CFE Exam Quiz 58

Fraudulent acts are usually of a financial nature. The fraud examiner must, therefore, understand the essential nature of financial transactions and how they affect records. Additionally, the fraud examiner should have a grasp of both financial terminology and accounting theory.

Accounting can be defined as the identification, accumulation, measurement, and communication of economic data about an enterprise for decision-makers and other interested parties. The measurement and recording of this data are accomplished by keeping a balance of the accounting equation. The accounting model or accounting equation, as shown below, is the basis for all double-entry accounting:

Assets = Liabilities + Owners’ Equity

By definition, assets consist of the net resources owned by an entity. Examples of assets include cash, receivables, inventory, property, and equipment, as well as intangible items of value such as patents, licenses, and trademarks. To qualify as an asset, an item must (1) be owned by the entity and (2) provide a future benefit.

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.

Owners’ equity represents the investment of a company’s owners plus accumulated profits (revenues less expenses). Owners’ equity is equal to assets minus liabilities.

This equation has been the cornerstone of accounting since Luca Pacioli developed it in 1494. Balance is the key to this equation. If a company borrows from a bank, cash (an asset) and notes payable (a liability) increase to show the receipt of cash and an obligation owed by the company. Since both assets and liabilities increase by the same amount, the equation stays in balance.

Discovering concealment efforts through a review of accounting records is one of the easier methods of detecting internal fraud; usually, one needs only to look for weaknesses in the various steps of the accounting cycle. Legitimate transactions leave an audit trail. They start with a source document such as an invoice, check, receipt, or receiving the report. These source documents become the basis for journal entries, which are chronological listings of transactions with their debit and credit amounts. Entries are made in various accounting journals. Then, entries are posted to the appropriate general ledger accounts. The summarized account amounts become the basis for a particular period’s financial statements.

To help explain how transactions affect the financial statements, this flow of transactional information through the accounting records is illustrated below, followed by examples of typical accounting transactions:

Transaction occurs > Purchase orders, receipts, and other documents are created > Transaction is recorded in journals > Journals are posted to individual accounts > Financial statements are generated from account balances.

Journal Entries

As transactions occur, they are recorded in a company’s books via journal entries. Each journal entry serves as a record of a particular transaction and forms an audit trail that can be retraced later to obtain an understanding of a company’s operations. Journal entries that are not prompted by a transaction, called adjusting journal entries, are also made periodically for items such as depreciation expense and accounts receivable write-offs.

Financial statements are presentations of financial data and accompanying notes prepared in conformity with either generally accepted accounting principles (GAAP)—such as International Financial Reporting Standards (IFRS) or a country’s specific accounting standards—or some other comprehensive basis of accounting.

The following is a list of typical financial statements:

• Statement of financial position (“balance sheet”)
• Statement of profit or loss and other comprehensive income for the period (“income statement”)
• Statement of changes in owners’ equity or statement of retained earnings
• Statement of cash flows

Balance Sheet

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.

As mentioned previously, 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. This category usually includes cash, accounts receivable (the amount owed to a company by customers for sales on credit), inventory, and prepaid items. Following the current assets are the long-term assets, or those assets that will likely not be converted to cash in the near future, such as fixed assets (e.g., land, buildings, equipment) and intangible assets (e.g., patents, trademarks, goodwill). A company’s fixed assets are presented net of accumulated depreciation, an amount that represents the cumulative expense taken for wear-and-tear on a company’s property. Likewise, intangible assets are presented net of accumulated amortization, an the amount that represents the collective expense taken for declines in the value of the intangible property.

Cash Flows from Operations

The cash flows from operations section summarizes a company’s cash receipts and payments arising from its normal business operations. Cash inflows included in this category commonly consist of payments received from customers for sales, and cash outflows include payments to vendors for merchandise and operating expenses and payments to employees for wages.

This category can also be summarized as those cash transactions that ultimately affect a company’s operating income; therefore, it is often considered the most important of the three cash flow categories. If a company continually shows large profits per its income statement, but cannot generate positive cash flows from operations, then questionable accounting practices might be to blame. On the other hand, net income that is supported by positive and increasing net cash flows from operations generally indicates a strong company.

Users of Financial Statements

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.)

RELEVANCE
Any financial information that might affect a decision made by a user of the financial statements is considered relevant. Financial information is relevant if it has predictive value, confirmatory value, or both. Predictive value is present if the information can be used as an input to processes employed by users to predict future outcomes. The confirmatory value indicates the information provides feedback about previous evaluations.

MATERIALITY

The amount of an item is material if its omission or misstatement would affect the judgment of a reasonable person who is relying on the financial statements. Materiality is an entity-specific aspect of relevance based on nature or magnitude, or both, of the items to which the information relates in the context of an individual entity’s financial report.

FAITHFUL REPRESENTATION

Financial information must faithfully represent the economic data of the enterprise that it purports to represent. Every effort shall be made to maximize the qualities of perfectly faithful representation: complete, neutral, and free from error. A complete depiction includes all information necessary to understand the data presented. A neutral depiction is without bias in the selection or presentation of financial information. Free from error means there are no material errors or omissions in the financial reporting data, and the process used to produce the reported information has been selected and applied with no errors.

COMPARABILITY AND CONSISTENCY

Users of financial statements base their decisions on comparisons between different entities and on similar information from a single entity for another reporting period. Comparability is the qualitative characteristic that enables users to identify and understand similarities and differences between such items. Information about a company is more useful if it is comparable with similar information about other entities and with similar information about the same entity for another period or another date. Although a single economic occurrence can be faithfully represented in multiple ways, permitting alternative accounting methods for the same economic occurrence diminishes comparability.

RECOGNITION OF ASSETS

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.

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.

The measurement basis most commonly adopted by entities in preparing their financial statements is historical cost. This is usually combined with other measurement bases. For example, inventories are usually carried at the lower of cost or net realizable value; marketable securities can be carried at market value, and pension liabilities are carried at their present value. Furthermore, some entities use the current cost basis as a response to the inability of the historical cost accounting model to deal with the effects of changing prices of non-monetary assets.

The question of when it is appropriate to stray from GAAP is a matter of professional judgment; there is no clear-cut set of circumstances that justify such a departure. 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.

Departures from GAAP can be justified in the following circumstances:

• It is common practice in the entity’s industry for a transaction to be reported in a particular way.
• The substance of the transaction is better reflected (and, therefore, the financial statements are more fairly presented) by not strictly following GAAP.
• 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.
• 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).
• 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.

Financial statement schemes are one of a large category of frauds that fall under the heading of Occupational Fraud and Abuse, which is defined as “the use of one’s occupation for personal enrichment through the deliberate misuse or misapplication of the employing organization’s resources or assets.” Simply stated, occupational frauds are those in which an employee, manager, officer, or owner of an organization commits fraud to the organization’s detriment. The three major types of occupational fraud are corruption, asset misappropriation, and financial statement fraud. The following diagram shows the complete classification of occupational fraud frequently referred to as the Fraud Tree.

Financial statement fraud is the deliberate misrepresentation of the financial condition of an enterprise accomplished through the intentional misstatement or omission of amounts or disclosures in the financial statements to deceive financial statement users.

Note that financial statement fraud, much like all types of fraud, is an intentional act. As stated in the International Standard on Auditing (ISA) 240, The Auditor’s Responsibility Relating to Fraud in an Audit of Financial Statements, “misstatements in the financial statements can arise from error or fraud. The distinguishing factor between error and fraud is whether the underlying action that results in the misstatement of the financial statements is intentional or unintentional.”

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. Since fraud investigations are typically conducted or overseen by management, financial statement fraud cases often persist for a long time before the fraud is discovered.

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 ability of the company’s management and its auditors, and the company’s stock price will decrease accordingly.

Many jobs might be lost as companies restructure to restore profitability. Financial statement fraud can influence the well-being of employees, who might lose their jobs, retirement funds, any savings invested in their employer’s stock, and health care and other benefits. The company’s auditors are likely to be sued for the amount of investors’ losses, which could mean billions of dollars for large public companies. For large and small companies alike, financial statement fraud can be costly and potentially destroy the company.

There are a number of reasons why individuals commit financial statement fraud. Most commonly, financial statement fraud is used to make a company’s earnings look better on paper. Financial statement fraud occurs through a variety of methods, such as valuation judgments and manipulating the timing of transaction recording. These more subtle types of fraud are often dismissed as either mistakes or errors in judgment and estimation. Some of the more common reasons why people commit financial statement fraud include:

• To encourage investment through the sale of stock
• To demonstrate increased earnings per share or partnership profits interest, thus allowing increased dividend/distribution payouts
• To cover the inability to generate cash flow
• To avoid negative market perceptions
• To obtain financing, or to obtain more favorable terms on existing financing
• To receive higher purchase prices for acquisitions
• To demonstrate compliance with financing covenants
• To meet company goals and objectives
• To receive performance-related bonuses

This limited list of reasons shows that the motivation for financial statement fraud does not always involve direct personal financial gain. Sometimes, the cause of fraudulent financial reporting is the combination of situational pressures on either the company or the manager and the opportunity to commit the fraud without the perception of being detected. These pressures are known as “red flags.” That is to say, if red flags (situational pressures and opportunity) are present, then the risk of financial reporting fraud increases significantly.

Some of the more obvious opportunities for the existence of fraud are:

• Absence of a board of directors or audit committee
• Improper oversight or other neglectful behavior by the board of directors or audit committee
• Weak or nonexistent internal controls, including an ineffective internal audit staff and a lack of external audits
• Unusual or complex transactions (an understanding of the transactions, their component parts, and their effect on financial statements is paramount to fraud deterrence)
• Financial estimates that require significant subjective judgment by management