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Identifying Fraudulent Financial Transactions

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Chapter 1
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An Introduction to Financial Statement Fraud
Chapter Outline
Importance of Accurate Financial InformationNature of Financial Statement FraudFinancial Statement FraudStatisticsAn ExampleMotivationsfor Financial Statement Fraud
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Importance of Accurate Financial Information
Why is accurate financial information important?Financial statements provide meaningful disclosures of a company’s past, present, and futureMost Financial Statements are prepared with integrity, but sometimes they are prepared in ways that misrepresent actual financialpositionMisstatement of financial statements can result from manipulation, falsification, or altering of accounting records or supporting documentation from which the statements are prepared,Misrepresentation or intentional omission of events, transactions, other significant informationIntentional misapplication of accounting principles relating to amounts, classification, manner of presentation or disclosure
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Accountants have been given a “watchdog” role by the SECSEC and other parties rely on auditors to issue audit opinions that act like Good Housekeeping Seal of ApprovalEnron is only 1 of 600 financial statements frauds that have been investigated by the SECAccountants must understand as much as possible about financial statements and financial statement fraudAllows auditors to be more discriminating in the kinds of audits they accept, give better advice to clients
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Nature of Financial Statement Fraud
Involves intentional deceit andconcealment through falsified documentation, forgery, collusion among management, employees, and third partiesUnlike fraud where employees and others take advantage of the organization, when financial statement fraud takes place management acts on behalf of the organization to make the organization appear more profitable than it actually is
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Copyright 2014-2015 AICPA Unauthorized copying prohibited
Financial statement fraud is rarely seenWhen fraud does occur fraud symptoms, indicators, or red flags are usually observedBecause these symptoms can be caused by other legitimate factors the presence of fraud symptoms does not always indicate that fraud existsfor example a document may be missing, the GL may be out of balance, an analytical relationship may not make senseThese may simply indicate errors, lost documents, or changes in the firm’s underlying economic condition
Even a tipster reporting fraud may be motivated to make false allegations
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Red flags
Fraud symptoms cannot be easily ranked in order of importance or combined into effective predictive modelsSome factors exist when no fraud is presentA smaller number of red flags may exist when fraud is presentIt can be hard to predict fraud once it is suspectedWithout a confession, a number of repeated similar fraudulent acts (fraud can be inferred from a pattern) or obviously forged documents, it is very difficult to convict someone of fraudulent behaviorAuditors must exercise extreme care when conducting audits, performing fraud examinations, trying to quantify fraud or performing other fraud related engagements
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SEC AAERs
The best measure of financial statement fraud is to look at the SEC enforcement releases (AAERs)One or more enforcement releases is issued when financial statement fraud occurs at a company whose stock is publicly tradedMost comprehensive study of the AAERs was conducted by COSO, examining all financial statement frauds from 1998 to 2007
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Financial Statement Fraud Statistics
A Few Interesting Facts Revealed in the COSO study of Financial Statement Frauds that occurred between 1998 and 2007:Of the 347 alleged cases of public company fraudulent financial reporting, the medianfinancial statement fraud was $12.05 millionThe most common methods used to misstate financial statementswere, in order, improperrevenue recognition, overstatement of assets, andcapitalizationofexpenses.
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Financial Statement Fraud Statistics (Continued)
Organizations involved in fraudulent financial reporting had assets and revenues of just under 100 millionIn89%of the cases, theCEO and/or CFOwas named in the AAER for some level of involvementWithin 2 years of the completion of the investigation,20 percentof theCEOs and CFOswere indicted and over60 percentof those indictedwereconvicted26 percentof the fraud firms in the study changed auditors between the last clean financialstatement dateandthefraudulent financialstatementdate, only 12% of no fraud firms switched auditors during the same period
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Financial Statement Fraud Statistics (Continued)
Once news of an alleged fraud reached the press, company stock declined on average 16.7%Consequencesfor the fraud firms were severe and often included bankruptcy, delisting from stock exchanges,andmaterial assets sales following the discovery of the fraudThese findings are consistent with other similar reports such as theReport Pursuant to Section 704 of the SOX 2002
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Section 704 of SOX 2002
Section 704 requires the SEC to review and analyze all enforcement actions by the SEC involving violations of reporting requirements, and restatements of financial statements,to identify areas of reporting that are most susceptible to fraud, inappropriate manipulation, or inappropriate earnings management, such as revenue recognition and the accounting treatment of off-balance-sheet special purpose entities.The Commission is required to report its findings to theCommittee on Financial Services of the House of Representatives and the Committee on Banking, Housing and Urban Affairs of the Senate, not later than 180 days after the date of the enactment of the Act and to use its findings to revise its rules and regulations as necessary.
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The Commission reviewed and analyzed 515 enforcement actions for financial reporting and disclosure violationsThese included 869 named parties, 164 entities and 705 individuals
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Copyright 2014-2015 AICPA Unauthorized copying prohibited
The greatest number of actions brought in the area of revenue recognitionImproper timing of revenue recognitionImproper valuation of revenue101 enforcement matters involved improper expense recognitionImproper capitalization or deferral of expenses, improper use of reserves, or understatement of expenses23 enforcement matters involved improper accounting for business combinationsOther matters involved disclosure issues, such as inadequate MDA and improper use of off balance sheet arrangements
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Specific types of Financial Statement Fraud
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Specific types of Financial Statement Fraud
Type ofFraudImproperexpenserecognitionSpecific SchemeNo. of CasesOverstating ending inventory values to reduce cost of goodssold 25Understating bad debts or loanlosses 19Improper use of restructuring and other reserves17Failure to record assetimpairments 5
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Specific types of Financial Statement Fraud
Type of FraudImproperaccounting in connection with businesscombinationsSpecificSchemeNo. of CasesImproper assetvaluation 8Improper use of mergerreserves 8Inappropriate application of purchase/poolingmethods 4
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Specific types of Financial Statement Fraud
Type of FraudOtherareas of improperaccountingSpecificSchemeNo. of CasesInadequatedisclosure in MD&A andelsewhere 43Failure to disclose related-partytransactions 23Improper accounting for non-monetary and roundtriptransactions 19Improper accounting for foreign payments in violation ofFCPA 6Improper use of off-balance-sheetarrangements 3Improper use of non-GAAP financialmeasures 2
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Participation of Management
Majority of persons held responsible for accounting violations were senior managementIn these enforcement matters, charges were brought against 75 Chairmen of the Board, 111 Chief Executive Officers, 111 Presidents, 105 Chief Financial Officers, 21 Chief Operating Officers, 16 Chief Accounting Officers, and 27 Vice Presidents of Finance.
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Some of the cases that occurred between 1997 and 2002 included Enron, WorldCom, Adelphia, Home Store, Cendant, Qwest, Xerox, Sunbeam, and Waste Management.Many of these frauds have led to huge bankruptcies, the loss of investor confidence, and the loss of trillions of dollars in market value
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Unfortunately, when a company perpetrates financial statement fraud, the market value of that company's stock usually declines much more than the amount of the fraud.
Copyright 2014-2015 AICPA Unauthorized copying prohibited
Phar-Mor: An Example of Financial Statement Fraud
Background of the Phar-Mor Case:Phar-Mor’s prices were so low that competitors wondered how Phar-Mor could make a profitPhar-Mor began losing money after 5 to 6 yearsMickeyMonusand his team manipulated income statements to avoid reporting losses on the financial statements and to meet Wall StreetexpectationsIn order to hide cash flow problems, attract investors, and make the company look profitable, MickeyMonusand his employees altered inventory accounts to understate cost of goods sold and overstate incomeIn addition to financial statement fraud internal investigations of the company revealed estimated embezzlement of excess of $10 million
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Understated certain expenses that came in over budget and overstate those expenses that came in under budget to make operating results appear in line with budgeted resultsTo inflate inventory accountants would credit inventory on sales, but debit—not cost of goods sold—but a “bucket” accountAt year end bucket accounts were emptied by allocating the balance to inventory—thereby understating cost of goods sold—and overstating incomeAlso took exclusivity payments from vendors—recognizing all as income immediatelyThe fraud led to the bankruptcy of the 28th largest private company in the US, causing $1 billion in lossesMickeyMonusreceived a seven-month prison sentence for his involvement in the fraud
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The fraud was discovered when a travel agent noted that Phar-Mor's checks were being used to cover World Basketball League expenses, the travel agent then showed the check to her landlord, a Phar-Mor investor.
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Motivations for Financial Statement Fraud
Attempt to improve the reported financial information to support a high stock price, to support a bond or stock offering, or to increase the company's stock priceWhentop executives own considerable amounts of company stock, or stock options, a decrease in stock price would significantly decrease their own personal net worth or make the stock options worthless. As a result, top executives need to keep the stock price high and, therefore, need high income to support a high stock price.Investors place value on stocks that report increased earnings each year. Indeed, a dip in income can significantly reduce a company's stock price.
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Sometimes, fraudulent financial statements result because division managers overstate their results to meet company or other expectations.Two different motivations for committing financial statement fraud.In the first case, managers were motivated to commit fraud in order to meet Wall Street's earnings forecasts, and in doing so, boost the company's stock price and subsequently the value of management's personal stock.In Phar-Mor's case, it was the fear of failure that motivated the fraud. In the end, these two reasons, greed and fear, motivate not just financial statement fraud but nearly all types of fraud.
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Backdating stock options
As many as 20% of all public corporations may have allowed officers and directors to illegally "backdate" personal stock options.Until 2006, if the option granting price ($15 in this case) were the same as the market price on the date the option was granted, the company was not required to report compensation expense on its income statement. However, if the options were granted at a price lower than the market share price (referred to as "in-the-money" options) on the day the options were granted, say $10 in this example, then the $5 difference between the option granting price and the market price had to be reported as compensation expense by the company and represented taxable income to the recipient.
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The fraudulent stock option backdating practices involved corporations, by authority of their executives and/or boards of directors, awarding stock options to their officers and directors and dating those options to a past date in which the share price of the company's stock was unusually low. Dating the options in this manner ensured that the exercise price was set well below market, thereby nearly guaranteeing that these options would always be "in the money" when they vested and thus provided the recipients with windfall profits.
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Identifying Fraudulent Financial Transactions