CHAPTER 11 Financial Statement Fraud Albrecht Fraud Examination

CHAPTER 11 Financial Statement Fraud Albrecht, Fraud Examination, 6 th Edition. © 2019 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

LEARNING OBJECTIVES After studying this chapter, you should be able to: } Discuss the role that financial statements play in capital markets. } Understand the nature of financial statement fraud. } Become familiar with financial statement fraud statistics. } See how financial statement frauds occur and are concealed. } Outline the framework for detecting financial statement fraud. } Identify financial statement fraud exposures. } Explain how information regarding a company’s management and directors, nature of organization, operating characteristics, relationship with others, and financial results can help assess the likelihood of financial statement fraud. Albrecht, Fraud Examination, 6 th Edition. © 2019 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. CHAPTER 11 2

The Problem of Financial Statement Fraud } Financial statements are sometimes prepared in ways that intentionally misstate the financial position and performance of an organization. } Such misstatements can result from manipulating, falsifying, or altering accounting records. } Misleading financial statements cause serious problems in the market and the economy. } They often result in large losses for investors, lack of trust in the market, and litigation and embarrassment for individuals and organizations associated with financial statement fraud. Albrecht, Fraud Examination, 6 th Edition. © 2019 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. CHAPTER 11 3

Financial Statement Fraud in Recent Years } Misstated financial statements or “cooking the books” } Inappropriate executive loans and corporate looting } Insider trading scandals } Initial public offering (IPO) favoritism } Spinning involves giving IPO opportunities to those who arrange quid pro quo opportunities } Laddering involves giving IPO opportunities to those who promise to buy additional shares as prices increase } Excessive CEO retirement perks } Exorbitant compensation (both cash and stock) for executives } Loans for trading fees and other quid pro quo transactions } Bankruptcies and excessive debt } Backdating stock options Albrecht, Fraud Examination, 6 th Edition. © 2019 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. CHAPTER 11 4

Figure 11. 1 Fraud Triangle } The explanations covered previously about why people commit other frauds apply to financial statement fraud as well. } Three elements come together to motivate all frauds: } A perceived pressure } A perceived opportunity } The ability to rationalize Albrecht, Fraud Examination, 6 th Edition. © 2019 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. CHAPTER 11 5

Elements of Perfect Fraud Storm } Element 1: A Booming Economy } Element 2: Decay of Moral Values } Element 3: Misplaced Incentives } Element 4: High Analysts’ Expectations } Element 5: High Debt Levels } Element 6: Focus on Accounting Rules Rather Than Principles } Element 7: Lack of Auditor Independence } Element 8: Greed } Element 9: Educator Failures Albrecht, Fraud Examination, 6 th Edition. © 2019 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. CHAPTER 11 6

Nature of Financial Statement Fraud } Involves intentional deceit and attempted concealment } Actual fraud rarely seen } Fraud symptoms, indicators, or red flags are usually observed. } Presence of fraud symptoms does not always indicate the existence of fraud. } Conviction is very difficult } Because of the difficulty of detecting and proving fraud, investigators must exercise extreme care when performing fraud examinations, quantifying fraud, or performing other types of fraud-related engagements. Albrecht, Fraud Examination, 6 th Edition. © 2019 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. CHAPTER 11 7

Financial Statement Fraud Statistics, 1987– 1997 } The average fraud lasts about two years. } Improper revenue recognition, overstatement of assets, and understatement of expenses were the most common fraudulent methods used. } The average magnitude of fraud was $25 million ($4. 1 million median). } CEO perpetrated the fraud in 72 percent of the cases. } Fraudulent companies’ size: Average assets were $532 million ($16 million median) and average revenues were $232 million ($13 million median). } Severe consequences were usually associated with companies having fraudulent financial statements. } Most of these firms had no audit committee, or one that met only once per year. } Boards of directors were dominated by insiders and “gray” directors. } Some companies were experiencing net losses or were close to breakeven positions. } Just over 25 percent of the companies changed auditors during the fraud period. Albrecht, Fraud Examination, 6 th Edition. © 2019 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. CHAPTER 11 8

Financial Statement Fraud Statistics, 1998– 2007 } Approximately 18 percent more frauds were investigated by the SEC during this 10 -year period relative to the prior 10 -year period. } Average fraud increased from $25 million (median of $4. 1 million) to approximately $400 million ($12 million). } Median assets for the companies involved in this study increased from approximately $16 million to nearly $100 million. } The CFO and/or CEO were named in over 89 percent of the cases. } About 20 percent of these individuals were indicted within two years of the SEC’s investigation. } Improper revenue recognition continues to be the most common fraud method and accounted for over 60 percent of the cases. } Characteristics of boards of directors for these firms were noticeably different from those of similar firms that were not charged with fraud. } Twenty-six percent of the firms changed auditors around the time of the fraud. } Press coverage of a company’s alleged fraud led to a 16. 7 percent abnormal decline in the company’s stock price, and news of a government investigation of the fraud led to a 7. 3 percent abnormal stock price decline. Albrecht, Fraud Examination, 6 th Edition. © 2019 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. CHAPTER 11 9

Auditor Deficiencies Associated with SEC Investigations (1998– 2010) } In 73 percent of the cases, the audit failed to collect a sufficient level of competent audit evidence. } In 67 percent of the cases, due professional care was not exercised. } In 60 percent of the cases, the auditor(s) lacked a sufficient level of professional skepticism. } In 54 percent of the cases, the auditor failed to obtain adequate evidence related to management representations. } In 47 percent of the cases, an appropriate audit opinion was not expressed. Albrecht, Fraud Examination, 6 th Edition. © 2019 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. CHAPTER 11 10

Professional Skepticism A skeptical mind-set has the following six characteristics: 1. Questioning mind-set } A disposition to inquiry, with some sense of doubt 2. Suspension of judgment } Withholding judgment until appropriate evidence is obtained 3. Search for knowledge } A desire to investigate beyond the obvious, with a desire to corroborate 4. Interpersonal understanding } Recognition that people’s motivations and perceptions can lead them to provide biased or misleading information 5. Autonomy } The self-direction, moral independence, and conviction to decide for oneself, rather than accepting the claims of others 6. Self-esteem } The self-confidence to resist persuasion and to challenge assumptions or conclusions Albrecht, Fraud Examination, 6 th Edition. © 2019 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. CHAPTER 11 11

Motivations for Financial Statement Fraud } Motivations to issue fraudulent financial statements vary. } Examples: } Support a high stock price or a bond or stock offering } Increase the company’s stock price } Maximize a bonus } Increase personal net worth } Meet company expectations } Although the motivations for financial statement fraud differ, the results are always the same—adverse consequences for the company, its principals, and its investors. Albrecht, Fraud Examination, 6 th Edition. © 2019 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. CHAPTER 11 12

A Framework for Detecting Financial Statement Fraud } Strategic reasoning } The ability to anticipate a fraud perpetrator’s potential methods of engaging in and concealing a fraud } Questions to ask: } What types of fraud schemes is management likely to use to commit financial statement fraud? } What typical tests are used to detect these schemes? } How could management conceal their scheme from the typical test? } How could the typical test be modified so as to detect the concealed scheme? } Financial statement analysis } Focus on the changes in reported assets, liabilities, revenues, and expenses from period to period or compare company performance to industry norms. } Nonfinancial performance measures } Look for a discrepancy between the company’s financial and nonfinancial performance Albrecht, Fraud Examination, 6 th Edition. © 2019 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. CHAPTER 11 13

Figure 11. 2 Fraud Exposure Rectangle Albrecht, Fraud Examination, 6 th Edition. © 2019 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. CHAPTER 11 14

Management and the Board of Directors } Managements’ backgrounds } Managements’ motivations } Managements’ influence in making decisions for the organization } Understanding management (including directors’) backgrounds } Understanding what motivates management (including the board of directors) } Understanding the degree of influence of key members of management (including the board of directors) Albrecht, Fraud Examination, 6 th Edition. © 2019 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. CHAPTER 11 15

Relationships with Others } Relationships should be examined to determine if they present management fraud opportunities or exposures. Albrecht, Fraud Examination, 6 th Edition. © 2019 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. CHAPTER 11 16

Relationship with Financial Institutions } Relationships with financial institutions and bondholders are important because they provide an indication of the extent to which the company is leveraged. Albrecht, Fraud Examination, 6 th Edition. © 2019 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. CHAPTER 11 17

Relationship with Related Organizations and Individuals } Related parties, which include related organizations and individuals such as family members, should be examined because structuring “non-arm’s length” and often unrealistic transactions with related parties is one of the easiest ways to perpetrate financial statement fraud. } These relationships are usually identified by examining large and/or unusual transactions. Albrecht, Fraud Examination, 6 th Edition. © 2019 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. CHAPTER 11 18

Relationship with Auditors } The termination of an auditor–auditee relationship is most often caused by one of the following: } Failure of the client to pay } An auditor–auditee disagreement } Suspected fraud or other problems by the auditor } The auditee believing the auditor’s fees are too high } The first three can all be reasons that suggest a financial statement fraud problem. Albrecht, Fraud Examination, 6 th Edition. © 2019 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. CHAPTER 11 19

Relationship with Lawyers } Relationships with lawyers pose even greater risks than relationships with auditors. } Whereas auditors are supposed to be independent and must resign if they suspect that financial results may not be appropriate, lawyers are usually advocates for their clients and will often follow and support their clients until it is obvious that fraud has occurred. } In addition, lawyers usually have information about a client’s legal difficulties, regulatory problems, and other significant occurrences. Albrecht, Fraud Examination, 6 th Edition. © 2019 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. CHAPTER 11 20

Relationship with Investors } Relationships with investors are important because financial statement fraud is often motivated by a debt or an equity offering to investors. } In addition, knowledge of the number and kinds of investors can often provide an indication of the degree of pressure and public scrutiny upon management of the company and its financial performance. Albrecht, Fraud Examination, 6 th Edition. © 2019 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. CHAPTER 11 21

Relationship with Regulatory Bodies } If the company you are examining is a publicly held client, you need to know whether the SEC has ever issued an enforcement release or Wells Notice (notice of an impending enforcement action) against it. } It’s also important to know if all annual, quarterly, and other reports have been filed on a timely basis. } If the company is in a regulated industry, you need to know if there any problematic issues related to the appropriate regulatory bodies } Whether the organization owes back taxes to the federal or state government or to other taxing districts is also important. } Because of the recourse and sanctions available to taxing authorities, organizations usually do not fall behind on their payments unless something is wrong or the organization is having serious cash flow problems. Albrecht, Fraud Examination, 6 th Edition. © 2019 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. CHAPTER 11 22

Organization and Industry } Financial statement fraud is sometimes masked by creating an organizational structure that makes it easy to hide fraud. } The attributes of an organization that suggest potential fraud exposures include such things as: } An unduly complex organizational structure } An organization without an internal audit department } A board of directors with no or few outsiders on the board or audit committee } An organization in which one person or a small group of individuals controls related entities } An organization that has offshore affiliates with no apparent business purpose } An organization that has made numerous acquisitions and has recognized large merger-related charges } An organization that is new Albrecht, Fraud Examination, 6 th Edition. © 2019 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. CHAPTER 11 23

Financial Results and Operating Characteristics } Much can be learned about exposure to financial statement fraud by closely examining management and the board of directors, relationships with others, and the nature of the organization. } Looking at those three elements usually involves the same procedures for all kinds of financial statement frauds, whether the accounts manipulated are revenues, assets, liabilities, expenses, or equities. } The kinds of exposures identified by the financial statements and operating characteristics of the organization differ from fraud scheme to fraud scheme. } Twenty-three of the critical questions that must be asked about financial statement relationships and operating results appear on the next four slides. Albrecht, Fraud Examination, 6 th Edition. © 2019 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. CHAPTER 11 24

Critical Questions about Financial Statement Relationships and Operating Results (1– 6) 1. Are unrealistic changes or increases present in financial statement account balances? 2. Are the account balances realistic given the nature, age, and size of the company? 3. Do actual physical assets exist in the amounts and values indicated on the financial statements? 4. Have there been significant changes in the nature of the organization’s revenues or expenses? 5. Do one or a few large transactions account for a significant portion of any account balance or amount? 6. Are significant transactions made near the end of the period that positively impact results of operations, especially transactions that are unusual or highly complex or that pose “substance over form” questions? Albrecht, Fraud Examination, 6 th Edition. © 2019 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. CHAPTER 11 25

Critical Questions about Financial Statement Relationships and Operating Results (7– 10) 7. Do financial results appear consistent on a quarter-by-quarter or month-by-month basis, or are unrealistic amounts occurring in a subperiod? 8. Does the entity show an inability to generate cash flows from operations while reporting earnings and earnings growth? 9. Is significant pressure felt to obtain additional capital necessary to stay competitive, considering the financial position of the entity—including the need for funds to finance major research and development or capital expenditures? 10. Are reported assets, liabilities, revenues, or expenses based on significant estimates that involve unusually subjective judgments or uncertainties or that are subject to potential significant change in the near term? Albrecht, Fraud Examination, 6 th Edition. © 2019 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. CHAPTER 11 26

Critical Questions about Financial Statement Relationships and Operating Results (11– 16) 11. Does growth or profitability appear rapid, especially compared with that of other companies in the same industry? 12. Is the organization highly vulnerable to changes in interest rates? 13. Are unrealistically aggressive sales or profitability incentive programs in place? 14. Is a threat of imminent bankruptcy, foreclosure, or hostile takeover pertinent? 15. Are adverse consequences on significant pending transactions possible, such as a business combination or contract award, if poor financial results are reported? 16. Has management personally guaranteed significant debts of the entity when its financial position is poor or deteriorating? Albrecht, Fraud Examination, 6 th Edition. © 2019 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. CHAPTER 11 27

Critical Questions about Financial Statement Relationships and Operating Results (17– 23) 17. Does the firm continuously operate on a “crisis” basis or without a careful budgeting and planning process? 18. Does the organization have difficulty collecting receivables or have other cash flow problems? 19. Is the organization dependent on one or two key products or services, especially products or services that can become quickly obsolete or where other organizations have the ability to adapt more quickly to market swings? 20. Do the footnotes contain information about difficult-tounderstand issues? 21. Are adequate disclosures made in the footnotes? 22. Are financial results or operating characteristics accompanied by questionable or suspicious factors? 23. Are financial results consistent with nonfinancial performance indicators? Albrecht, Fraud Examination, 6 th Edition. © 2019 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. CHAPTER 11 28