CFE Exam Quiz 57

The material in the Financial Transactions section is divided into three principal topic areas. First, general accounting concepts are illustrated, including the basics of debits and credits, as well as the contents of financial statements. Second, employee defalcation schemes are detailed. This section includes discussion on fraudulent financial statement schemes, asset misappropriation schemes, and bribery and corruption.

Note that Examples of assets include cash, receivables, inventory, property, and equipment, as well as intangible items of value such as patents, licenses, and trademarks.

Note that, Liabilities are the obligations of an entity or outsider’s claims against a company’s assets. Liabilities usually arise from the acquisition of assets or the incurrence of operational expenses. Examples of liabilities include accounts payable, notes payable, interest payable, and long-term debt.

There are two primary methods of accounting: cash-basis and accrual-basis. Cash-basis accounting involves recording revenues and expenses based on when a company pays or receives cash. For example, sales are recorded when a company receives payment for goods, regardless of when the goods are delivered. If a customer purchases goods on credit, the company does not book the sale until the cash is received for the sale. Likewise, if a customer prepays for a sale, the company records the sales revenue immediately rather than when the goods are passed off to the customer. The same holds true with expenses: They are recorded when paid, without consideration to when they are incurred.

The following is a list of typical financial statements:
1. Statement of financial position (“balance sheet”).
2. Statement of profit or loss and other comprehensive income for the period (“income statement”).
3. Statement of changes in owners’ equity or statement of retained earnings.
4. Statement of cash flows.

Financial statements might also include other financial data presentations, such as:
1. Statement of assets and liabilities that do not include owners’ equity accounts.
2. Statement of revenue and expenses.
3. Summary of operations.
4. Statement of operations by product lines.
5. Statement of cash receipts and disbursements.
6. Prospective financial information (forecasts).
7. Proxy statements.
8. Interim financial information (for example, quarterly financial statements).
9. Current value financial presentations.
10. Personal financial statements (current or present value).
11. Bankruptcy financial statements.

Note that, The balance sheet, or statement of financial position, shows a “snapshot” of a company’s financial situation at a specific point in time, generally the last day of the accounting period. The balance sheet is an expansion of the accounting equation, assets = liabilities + owners’ equity.
That is, it lists a company’s assets on one side and its liabilities and owners’ equity on the other side. The nature of the accounting equation means that the two sides of the statement should balance.

The following is a list of typical financial statements:
1. Statement of financial position (“balance sheet”)
2. Statement of profit or loss and other comprehensive income for the period (“income statement”)
3. Statement of changes in owners’ equity or statement of retained earnings
4. Statement of cash flows

Assets are the resources owned by a company. Generally, assets are presented on the balance sheet in order of liquidity, or how soon they are expected to be converted to cash. The first section on the assets side, current assets, includes all those assets that are expected to be converted to cash, sold, or used up within one year. Liabilities are presented in order of maturity. Like current assets, current liabilities are those obligations that are expected to be paid within one year, such as accounts payable.

Note that the statement of cash flows reports a company’s sources and uses of cash during the accounting period. This statement is often used by potential investors and other interested parties in tandem with the income statement to determine a company’s true financial performance during the period being reported.

Cash inflows from investing activities usually arise from the sale of fixed assets (e.g., property and equipment), investments (e.g., the stocks and bonds of other companies), or intangible assets (e.g., patents and trademarks). Similarly, cash outflows from investing activities include any cash paid for the purchase of fixed assets, investments, or intangible assets.

Financial statement fraud schemes are most often perpetrated by management against potential users of the statements. Financial statement users include company ownership and management, lending organizations, investors, regulatory agencies, vendors, and customers. The production of truthful financial statements plays an important role in an organization’s continued success. However, fraudulent statements can be used for a number of reasons. The most common use is to increase an organization’s apparent success in the eyes of potential and current investors. (For more information, see the chapter on “Financial Statement Fraud” in this section of the Fraud Examiners Manual.)

The International Financial Reporting Standards (IFRS) Foundation was formed in 2001 with the goal of developing “a single set of high quality, understandable, enforceable, and globally accepted [reporting standards] through its standard-setting body, the International Accounting Standards Board (IASB).” For each accounting function, the IASB looks for the most appropriate principle for how transactions should be accounted for, or the most a suitable method of reporting the results. More than 120 countries permit or require IFRS for domestic reporting and about 90 of those have fully conformed to IFRS as publicized by the IASB and include a statement acknowledging such conformity in their audit reports.

Verifiability helps assure users that information is accurate and faithfully represents the financial position of the entity. Verifiability means that different knowledgeable and independent observers could reach consensus, although not necessarily complete agreement, that a particular depiction is a faithful representation.

Note that,
Classifying, characterizing, and presenting information clearly and concisely makes it understandable. However, some economic data are fundamentally complex. Therefore, enough information should be provided about such events so that a reasonable financial-statement user can understand what took place. An entity’s financial statements should include all information necessary for users to make valid decisions and must not mislead them.

THE PROBABILITY OF FUTURE ECONOMIC BENEFIT The concept of probability is used in the recognition criteria to refer to the degree of uncertainty that the future economic benefits associated with the item will flow to or from the entity. The concept is in keeping with the uncertainty that characterizes the environment in which an entity operates. Assessments of the degree of uncertainty attaching to the flow of future economic benefits are made on the basis of the evidence available when the financial statements are prepared.

An asset is recognized in the balance sheet when it is probable that the future economic benefits will flow to the entity and the asset has a cost or value that can be measured reliably.

Note that A liability is recognized in the balance sheet when it is probable that an outflow of resources embodying economic benefits will result from the settlement of a present obligation and the amount at which the settlement will take place can be measured reliably

Note that, Income is recognized in the income statement when an increase in future economic benefit related to an increase in an asset or a decrease of a liability has arisen that can be measured reliably. This means, in effect, that recognition of income occurs simultaneously with the recognition of increases in assets or decreases in liabilities (for example, the net increase in assets arising on a sale of goods or services or the decrease in liabilities arising from the waiver of a debt payable).

Note that, In general, revenue is recognized or recorded when it becomes realized or realizable, and earned. According to accrual accounting, revenue should not be recognized for work that is to be performed in subsequent accounting periods, even though the work might currently be under contract. In general, revenue should be recognized in the period in which the work is performed.

Note that, Expenses are recognized in the income statement when a decrease in future economic benefit related to a decrease in an asset or an increase of a liability has arisen that can be measured reliably. This means, in effect, that recognition of expenses occurs simultaneously with the recognition of an increase in liabilities or a decrease in assets (for example, the accrual of employee entitlements or the depreciation of equipment) Expenses are recognized in the income statement on the basis of a direct association between the costs incurred and the earning of specific items of income. This process, commonly referred to as the matching principle, involves the simultaneous or combined recognition of revenues.

A number of different measurement bases are employed to different degrees and in varying combinations in financial statements. They include the following:
1) Historical cost—Assets are recorded at the amount of cash or cash equivalents paid or the fair value of the consideration given to acquire them at the time of their acquisition. Liabilities are recorded at the number of proceeds received in exchange for the obligation, or in some circumstances (for example, income taxes), at the amounts of cash or cash equivalents expected to be paid to satisfy the liability in the normal course of business.
2) Current cost—Assets are carried at the amount of cash or cash equivalents that would have to be paid if the same or an equivalent asset was acquired currently. Liabilities are accounting Concepts Financial Transactions 1.122 2017 Fraud Examiners Manual (International) carried at the undiscounted amount of cash or cash equivalents that would be required to settle the obligation currently.
3) Realizable (settlement) value—Assets are carried at the amount of cash or cash equivalents that could currently be obtained by selling the asset in an orderly disposal. Liabilities are carried at their settlement values; that is, the undiscounted amounts of cash or cash equivalents expected to be paid to satisfy the liabilities in the normal course of business.
4) Present value—Assets are carried at the present discounted value of the future net cash inflows that the item is expected to generate in the normal course of business. Liabilities are carried at the present discounted value of the future net cash outflows that are expected to be required to settle the liabilities in the normal course of business.

Note that, As with rules for most things, departures from GAAP are sometimes required. It was impossible for GAAP developers to anticipate all circumstances to which the principles are applied. It can be assumed that adherence to GAAP almost always results in financial statements that are fairly presented. However, the standard-setting bodies recognize that, upon occasion, there might be an unusual circumstance when the literal application of GAAP would render the financial statements misleading. In these cases, a departure from GAAP is the proper accounting treatment. However, the fact that complying with GAAP would be more expensive or would make the financial statements look weaker is not a reason to use a non-GAAP method of accounting for a transaction.

Note that, Departures from GAAP can be justified in the following circumstances:
I) It is common practice in the entity’s industry for a transaction to be reported in a particular way.
II) The substance of the transaction is better reflected (and, therefore, the financial statements are more fairly presented) by not strictly following GAAP.
III) If a transaction is considered immaterial (i.e., it would not affect a decision made by a prudent reader of the financial statements), then it need not be reported.
IV) There is a concern that assets or income would be overstated (the conservatism constraint requires that when there is any doubt, one should avoid overstating assets and income).
V) The results of departure appear reasonable under the circumstances, especially when strict adherence to GAAP would produce unreasonable results and the departure is properly disclosed.

Note that, Financial statement fraud is usually a means to an end rather than an end in itself. When people “cook the books,” they might be doing it to “buy more time” to quietly fix business problems that prevent their company from achieving its expected earnings or complying with loan covenants. Financial statement fraud almost always involves overstating assets, revenues, and profits and understating liabilities, expenses, and losses. However, sometimes the opposite result is desired. For example, understating assets or revenue might lead to a smaller tax liability for the company. Alternatively, a fraudster might wish to minimize over-budget results in a good year in order to help make up for any shortcomings during the subsequent year. Financial statements are the responsibility of the organization’s management. Accordingly, financial statement fraud is typically committed by someone in a managerial role who not only has the ability to alter the financial statements, but also has an incentive to do so.

Financial statement fraud frequently has a devastating effect on an organization’s reputation and financial position, as well as on the people involved. The stock market capitalization of companies affected by financial statement fraud might fall substantially almost overnight, losing billions of dollars for investors. Even if the balance sheet and income statement do not change substantially, a restatement is likely to damage investors’ confidence in the
reporting the ability of the company’s management and its auditors, and the company’s stock price will decrease accordingly.

The more common reasons why people commit financial statement fraud include:
1 To encourage investment through the sale of stock.
2 To demonstrate increased earnings per share or partnership profits interest, thus allowing increased dividend/distribution payouts.
3 To cover an inability to generate cash flow.
4 To avoid negative market perceptions.
5 To obtain financing, or to obtain more favorable terms on existing financing.
6 To receive higher purchase prices for acquisitions.
7 To demonstrate compliance with financing covenants.
8 To meet company goals and objectives.
9 To receive performance-related bonuses.

Examples of situational pressures include:
1 Sudden decreases in revenue or market share experienced by a company or an industry
2 Unrealistic budget pressures, particularly for short-term results (the pressures become even greater with arbitrarily established budgets that are without reference to current conditions)
3 Financial pressures resulting from bonus plans that depend on short-term economic performance (these pressures are particularly acute if the bonus is a significant component of the individual’s total compensation)

Some of the more obvious opportunities for the existence of fraud are:
1. Absence of a board of directors or audit committee
2. Improper oversight or other neglectful behavior by the board of directors or audit committee
3. Weak or nonexistent internal controls, including an ineffective internal audit staff and a lack of external audits
4. Unusual or complex transactions (an understanding of the transactions, their component parts, and their effect on financial statements is paramount to fraud deterrence)
5. Financial estimates that require significant subjective judgment by management

The following areas reflect their financial statement classifications, keep in mind that the other
side of the fraudulent transaction exists elsewhere. The five classifications of financial
statement schemes are:
I) Fictitious revenues
II) Timing differences (including improper revenue recognition)
III) Improper asset valuations
IV) Concealed liabilities and expenses
V) Improper disclosures