Improper Disclosures • Domination of management • Ineffective board of directors or audit committee Ineffective communication • Rapid growth or unusual profitability

  17. Red Flags – Improper Disclosures • Significant, transactions • related-party transactions • tax haven jurisdictions • Overly complex organizational structure • history • Recurring attempts by management to justify • Formal or informal restrictions on the auditor

  18. Improper Asset Valuation • Inventory valuation • Accounts receivable • Business combinations • Fixed assets

  19. Red Flags – Improper Asset Valuation • negative cash flows • industry or overall economy • estimates • Nonfinancial management’s excessive participation • industry peers

  20. Red Flags – Improper Asset Valuation • number of days’ sales in receivables • number of days’ purchases in inventory • Shrinking allowances • changes in the relationship between fixed assets and depreciation • competitors

  21. Detection of Fraudulent Financial Statement Schemes • SAS 99 – Consideration of Fraud in a Financial Statement Audit • “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.”

  22. SAS 96 – Audit Documentation • Contains a list of factors that the auditor should consider in determining the nature and extent of the documentation for a particular audit area

  23. Financial Statement Analysis • Vertical analysis • Horizontal analysis • Ratio analysis

  24. Deterrence of Financial Statement Fraud • Reduce pressures to commit financial statement fraud • Reduce the opportunity to commit financial statement fraud • Reduce rationalization of financial statement fraud

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