CFE Exam Quiz 56

Reduce the Situational Pressures that Encourage Financial Statement Fraud

• Avoid setting unachievable financial goals.
• Eliminate external pressures that might tempt accounting personnel to prepare fraudulent financial statements.
• Remove operational obstacles that block effective financial performance, such as working capital restraints, excess production volume, or inventory restraints.
• Establish clear and uniform accounting procedures that do not contain exception clauses.

By performing a financial statement analysis, the fraud examiner might be directed toward the direct evidence to resolve an allegation of fraud. After the analysis, the fraud examiner can select statistical samples in the target account and eventually examine the source documents. If an irregularity of overstatement is suspected, the fraud examiner should begin the examination with the financial statements. If, however, an irregularity of understatement is suspected, the fraud examiner should begin the examination with a review of the source documents. This rule of thumb is especially effective in the area of omission of liabilities, such as litigation, contingent liabilities, leases, and some product warranties. The asset turnover ratio is one of the more reliable indicators of financial statement fraud. A sudden or continuing decrease in this ratio is often associated with an improper capitalization of expenses, which increases the denominator without a corresponding increase in the numerator.

Financial statement fraud does not occur in an isolated environment. People in organizations who have both motive and opportunity are the prime candidates to commit fraudulent misstatement. In the overwhelming majority of situations, two key managers participate actively in the fraud: the chief executive officer and the chief financial officer. Others become involved largely out of necessity. Those who are not directly involved most often are not aware that anything is wrong.

Investigations of financial statement frauds are unique in that they almost always involve interviewing the executive management of the organization. To detect or deter financial statement fraud, it is absolutely necessary that top management be interviewed by a competent and experienced fraud examiner who possesses the ability to solicit honest answers to tough—but vital—questions about whether anyone has tampered with the books.

DEBT-TO-EQUITY RATIO

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 relative risk assumed by the creditors and owners. The higher the ratio, the more difficult it will be for the owners to raise capital by increasing long-term debt. Debt-to-equity requirements are often included as borrowing covenants in corporate lending agreements. The example displays a very favorable Year One ratio of 0.89. Year Two, however, shows a ratio of 1.84, which indicates that debt is greatly increasing. In this case, the increase in the ratio corresponds with the rise in accounts payable. Sudden changes in this ratio might signal a fraud examiner to look for fraud.

INVENTORY TURNOVER

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. This ratio is a good determinant of purchasing, production, and sales efficiency. In general, a higher inventory turnover ratio is considered more favorable. For example, if the cost of goods sold has increased due to the 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 Two, signaling the possibility that embezzlement is buried in the inventory account. A fraud examiner should investigate the changes in the ratio’s components to determine where to look for possible fraud.

The quick ratio, often referred to as the acid test ratio compares the most liquid assets to current liabilities. This calculation divides the total of cash, securities, and receivables by current liabilities to yield a measure of a company’s ability to meet sudden cash requirements. The quick ratio is a conservative measurement of liquidity that is often used in turbulent economic times to provide an analyst with a worst-case scenario of a company’s working capital situation.

The current ratio—current assets to current liabilities—is probably the most commonly 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 that the accounts involved have been manipulated. Embezzlement will cause the ratio to decrease, and liability concealment will cause a more favorable ratio.

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. Many professionals, including bankers, investors, and business owners, as well as major investment firms, use this method. Ratio analysis allows for internal evaluations using financial statement data. Traditionally, financial statement ratios are compared to an entity’s industry averages. The ratios and comparisons can be very useful in detecting red flags for a fraud examination. If the financial ratios present a significant change from one year to the next or over a period of years, it becomes obvious that there could be a problem. As in all other analyses, specific changes are often explained by changes in business operations. If a change in specific ratios is detected, the appropriate source accounts should be researched and examined in detail to determine if fraud has occurred. For instance, a significant decrease in a company’s current ratio might point to an increase

Horizontal Analysis

Horizontal analysis is a technique for analyzing the percentage change in individual financial statement line items from one period to the next. The first period in the analysis is considered the base period, and the changes in the subsequent period 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. The resulting percentages are then studied in detail. As is the case with vertical analysis, this technique does not work for small, immaterial frauds.

Vertical Analysis

There are traditionally two methods of percentage analysis of financial statements: horizontal and vertical analysis. Vertical analysis is a technique for analyzing the relationships among the items on an income statement, balance sheet, or statement of cash flows by expressing components as percentages of a specified base value. This method is often referred to as common sizing financial statements because it allows an analyst to compare entities of different sizes more easily. In the vertical analysis of an income statement, net sales are the base value and is assigned 100 percent. On the balance sheet, total assets are assigned 100 percent on the asset side, and total liabilities and equity are expressed as 100 percent. All other items in each of the sections are expressed as a percentage of these numbers.

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; in addition, it allows the reader to more readily compare current performance with past performance. 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 a fraud examiner in the direction of possible fraud. If large enough, a fraudulent misstatement can affect the financial statements in such a way that relationships between the numbers become questionable. Many schemes are detected because the financial statements do not make sense when analyzed closely. Financial statement analysis includes the following:

• Vertical analysis
• Horizontal analysis
• Ratio analysis

What Red Flags Are Associated with Improper Disclosures?

The following red flags might indicate improper disclosures:

• Domination of management by a single person or small group (in a nonowner-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 a period’s end that pose difficult “substance over form” questions
• Significant related-party transactions not in the ordinary course of business or with related entities either not audited or audited by a different 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 limit the auditor’s ability to communicate effectively with the board of directors or audit committee

Management has an obligation to disclose all significant (material) information appropriately in the financial statements and in management’s discussion and analysis. In addition, the disclosed information must not be misleading.

Improper disclosures resulting in financial statement fraud usually involves the following:

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

What Red Flags Are Associated with Concealed Liabilities and Expenses?

The following red flags are indicators of concealed liabilities and expenses schemes:

• Recurring negative cash flows from operations or an inability to generate positive 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 support
• 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/provisions for sales returns, warranty claims, etc., 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 ratio
• Reducing accounts payable while competitors are stretching out payments to vendors

Liability/Expense Omissions

The preferred and easiest method of concealing liabilities or expenses is to simply fail to record them. Large monetary judgments against a company from a recent court decision might be conveniently ignored. Vendor invoices might be thrown away or stuffed into drawers rather than 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 solely to create additional income. Whether these items are properly recorded in a subsequent accounting period does not change the fraudulent nature of the current financial statements.

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

There are three common methods for concealing liabilities and expenses:

• Liability/expense omissions
• Improperly capitalizing costs rather than expensing them
• Failure to disclose warranty costs and product-return liabilities

What Red Flags Are Associated with Improper Asset Valuation?

The following red flags commonly indicate improper asset valuation schemes:

• Recurring negative cash flows from operations or an inability to generate positive cash flows from operations while reporting earnings and earnings growth
• Significant declines in customer demand and increasing business failures in either the industry or the overall economy
• Assets, liabilities, revenues, or expenses based on significant estimates that involve subjective judgments or uncertainties that are difficult to support
• 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 ratio
• Unusual growth in the number of days’ purchases in inventory ratio
• Reduction in allowances (or provision) for bad debts, excess inventory, and obsolete inventory especially if relevant ratios are 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

BOOKING FICTITIOUS ASSETS

One of the easiest methods of asset misrepresentation is 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. In other instances, the equipment is leased, not owned, and this fact is not disclosed during the audit of fixed assets. Fictitious fixed assets can sometimes be detected because the fixed asset addition makes no business sense.

Improper asset valuations usually take the form of one of the following classifications:

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

What Red Flags Are Associated with Timing Differences (Including ImproperRevenue Recognition)?

• 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 positive cash flows from operations while reporting earnings and earnings growth
• Significant, unusual, or highly complex transactions, especially those close to the period’s end, that lead to difficult “substance over form” questions
• Unusual increase in the gross margin or gross margin in excess of industry peers
• Unusual growth in the days’ sales in receivables ratio (receivables/average daily sales)
• Unusual decline in the days’ purchases in accounts payable ratio (accounts payable/average daily purchases)

Channel Stuffing

A challenging area of revenue recognition is channel stuffing. This term 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 or extended payment terms. This practice is especially attractive to industries with high gross margins—such as tobacco, pharmaceuticals, perfume, soda concentrate, and branded consumer goods—because it can increase short-term earnings. On the downside, however, stealing from future periods’ sales makes it harder to achieve sales goals in those future periods. The pressure to meet sales goals can, in turn, lead to increasingly disruptive levels of channel-stuffing and, ultimately, to a restatement. Although orders are received, the terms of the order might raise questions about the collectability of the accounts receivable, and any existing side agreements that grant a right of return might, effectively, turn the sales into consignment sales. Also, there might be a greater risk of returns for certain products if they cannot be sold before their shelf life ends.

Financial reporting fraud risks associated with multiple-element revenue arrangements include:

• Falsely claiming that the criteria for a multiple-element revenue arrangement have been met
• Manipulating the allocation of revenue among the individual components of the arrangement to accelerate revenue recognition (by allocating more to the components to be recognized early and less to components that must be deferred to future periods)

Long-Term Contracts

Long-term contracts can cause special problems for revenue recognition. In many countries, for example, revenues and expenses from long-term construction contracts can be recorded using 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 the 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 to recognize revenues prematurely and conceal contract overruns.

Sales with Conditions

Sales with conditions are those that have terms that have not been completed and those with rights and risks of ownership that have not passed to the purchaser. In most cases, such sales cannot be recorded as revenue. These types of sales are similar to schemes involving the recognition of revenue in improper periods since the conditions for sale might become satisfied in the future, at which point revenue recognition would become appropriate. External pressures to succeed that are placed on business owners and managers by 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 U.S. Securities and Exchange Commission (SEC) to have manipulated earnings for two years in a row (2002 and 2003) to meet performance targets by recording $381 million in “sales” of locomotives to financial partners. Since GE had not relinquished 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.

The core principle of the revised revenue recognition standard is that an entity should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services.

To achieve compliance with this revised standard, an entity should apply the following steps:

1. Identify the contract(s) with a customer. A contract is an agreement between two or more parties that creates enforceable rights and obligations.
2. Identify the performance obligations in the contract. A contract includes promises to transfer goods or services to a customer. If those goods or services are distinct, the promises are performance obligations and are accounted for separately.
3. Determine the transaction price. The transaction price is the amount of consideration in a contract to which an entity expects to be entitled in exchange for transferring promised goods or services to a customer.
4. Allocate the transaction price to the performance obligations in the contract. An entity usually allocates the transaction price to each performance obligation based on the comparative standalone selling prices of each distinct good or service promised in the contract. If a standalone selling price is not easily observable, it must be estimated.
5. Recognize revenue when (or as) the entity satisfies a performance obligation. An entity recognizes revenue when (or as) it satisfies a performance obligation by transferring a promised good or service to a customer (which is when the customer obtains control of that good or service). The amount of revenue recognized is the amount allocated to the satisfied performance obligation.

What Red Flags Are Associated with Fictitious Revenues?

The following red flags are associated with fictitious revenues:

• An unusually large amount of long-overdue accounts receivable
• Outstanding accounts receivable from customers that are difficult or impossible to identify and contact
• 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 positive 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 a separate firm
• Significant, unusual, or highly complex transactions, especially those close to the period’s end that pose difficult “substance over form” questions
• Unusual growth in the days’ sales in receivables ratio (receivables/average daily sales)
• A significant volume of sales to entities whose substance and ownership is not known
• An unusual increase in sales by a minority of units within a company or in sales recorded by corporate headquarters

In reviewing purchase orders, auditors should look for cancellation clauses that could contradict the sale. Auditors should read sales contracts and look for cancellation privileges and lapse dates. Revenue should not be recorded until the cancellation privilege lapses. The absence of a requested shipping date on a purchase order might indicate that the customer will notify the seller when shipment is to occur, which might mean that no exchange is presently being requested.

Fictitious Revenues

Fictitious or fabricated revenues involve the recording of sales of goods or services that did not occur. Fictitious sales most often involve fake customers, but can also involve legitimate customers. For example, a fictitious invoice can be prepared (but not mailed) for a legitimate customer even though the goods are not delivered or the services are not rendered. At the end of the accounting period, the sale will be reversed, which will help conceal the fraud. However, the artificially high revenues of the period might 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 to reflect higher amounts or quantities than are actually sold.

To demonstrate the over- and understatements typically used to fraudulently enhance the financial statements, the schemes have been divided into five classes. Because the maintenance of financial records involves a double-entry system, fraudulent accounting entries always affect at least two accounts and, therefore, at least two categories on the financial statements. While 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:

• Fictitious revenues
• Timing differences (including improper revenue recognition)
• Improper asset valuations
• Concealed liabilities and expenses
• Improper disclosures

Fraud in financial statements typically takes the form of:

• Overstated assets or revenue
• Understated liabilities and expenses