Professional Documents
Culture Documents
Contents
1 Introduction
2 Categories of Financial Statement Fraud
3 Fraudulent Financial Reporting
3.1 Earnings Management Methods Permissible by GAAP; The Grey Zone
3.2 Earnings Management Methods Not Permissible by GAAP
4 Overview of Largest Fraudulent Financial Reporting Cases
(1997 2002)
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1. Introduction
Statement on Auditing Standards No. 991 (SAS 99) requires auditors to focus
on two broad areas of fraud: (i) fraudulent financial reporting and (ii)
misappropriation of assets. Each of these has a multitude of fraud schemes.
This chapter provides an overview of the most common financial statement fraud
schemes, indicators of their occurrence, and methods of detection.
The focus is to familiarize the reader with certain fraud schemes, the various
indicators which evidence that these schemes may be or are being perpetrated
and how an auditor might detect those schemes. While this chapter discusses
numerous fraud schemes, it does not contain a comprehensive list of all possible
schemes. Similarly, with respect to the listed schemes, space constraints
prevent discussion of all possible detection procedures the auditor can perform to
determine whether the particular scheme exists.
Frauds committed against the corporation carry financial risk, that is, the loss of
income or assets because of fraud. External and internal misappropriations of
assets are by far the most common fraud against the corporation.
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Accountants working with public companies, however, take note. The SEC takes
the position that compliance with GAAP will not necessarily protect an entity from
an SEC enforcement action, if financial performance is distorted.3
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Entities have a host of reasons for selecting those principles that will paint the
rosiest financial picture. Some would argue that the market demands it, as
reflected by the stock price punishment for companies that differ by as little as
one penny per share from prior estimates. External market pressures to meet
the numbers conflicts with market pressure for transparency in financial
reporting.
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financial picture. If management selects the policy but refuses to recognize the
negative effect, does that demonstrate fraud in the selection of the policy?
Some financial frauds have no grey; that is, earnings management that are
clearly not within the parameters of GAAP. These techniques can inflate
earnings, create an improved financial picture, or conversely, mask a
deteriorating one.
To demonstrate the breadth of recent fraud cases, the table below outlines some
of the larger and more publicized frauds and accounting scandals detected over
the period 1997 2002. The schemes involved an array of industries and
included both frauds by and against the entity as well as corporate
misconduct.
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Many of the schemes described in this chapter violate more than one of the SAB
101 recognition criteria. The indicia for each listed scheme are not mutually
exclusive; that is; factors indicating the potential existence of one scheme can
often be used to detect others.
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Inquiries into alleged improper revenue recognition usually begin with a review of
the entitys revenue recognition policies and customer contracts. The auditor
considers the reasonableness of the companys normal recognition practice and
whether the company has done everything necessary to comply. For example, if
the company customarily obtains a written sale agreement, the absence of a
written agreement becomes a red flag.
The review should begin with a detailed reading of the contract terms and
provisions. Particular attention should be focused upon terms governing (i)
payment and shipment, (ii) delivery and acceptance, (iii) risk of loss, (iv) terms
requiring future performance on the part of the seller before payment, (v)
payment of up-front fees, and (vi) other contingencies. The auditor must consider
timing particularly as it relates to the companys quarter and year-end periods.
In which periods were the sales agreements obtained? When was the product or
equipment delivered to the buyers site? When did the buyer become obligated
to pay? What additional service(s) was required of the seller?
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internet face unique revenue recognition issues. The Emerging Issues Task
Force Abstract (EITF) 99-19, Reporting Revenue Gross as a Principal versus
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Net as an Agent, attempts to solve this problem by listing factors which are
considered by the SEC in determining whether revenue should be reported on a
gross or net basis. Similarly EITF 01-9, Accounting for Consideration Given by a
Vendor to a Customer (Including a Reseller of the Vendors Products),18
addresses the issue of sales incentives, such as discounts, coupons, rebates,
and "free" products or services offered by manufacturers to customers of retailers
or other distributors. Being aware of the applicable authority governing the facts
and circumstances can assist the auditor in his determination of recognition
violations.
The auditor should perform the following techniques when investigating revenue
recognition allegations:
Inquire of management and other relevant personnel as to the existence
factors causing the auditor to believe the scheme exists19;
Perform substantive analytics designed to detect the fraud being
investigated; and
Perform substantive testing to determine whether there is evidence to
support the existence of a scheme or lack of evidence to support the
validity of a transaction. Such substantive procedures include but are not
limited to:
- Request and review documents such as contracts and support
for invoices and deliveries;
- Confirmation with customers to the existence of accounts
receivable and the amount of consigned goods;
- Possible public records/background research/site visits
conducted on customers/third parties to verify existence of the
entity being billed;
- Analyzing journal entry activity and supporting documentation in
certain accounts, focusing on round dollar entries at the end of
periods;
- If entries are accruals, obtaining support for the reversal and
confirming the proper timing of the entries.
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The following general indicators can often alert the auditor or auditor as to the
potential existence of premature revenue recognition:
Unexplained change in recognition policies;
Unexplained improvements in gross margin;
Increasing sales with no corresponding increase in cash from operations;
Reported sales, revenue or accounts receivable balances which appear to
be to high or are increasing too fast;
Reported sales discount, sales returns or bad debts expenses which
appear to be too low;
Large, numerous or unusual sales transactions occurring shortly before
the end of the period;
Large amounts of returns or credits after the close of a period; or
Inconsistent business activity
- Increased revenues with no corresponding increase in distribution
costs or
- Increased revenues with no offsetting increase in accounts receivable.
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Of course, good interviewing and sound analytics will not substitute for having a
good understanding of the clients business. Even seasoned auditors have been
misled and thought revenue to be appropriate because they did not fully
understand the business. Thus, after all the analytics and interviews, the auditor
must ask him or herself whether the information and results obtained make
sense in light of the clients industry and business. The auditor should also to the
extent applicable, benchmark performance results against other companies in
the same industry.
While SAB 101 requires a definitive sales or service agreement, agreements can
and often are legitimately amended. Problems arise however when a company
enters into such an arrangement and subsequently modifies, supplements,
revokes, or otherwise amends the original agreement with a written or oral side
agreement prepared and agreed to outside the normal reporting channels of the
business.
The existence of numerous side agreements should raise red flags to the auditor
and require further detailed inquiry as to the facts and circumstances surrounding
how, when and why the agreements were entered into. Additional investigation
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Case Illustration
The case of Informix Corp illustrates the improper use of side-agreements.20
Informix sold licensed software to companies, which, in turn, would resell the
licenses to third parties. Consistent with then current GAAP for revenue
recognition with respect to software21, the companys written policy was to
recognize revenue from the sale of licenses only upon receipt of a signed and
dated license agreement. However, to meet the earnings expectations of the
company and financial analysts, management entered into numerous written and
oral side agreements containing different provisions, which caused them to
violate GAAP revenue recognition principles. These provisions included:
Allowing resellers to return and to receive a refund or credit for unsold
licenses;
Committing the company to use its own sales force to find customers for
resellers;
Offering to assign future end-user orders to resellers;
Extending payment dates beyond twelve months;
Committing the company to purchase computer hardware or services from
customers under terms that effectively refunded all, or a substantial
portion, of the license fees paid by the customer;
Offering to pay for customer storage costs;
Diverting the company's own future service revenues to customers as a
means of refunding their license fees; and
Paying fictitious consulting or other fees to customers to be repaid to the
company as license fees.
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In addition to inquires, the auditor should review the companys right of return
policy and understand its rationale. The auditor should satisfy him or herself by
reviewing a sample of contracts for side agreements and confirm with a sample
of customers the major contract terms of their contracts, including the existence
or absence of any side agreements.
Most industries allow customers to return products to sellers for any number of
reasons, and GAAP allows entities to recognize revenue in certain cases even
though the customer may have a right of return. Specifically, Statement of
Financial Accounting Standard (SFAS) No. 48, Revenue Recognition Where
Right of Return Exists22 provides that when customers are given a right of return,
revenue may be recognized at the time of sale if the:
Sales price is substantially fixed or determinable at the date of sale;
Buyer has paid or is obligated to pay the seller;
Obligation to pay is not contingent on resale of the product;
Buyer's obligation to the seller does not change in the event of theft or
physical destruction or damage of the product;
Buyer acquiring the product for resale is economically separate from the
seller;
Seller does not have significant obligations for future performance or to
bring about resale of the product by the buyer; and
Amount of future returns can be reasonably estimated.23
Sales revenue not recognizable at the time of sale is recognized either when the
return privilege has substantially expired or if the above conditions are
subsequently met. Companies can and often do run astray of SFAS 48 by
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Payment terms that extend over a substantial portion of the period in which the
customer is expected to use or market the purchased products also create
problems. These terms effectively create consignment arrangements inasmuch
as no economic risk has been transferred to the purchaser. As will be discussed
in Section 5.9.3, sales under consignment arrangements cannot be recorded as
revenue.
Case Illustration
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In the case of Midisoft Corporation, the SEC charged the company with
overstating revenue on in the amount of $458,000 on transactions for which
products were shipped, but for which, at the time of shipment, the company had
no reasonable expectation that the customer would accept and pay for the
products. The company eventually accepted back most of the product as sales
returns during the first quarter of the subsequent period.
The SEC noted that Midisofts written distribution agreements generally allowed
the distributor wide latitude to return product to Midisoft for credit whenever the
product was, in the distributor's opinion, damaged, obsolete, or otherwise unable
to be sold. In preparing Midisoft's financial statements for fiscal 1994, company
personnel submitted a proposed allowance for future product returns that was
unreasonably low in light of the large levels of returns Midisoft received in the first
several months of 1995. Furthermore, various officers and employees in the
companys Accounting and Sales Departments knew the exact amount of returns
the company had received prior to the end of March 1995, when the companys
independent auditors finished their field work on the 1994 audit. Had Midisoft
revised the allowance for sales returns to reflect the returns information, it would
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have had to reduce accordingly the amount of net revenue reported for fiscal
1994. Instead, several Midisoft officers and employees devised schemes to
prevent the auditors from discovering the true amount of the returns including
preventing the auditors from touring that portion of the Midisoft headquarters
where the returned goods were stored. In addition, Midisoft accounting
personnel altered records contained in the computer accounting system to
reduce falsely the level of returns.
Midisoft teaches that the auditor should carefully review the terms of the
contracts and any side or extension agreements to determine what rights are
afforded the customer with respect to returning and exchanging the delivered
product. Only in those cases where the customer has limited or no right to return
the product should revenue be recognized. The auditor should also inquire into
the companys refund and exchange policy: how it was derived, whether it is
subject to override, by whom and how often it is overridden. Other relevant
inquiries include sales personnel as to whether the company has offered
customers price concessions, refunds, or new products.
Auditors should also inquire of accounting staff and financial personnel as to the
returns policy and confirm with warehouse personnel who process returns that
the policy is being followed. In addition to the inquiries, the auditor may also
choose to perform the following analytics:
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Case Illustration
The case against Sunbeam Corporation25 is illustrative. In December 1997,
Sunbeam established a program offering discounts, favourable payment terms,
guaranteed mark-ups and the right of return or exchange on unsold products to
any distributor willing to accept the companys products before year-end. The
company failed to disclose this practice in its quarterly 10Q. As a result, the SEC
charged that the companys 10Q statement was misleading and that the
company had eroded future sales and profit margins by pulling them into the
current period.
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after the close of a period as compared to prior periods and margins on sales
recorded immediately before the end of a reporting period.
Based on the provisions of SAB 101, income should not be recognized under
these circumstances because delivery has not actually occurred.
Customers on the other side of early delivery schemes often return the
unfinished product or demand more completion before payment is rendered.
Analytics that may reveal the existence of an early delivery scheme include:
Comparing returns in the current period and prior periods;
Comparing shipping costs in current period and prior periods; and
Comparing shipping costs as a percentage of revenue in the current
period and prior periods.
Careful scrutiny of the sales contract will also assist to detect these schemes.
When must payment be made in relation to delivery? Which party bears the risk
of loss on shipment? The audit or investigative team should then compare these
contract terms with the requirements of SAB 101 and other accounting literature.
The auditor should also make broad inquiries of non-financial personnel such as:
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Case Illustration
The SECs enforcement action against FastComm Communications Corp is
illustrative.26 In 1999, the SEC charged FastComm with recognizing revenue on
the sale of products that were not fully assembled or functional. The SEC
charged that it was improper because delivery had not yet occurred.
Auditing for partial shipments is similar to auditing for early product delivery. The
auditor must consider:
Numerous returns of incomplete products after the close of period by
customers seeking the full product;
Large, numerous or unusual transactions occurring shortly before the end
of the period;
Examining product details on the invoices;
Is the invoice cut with all products ordered whether shipped or not?
Obtain understanding of drop shipments to customers; if a drop
shipment is partial, is the invoice to the customer also partial?
How does the company ensure all drop shipped products are
properly accounted for in the sales invoice process and also in
paying for the goods to the supplier?
Reviewing customer complaints regarding lack of completeness in
shipments.
In addition, the auditor will want to inquire of management and sales personnel
regarding the policy and process for billing partially filled orders. A review of the
shipping documents and comparison to the sales journal will also often reveal
what was booked as sales and what was actually shipped. The auditor may also
consider talking to customers or reviewing correspondence from customers to
see if there are numerous complaints from customers regarding partial
shipments.
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Case Illustration
In 1996, the SEC charged Advanced Medical Products employees with
recognizing revenues on soft sales or sales for which the customer had
expressed interest but not actually committed to purchasing. The company
shipped the products to its field representatives, who held them while the
customer decided whether to purchase the product.
The company however, recognized the revenue as of the date of the shipment to
the field representative. Employees withheld sending invoices and monthly
statements to prevent customer complaints resulting from being invoiced for
equipment that they had not agreed to purchase.
To detect this scheme, the auditor may wish to review customer complaint logs
and correspondence for complaints of goods shipped prior to the customers
readiness to accept or when the customer was merely making inquiry into the
goods.
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Case Illustration
The SEC action against Advanced Medical Products is a classic example of
improperly recognizing revenue on contracts with multiple deliverables.29 Rather
than shipping the product to the customer, Advanced Medical Products shipped
products to companys field representatives, who were responsible for installing
the product and training the customers employees. The SEC charged that the
company incorrectly recognized revenue upon shipment to the field
representatives. This policy contravened GAAP as there was no economic
exchange and risk of loss had not passed to the customer because the products
were still in the control of the company.
In addition to the general indicators listed above, this scheme, which has been
prevalent in the software industry, can possibly be uncovered by confirming with
major customers whether all services have been performed with respect to the
products purchased and received. For companies that deal with distributors of
their product, auditors should obtain an understanding as to whether the
company forces a pre-determined listing of SKUs to its distributors, without an
order from the distributors. If this is the case, there may be a culture of forcing
product out to distributors to meet the numbers. A rash of returns from the
distributors in subsequent months might also reveal this practice. Further
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manipulation of the books and records can occur by the entity when these
returns are not processed in a timely fashion.
Some firms will collect up-front fees for services provided over an extended
period, e.g., maintenance contracts. SAB 101 provides that up-front fees should
generally be recognized over the life of the contract or the expected period of
performance.
Bill and Hold schemes are another common method of bypassing the delivery
requirement. As its name implies, a legitimate sales order is received,
processed, and ready for shipment. The customer however, for whatever
reason, may not be ready, willing, or able to accept delivery of the product at that
particular point in time. The seller holds the goods in its facility or ships them to a
different location, such as a third party warehouse for storage until the customer
is ready to accept shipment.
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In addition to the above factors, the SEC also recommends preparers of financial
statements to consider:
The date by which the seller expects payment, and whether the seller has
modified its normal billing and credit terms for this buyer;
The seller's past experiences with and pattern of bill and hold transactions;
Whether the buyer has the expected risk of loss in the event of a decline
in the market value of goods;
Whether the seller's custodial risks are insurable and insured; and
Whether extended procedures are necessary in order to assure that there
are no exceptions to the buyer's commitment to accept and pay for the
goods sold (i.e., that the business reasons for the bill and hold have not
introduced a contingency to the buyer's commitment).31
Auditors coming across agreements that do not meet the above criteria should
be wary of potential bill and hold schemes. Auditors should consider whether:
Bills of lading are signed by a company employee rather than shipping
company;
Review of shipping documents indicates excessive shipments made to
warehouses rather than to a customer's regular address (which could
mean that shipments are made to the sellers warehouses rather than
customer locations);
Shipping information is missing on invoices;
High shipping costs incurred near the end of the accounting period;
Large, numerous or unusual sales transactions occurring shortly before
the end of the period; or
Decrease in current year monthly sales from the prior year that may
indicate the reversal of fraudulent bill and hold transactions in a
subsequent period.
When confronted with the above indicators, the auditor should first inquire of
management regarding any bill and hold policies and any customers with bill and
hold arrangements. The auditor should also make inquiry of warehouse
personnel regarding customer inventory being held on the premises in a third
party warehouse, or shipped to another company facility. Finally, the auditor
should inquire of shipping department or finance personnel if they have ever
been asked to falsify or alter shipping documents.
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Case Illustration
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Fictitious revenue schemes can and often will be detected by the same methods
used to detect premature revenue recognition schemes. Auditors should
consider:
Discovery of significant revenue adjustments to revenue at the end of the
reporting period;
Unexpected increases in sales by month at period end;
Customers with unknown names or addresses or which have no apparent
business relation to the business;
Increased sales accompanied by stagnant or decreasing cost of sales and
corresponding improvement in gross margins;
Improvement in bad debts as a percentage of sales; and/or
Decrease of shipping costs compared with sales.
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The auditor should also inquire whether sales or shipping personnel have noted
any unusually high sales or shipments to customers with no reasonable
explanation or noted any significant sales or shipments to unfamiliar new
customers.
Case Illustration
Consider the case of medical device supplier, Boston Japan33, which during fiscal
years 1997-1998 recognized over $75 million dollars of revenue from fraudulent
sales. Company sales managers leased commercial warehouses, recorded false
sales to distributors, and shipped the goods to the leased warehouses. The
company masked the fact that the distributors never paid for the goods by issuing
credits to the distributors and then recording false sales of the same goods to
other distributors, without ever moving the goods out of the leased warehouses.
Company employees even recorded sales to distributors that were not involved
in the medical device business, but that had agreed with company sales
managers to collude in the fraud. Some of the false sales were made to
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distributors that never resold any of the goods and never paid Boston Japan for
any purported sales. The sales managers and cooperating independent
distributors further colluded to cover up false sales by falsely confirming the
legitimacy of the sales to the companys auditors.
Case Illustration
In 2002, the SEC began investigating the way telecom giant Qwest
Communications International Inc. and some of its competitors, such as Global
Crossing accounted for sales of fiber-optic capacity and whether it was proper for
the company to recognize the revenue right away immediately.
Qwest sold capacity on their fiber-optic network to carriers and also purchased
capacity from them. Both companies recognized revenue from capacity swaps
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and indefeasible rights of use (IRU) that allowed another carrier or company the
unfettered use of the capacity over a long period of time. In some cases, the
amount of the sale and purchase were almost identical. Qwest booked the
revenue from these sales all at one time instead of deferring part of it over many
years. GAAP however, requires companies to record the revenue generated by
an IRU over the time of the contract.
The effect was to boost Qwest's revenue by $1 billion in 2001 and $465 million in
2000.
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Improperly holding open the books beyond the end of an accounting period can
enable companies to record additional end of period sales that are invoiced and
shipped after the end of a reporting period. While standard cut-off testing will
often discloses these schemes, auditors should be cognizant and skilled in
detecting manipulation of information systems to achieve this result. Direct
inquiry of accounting personnel, billing clerks and warehouse personnel may
assist in determining whether the books are held open past the end of the period.
Computer forensics can also be used to ferret out these schemes.
Case Illustration
In 1993, the management of Platinum Software Corp., was concerned about the
companys "days sales outstanding" ("DSO") the measure of the time a
company takes to collect its receivables. The companys DSO had increased
throughout 1993, in part because it had improperly recognized revenue on
contingent or cancelled license agreements. One of the companys responses to
the increasing DSO was to hold open the companys open for cash received after
period-end. Management recorded checks received by the company in July
1993, on the companys balance sheet as an increase in cash and a reduction in
receivables as of June 30. Holding the books open resulted in a cash
overstatement and associated receivable understatement. Similarly, for the
quarter ending September 1993, management included cash that the company
received for about a week into October, resulting in a cash overstatement and
accounts receivable understatement of $724,000. The same pattern continued
through December 1993, resulting in a cash overstatement and accounts
receivable understatement of $3,463,000. The company was ultimately ordered
to cease and desist in this practice by the SEC.
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Case Illustration
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The percentage of completion is the method that is most often subject to abuse.
Some companies will use the percentage of completion method notwithstanding
that they do not qualify for that method. Companies can artificially inflate
revenue by increasing the costs incurred toward completion, underestimating the
costs of completion, or overestimating the percentage completed.
The auditor should perform the following procedures when performing an audit or
investigation of contracts:
Select a sample of contracts and confirm:
o Original contract price;
o Total approved change orders;
o Total billings and payments;
o Details of claims;
o Back charges or disputes; and
o Estimated completion date.
Ensure that all incurred costs are supported with adequate documentation
detailing the nature and amount of expense;
Audit estimated costs to complete by reviewing estimates and comparing
with actual costs incurred after the balance sheet date;
Ensure that all estimated costs to complete the contract should be
supported by reasonable assumptions;
Ensure that all contracts are approved by appropriate personnel;
Review unapproved change orders;
Identify unique contracts and retest the estimates of cost and progress on
the contract;
Test contract costs to ensure costs are matched with appropriate
contracts and costs are not shifted from unprofitable contracts to profitable
ones;
Ensure that losses are recorded as incurred;
Review all disputes and claims;
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Case Illustration
In 1996, the SEC charged 3Net Systems with improperly recognizing over $1
million of revenue in both 1991 and 1992, by misrepresenting to its outside
auditors the degree to which certain work had been completed under certain
contracts with existing customers. In fact, 3Net had not completed any of the
contracts, and in addition, had not even determined the costs to complete.
Further, 3Net had no other means of reliably estimating progress toward
completion for these contracts, as it lacked the systems necessary to estimate
and track progress on their development. Because 3Net could not reliably
estimate progress toward completion, the contracts in question did not qualify for
the percentage of completion method. The SEC charged 3Net should have used
the completed contract method for the contracts. Had it done so, 3Net would not
have reported revenue in fiscal 1991 because it completed none of these
contracts by the end of fiscal 1991.39
Sham related party transactions are transactions between related parties where
either little or no consideration is given for the product or service. The existence
of related party transactions cuts to the very first criteria of SAB 101 that there be
persuasive evidence of an arms length arrangement. Sales transactions should
stem from express or implied contracts and represent exchanges between
independent parties at arms-length prices and terms. Accordingly, arms-length
transactions cannot be achieved in those situations where the parties are related
or where one party can exercise substantial control over the other.
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Related party transactions carry the presumption that one or both parties have
received a benefit that they would not have otherwise received had the
transactions been truly arms length. Related party schemes can take place in
the context of any of the schemes listed in this chapter.
An auditor may encounter related parties that are known by some members of
the company; however, the relationships are not properly disclosed in the books
and records. The auditor should inquire as to outside business interests and
then try to determine whether they are properly disclosed, and the volume of
transactions, if any, that are occurring between the entities.
Auditors should also focus on the relationship and identity of the other party to
the transaction and whether the transaction emphasizes form over substance.
Common indicators of such related party, sham transactions include but are not
limited to:
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An auditor can often become alert to the possibility of fictitious or over inflated
assets by inquiring as to whether the entity intends to secure financing. If the
answer is yes and if that financing is contingent on the value of particular assets
such as receivables or inventory, that should lead the auditor to ask more
questions and perform additional procedures to verify the existence, and location
and value of these assets. As with certain other schemes, the auditor can most
often detect these schemes by observing the companys operations and inquiring
as to unusual items.
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The original COSO Report found that fraudulent asset valuations comprised
nearly half of the cases of financial fraud statements. Misstatements of
inventory, in turn, comprised the majority of asset valuation frauds.
Generally, when inventory is sold, the amounts are transferred to cost of goods
sold and included in the income statement as a direct reduction of sales. An
overvaluation of ending inventory will understate cost of goods sold and in turn,
overstate net income.
Following are indicators an auditor can look for to detect possible inventory
manipulation:
A gross profit margin which is higher than expected;
Inventory that increases faster than sales;
Inventory turnover that decreases from one period to the next;
Shipping costs that decrease as a percentage of inventory;
Inventory as a percentage of total assets that rise faster than expected;
Decreasing cost of sales as a percentage of sales;
Cost of goods sold per the books that do not agree with the company's tax
return;
Falling shipping costs while total inventory or cost of sales have increased;
and
Monthly trend analyses that indicate spikes in inventory balances near
year-end.
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The most effective way for the auditor or auditor to confirm the inventory balance
is physically to observe the clients inventory, particularly at times when an
inventory count is being performed. In fact, Generally Accepted Auditing
Standards (GAAS) require auditors to physically observe, test, and inquire as to
the amount of inventory on hand and to satisfy themselves with respect to the
methods of inventory taking and the measure of reliance placed upon the clients
representations about the quantities and physical condition of inventories. 44
When the auditor cannot be satisfied as to the inventories he or she must
physically count the inventory and test transactions in that account.45 Where
inventory is stored outside the company site, such as public warehouses,
auditors should conduct additional procedures to confirm balance.
Case Illustration
Fraud history is filled with names of companies made famous or infamous by
fictitious inventory schemes including McKesson and Robbins, ZZZ Best and
Crazy Eddie. The most famous bogus inventory fraud perhaps is the Salad Oil
Swindle of the 1960s. In that case, management of the company rented
petroleum tanks and filled them with seawater. The company was able to
convince the auditors that the tanks contained over $100 million in vegetable oil
because the oil rose to the top of banks. In fact, the little oil that was present was
pumped from one tank to the next depending on the companys advance
knowledge of the auditors inventory observation plan.46
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The auditor should look for the following operational factors may arouse
suspicions of fictitious inventory:
Inventory that cannot be easily physically inspected;
Unsupported inventory, cost of sales or accounts payable journal entries;
Unusual or suspicious shipping and receiving reports;
Unusual or suspicious purchase orders;
Large test count differences;
Inventory that does not appear to have been used for some time or that is
stored in unusual locations;
Large quantities of high cost items in summarized inventory;
Unclear or ineffective cut-off procedures or inclusions in inventory of
merchandise already sold or for which purchases are not recorded;
Adjusting entries which have increased inventory over time;
Material reversing entries to the inventory account after the close of the
accounting period;
Inventory that is not subject to a physical count at year end;
Improper or accidental sales that are reversed and included in inventory
but not counted in physical observation (for example a company
accidentally delivers a specifics product to a customer, tells the customer
it was a mistake and requests the customer to send the product back);
and
Excessive inter-company and interplant movement of inventory with little
or no related controls or documentation.
Even physical observation however, is not fail-proof. Even when an auditor can
observe inventory, a company can still perpetrate fraud by:
Following the auditor during the course of the count and adding fictitious
inventory to the items not tested;
Obtaining advance notice of the timing and location of the inventory
counts thereby permitting the company to conceal shortages at locations
not visited;
Stacking empty containers at the warehouse which are not checked during
the count;
Entering additional quantities on count sheets, cards, scanners, etc. that
do not exist or adding a digit in front of the actual count;
Falsifying shipping documents to show that inventory is in transit from one
company location to another;
Falsifying documents to show that inventory is located at a public
warehouse or other location not controlled by the company;
Including consigned items as part of the inventory count; and
Including items being held for customers as part of the inventory count.
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To deter management from inflating inventory during physical counts, the auditor
should consider:
Reviewing company policy for inventory counts (frequency and
procedures);
Inquiring of management and internal audit as to the dollar adjustment of
the book to physical counts and the reasons for the significant differences;
Inquiring as to whether all inventory shrinkages have been reported;
Inquiring and observe inventory at third-party locations/off-site storage
locations;
Observing a physical inventory unannounced; and
Conducting physical inventories for multi locations all on the same date.
Auditors thus should be fully aware of the items comprising inventory and their
life cycles, particularly as it relates to that industry. In addition, during the
physical observation of the inventory, the auditor must look for and inquire about
older items that appear to be obsolete. Few or no write-downs to market or no
provisions for obsolescence in industries where there have been changes in
product lines or technology or rapid declines in sales or markets warrant further
investigation as to why the company has not accounted for such declines even
when the inventory in question may be relatively new.
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Companies can manipulate accounts receivable with the same techniques that
they can manipulate inventory; that is, by creating:
Fictitious receivables; and
Inflating the value of receivables.
The indicia of fictitious receivables are generally similar to those in our discussion
of fictitious earnings:
Unexpected increases in sales and corresponding receivables by month at
period end;
Large discounts, allowances, credits or returns after the close of the
accounting period;
Large receivable balances from related parties or conversely from
customers with unknown names or addresses or which have no apparent
business relation to the business;
Receivable balances increasing faster than sales;
Organizations that pay commissions based on sales rather than the
collection of the receivable;
Increased receivable balances accompanied by stable or decreasing cost
of sales and corresponding improvement in gross margins;
Lengthening of aging of receivables or granting of extended credit terms;
Excessive write offs of customer receivable balances after period end;
Re-aging of receivables;
Excessive use of account called miscellaneous/unidentified customer
Large unapplied cash balance;
Increased trend of past due receivables; and
Lack of adequate controls in the sales and billing functions.
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Fictitious receivables schemes can also often involve related parties, as related
parties are more likely to assist in collusion and providing of false information to
the auditor. Auditors should inquire into the legitimacy of receivables if they
appear to involve a related party.
Case Illustration
One of the most famous financial frauds occurred in the 1980s by Crazy Eddie
Antar, who operated a chain of consumer electronic stores. Among other
techniques used by Antar to overstate income was the creation of fictitious
receivables by having employees create phoney sales invoices showing
merchandise sales. Antar even had the cooperation of major suppliers, who lied
when auditors sought confirmations of receivable balances.48
Inflating the value of legitimate receivables has the same impact as creating
fictitious ones. GAAP requires accounts receivable to be reported at net
realizable value. Net realizable value is the gross value of the receivable less an
estimated allowance for uncollectible accounts.49 GAAP requires companies to
estimate the uncollectible portion of a receivable to determine the net realizable
value of receivables. The GAAP preferred method to determine uncollectible
receivables is to periodically record the estimate of uncollectible receivables as a
percentage of sales, outstanding receivables, or based on an aging of
outstanding receivables.
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Under the allowance method bad debt provisions are recorded as a debit to bad
debt expense, (an income statement account) and a credit to allowance for
doubtful accounts, (a balance sheet contra receivable account.) When all or a
portion of the receivable becomes uncollectible, the uncollectible amount is
charged against the allowance account. When receivables are recorded at their
true net realizable value, the recording of a bad debt provision decreases
accounts receivable, current assets, working capital and most importantly, net
income.
A related scheme is not writing off (or delaying the write-off) of receivables that
have in fact become uncollectible. These schemes are relatively easy to execute
given the subjectivity involved in estimating bad debt provisions.
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Company changes to its credit policy and the reason for such changes;
Management as to the reason for any change in the reserve rates or
policy for reserves in accounts receivable;
The sales force and Credit Department about whether they have been
pressured or requested to grant credit to customers who are not credit
worthy;
The Credit Department if they have been requested to extend payment
terms for certain customers;
The Credit Department to determine whether certain sales people have
instructed them to approve a customer and to avoid/circumvent the normal
approval process; and
The nature and details surrounding any disputes with customers.
Case Illustration
In 2002, pharmaceutical company Andrx Corp. announced the company would
have to restate its results going back to 1999 due to the discovery that an
employee of one of its subsidiaries altered certain accounting records pertaining
to accounts receivable balances and their associated aging relating to its
pharmaceutical and distribution operations.50
48
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As discussed below, the auditor must first be familiar with all of the entitys
investments and understand their classifications. This knowledge is necessary to
spot the red flags of potential fraudulent accounting practices. The auditor must
also be aware of the current market status of all investments and must confirm
that the entitys books and records reflect all increase or decreases in such
status. In addition, the auditor should question all classifications of securities to
ensure that they are indeed classified in a manner that is consistent with the
companys intentions and not just done to recognize gain or forgo recognizing
loss. The auditor should be also wary of losses on securities held as available
for sale that are accumulating in the other comprehensive income account. The
company must eventually take a charge for these losses either through a sale or
through a permanent write down. Evidence of accumulating losses may lead the
auditor to conclude that management is intentionally delaying the recognition of
such a loss.
Fictitious investments are similar to the creation of other fictitious assets. Indicia
include:
Missing supporting documentation;
Missing brokerage statements; and
Unusual investments (i.e., gold bullion) or ones held in remote locations or
with obscure third parties.
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Companies can also manipulate their financial statements by inflating the value
of investments by misclassifying them or failing to record unrealized declines in
market value for those investments. We begin our discussion with a brief
overview of the applicable GAAP requirements.
GAAP requires investments of debt securities (i.e., bonds and other corporate
51
paper) to be classified as either trading, held to maturity or available for sale.
Investments may be classified as held to maturity only if the holder has the
positive intent and ability to hold those securities to maturity. Held to maturity
securities are reported at amortized cost with no adjustment made for unrealized
holdings gains or losses unless the value has declined below cost and is not
expected to recover. In the latter instance, the security is written down to fair
value and a loss recorded in earnings.52
GAAP requires investments to be classified as trading if they are bought and held
principally for sale in the near term. Investments not classified as trading or as
held-to-maturity are classified as available-for-sale securities.53
Trading and available for sale securities are reported at fair market value and
must be periodically adjusted for unrealized gains and losses to bring them to fair
market value. Unrealized gains or losses from trading securities are included in
income for the period. Unrealized gains or losses from changes held as
available for sale are reported as a component of other comprehensive income.54
Equity securities (i.e., common or preferred stock) on the other hand, can be
classified only as trading or available for sale. Unrealized gains or losses from
50
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changes in fair market value are reported in earnings for trading securities and as
a component of other comprehensive income for securities held as available for
sale.
Misclassification of Investments
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The Treasury function most commonly decides the classification at the time that
the security is acquired. Auditors should review any changes in classification for
possible abuse.
The start of any audit with respect to questionable capitalization policies should
be the companys accounting policy with respect to this area in addition to the
policies of other entities in the industry. Is the company being overly aggressive
with its policies as compared to other companies? Due consideration must also
be given to managements reasons for selecting the policy. The auditor will also
want to consider whether the costs in question are providing future benefit
thereby warranting capitalization. Detecting capitalization policies can often be
achieved by considering or reviewing the following items:
52
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Case Illustration
The WorldCom case is perhaps the most infamous example of how a company
can inflate earnings through improper capitalization of expenses. The companys
internal audit department discovered that management had categorized billions
of dollars as capital expenditures in 2001 that, in fact, were ordinary expenses
paid to local telephone companies to complete calls. The scheme allowed
WorldCom to turn a $662 million loss into a $2.4 billion profit.
53
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GAAP generally requires R&D costs to be expensed due to the uncertainty of the
amount and timing of economic benefits to be gained from R&D. A company,
however, may capitalize materials, equipment, intangibles, or facilities that have
alternate future uses.57 The SEC has also been particularly concerned about
mergers and the acquirers who classify a large part of the acquisition price as in
process research and development (R&D), thereby allowing the entity to
immediately expense the costs.58 This practice allows the entity to write off the
R&D in a single chunk in the year of acquisition and not burdening future
earnings with amortized R&D charges. This type of practice also involves the
creation of liabilities for future operating expenses.
Case Illustration
The SEC action against Pinnacle Holdings, Inc. arising from its acquisition of
certain assets from Motorola is illustrative. The SEC found that that Pinnacle
improperly established more than $24 million of liabilities that did not represent
liabilities at the time of the acquisition.59
Similar to R&D, GAAP requires all start-up costs to be expensed in the year
incurred.60 However, many entities will label start up activities as other costs
thereby attempting to capitalize them.
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may not exceed the interest cost incurred during that period. Capitalization is no
longer allowed when the cost of the asset exceeds its net realizable value. One
potential scheme in this area is for the company to continue capitalizing interest
after construction has been completed.
Case Illustration
In 2000, the SEC charged America Online, (AOL), with incorrectly amortizing
for the fiscal years 1995 and 1996, the subscriber acquisition costs associated
with the manufacturing and distributing of computer disks containing its program
to prospective customers. The SEC claimed that because of the volatile and
unstable nature of the internet industry during the period in question, AOL could
not with any reliability make a prediction of future net revenues. Thus, the
subscriber costs were more like advertising costs and required expensing in
accordance with SOP 93-7. AOL had reported profits for six of the eight quarters
in 1995-1996 instead of the losses it would have reported had these costs been
expensed. The costs improperly capitalized amounted to approximately $385
million by September 30, 1996 when AOL decided to write them off.
55
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Tour of the clients facility to review fixed assets: select certain fixed
assets from the fixed asset listing (especially new, significant additions),
physically confirming that the fixed asset exists and physically inspecting
the assets serial number if applicable;
Determine that retired assets are no longer included in financial
statements; and
Review internal controls to ensure that there are written policies covering
retirement procedures which include serially [sequentially] numbered
retirement work orders, reasons for retirement and all necessary
approvals.
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7.1 General
Auditors can use various analytical indicators to search for indicia of these
schemes, including:
57
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The Enron scandal highlighted the practice of fraud by using off-balance sheet
vehicles to transfer and conceal debt.63 It must be noted however, that off-
balance sheet vehicles, despite a recent significant tightening in accounting
rules, are in fact permissible under GAAP. The fraud occurs when companies
use them to, for example, conceal debt thereby misleading investors about the
risks and rewards of a transaction, particularly when inadequate or misleading
disclosure is provided. Off-balance sheet transactions also have an income
statement impact as well. With an off-balance sheet transaction, a companys
investment account on the income statement will reflect the relevant proportion
of net profit or loss that results from operation of the underlying net assets. In
other words, the effect of non-consolidation should leave income the same as if
the off-balance sheet investment had been consolidated. However, the individual
line items composing that net income or loss are not explicitly shown. A
58
FIRST DRAFT
Off-balance sheet treatment has historically been used for among other things:
Securitization transactions - financial assets such as receivables are
sold to an off-balance sheet vehicle while the seller retains a
subordinated interest in that entity;
Leasing transactions long-lived assets are acquired by an off-
balance sheet entity. The use of the assets is conveyed to a third party
via an operating lease; and
59
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The second model, the SPE model, applied primarily to entities seen as
special purpose entities. Factors which would typically tend to indicate that a
vehicle is an SPE are (i) limited powers in the vehicles powers/charter or (ii) the
housing of assets, rather than a business, for which there were a limited purpose
and with respect to which few decisions need be made.
The potential for abuse under the old rules generally occurred in the following
areas:
Intentional manipulation in the determination of whether to apply
the voting control or the SPE model - - the result being that the
wrong conclusion had been reached;
Intentional manipulation in the application of the correct accounting
model; and
Intentional and overaggressive use of the wrong accounting model.
In light of the Enron scandal, the Financial Accounting Standards Board (FASB)
expanded upon the accounting guidance that governs when a company should
include the assets and liabilities of another entity in its own financial statements.
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FIN 46 places much emphasis on a risk and reward model of consolidation and
contains a new scope test that serves to direct whether an off-balance sheet
entity is a VIE, and thus whether the provisions of FIN 46 govern and require
consolidation of the off-balance sheet entity.
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The scope test itself is composed of two key questions. The first question is
whether there is sufficient equity in the entity. The second question is whether
the equity has the proper characteristics. A no answer to either question
means the entity is a variable interest entity that must apply the new model and
consolidate. To demonstrate whether an entity has enough residual equity
between the equity holders to absorb expected losses, as defined by FIN 46, in
most cases requires a demonstration that equity exceeds the expected losses, if
any. If they do not, the entity is a VIE requiring consolidation under FIN 46. The
second question asks whether the equity of the entity does have has certain
characteristics that make it act like true e residual common equity.
One of the issues involved with the scope test is the high degree of subjectivity
involved. What is sufficient equity as required by the rule? The rule creates a
rebuttable presumption that an equity investment of less than 10 percent of an
entity's total assets is not sufficient to permit an entity to finance its activities
without additional subordinated financial support. One can rebut the presumption
by demonstrating that the entity:
Is currently or intends to finance its activities without additional
subordinated financial support;
Has at least as much equity invested as other entities holding only
assets similar in quantity and quality that operate without additional
subordinated financial support; or
The amount of equity invested in the entity is greater than a reasonably
reliable estimate of the entity's expected losses.64
Assuming an entity is a variable interest entity, and thus within the scope of FIN
46, the rule then focuses upon which party to the transaction has a majority of
the risks and/or rewards. However, in order to determine who bears a majority of
the risk or reward, a projection of cash flows may be required. These projections
are an opening for a great degree of subjectivity and therefore manipulation.
The above rules are too new to have resulted any fraud cases. Obviously, hiding
or disguising information from the auditor or investing public is the easiest way
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for a company to keep assets and liabilities off its books or inflate income.
Another possibility as mentioned above, is manipulation of the amount of equity
reported in the entity to avoid coming under the provisions of FIN 46.
Management might also manipulate the estimate of expected losses in their cash
flow projections in order to obtain off-balance sheet treatment. Manipulation can
take many forms such as failing to recognize impairments that would decrease
expected cash flows.
Auditors will need to consider the potential of these new schemes on a case-by-
case basis.
While most fraud schemes are geared toward inflating the current financial
position, companies sometimes overstate the amount of provisions to cover the
expected costs of liabilities such as taxes, litigation, bad debts, job cuts and
acquisitions. In doing so, management will establish inflated accruals in those
years where the company is extremely profitable and doing well and can afford to
incur larger expense amounts. These cookie jar reserves are then tucked away
for management to reach into and reverse in future years where the company is
unprofitable or marginally profitable when a boost to earnings would be
beneficial.
Company managers estimate reserves. The outside auditor judges whether the
reserves are reasonable. Generally, it is difficult for auditors to challenge
company estimates because there are no clear accounting guidelines. This
creates a ripe environment for abuse.
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Without hesitation, the internal auditor cited an account number, which was
associated with an account named Miscellaneous Provision. Through account
analysis and collaboration with company employees, it was determined that over
$7 million was in this account to use for a rainy day. The explanation provided
was that the company had already met the goals to pay bonuses for the end of
the period, so this account had some reserve left if need be for future periods.
Case Illustration
In 2002, Microsoft Corp. settled SEC allegations that it had misstated earnings by
maintaining unsupported reserves regarding accruals, allowances, and liability
accounts relating to marketing expenses, sales to original equipment
manufacturers, accelerated depreciation, inventory obsolescence, valuation of
financial assets, interest income, and impairment of manufacturing facilities.
These reserves totalled between $200 million to $900 million during the fiscal
years ended June 30, 1995 through June 30, 1998. These corporate reserves
did not have properly substantiated bases but were based, in part, on judgment
regarding the likelihood of future business events. The SEC further charged the
company with failing to maintain sufficient documentation of the bases for these
reserve accounts and to apply its own accounting policy relating to the
reconciliation of entries in its accounting system. Microsoft failed to maintain
sufficient documentation of the bases for these reserve accounts and to apply its
own accounting policy relating to the reconciliation of entries in its accounting
system.65
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In all these instances, management has perpetrated a fraud on the readers of the
financial statements by not providing sufficient information required to make an
informed decision regarding the financial position of the company.
Case Illustration
Enron has become famous for its misleading disclosures. Consider for example,
the following disclosure provided by Enron Corp. in its 2000 Proxy Statement:
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This clearly inadequate disclosure was made despite the fact that SEC
Regulations expressly requires a description of any transactions involving a
registrant that exceed $60,000 and in which an executive of the company has a
material interest.66
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9. Materiality
Over time, companies and their auditors have also developed certain rules of
thumb to assist them in determining when a matter might be deemed material.
One frequently used rule of thumb is that a misstatement or omission that is less
than 5% of some factor (i.e., net income or net assets, etc.) is not material.
The SEC sought to settle the issue of materiality and remedy the potential for
earnings management abuse with the release of SAB No. 99, Materiality.72 SAB
No. 99 provides guidance for preparers and auditors on evaluating the materiality
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Thus, it is clear that numerical tests also will no longer satisfy a materiality
analysis and that the auditor must question the facts and circumstances
surrounding all suspicious transactions and cannot simply pass on them if they
are deemed financially immaterial.
The chapter has so far focused on reporting fraudulent financial reporting by the
corporation. However, financial fraud can and often is committed against the
corporation - - the most common being external or internal misappropriation of
assets. The Association of Certified Fraud Examiners estimates that up to 6% of
organizational revenues are lost to fraud.73 While most misappropriations are
often quantitatively immaterial when looked at in isolation, often times they occur
enough so that they rapidly become material to an organization.
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The chapter does not detail each and every way employees and third parties
steal from companies. Many schemes are interrelated and share similar
characteristics. For instance, register disbursement schemes can often be
detected by and prevented with the same techniques used to stop billing
schemes. The discussion of one satisfies the other. One common theme
however, is the importance of having and applying strong internal controls, which
cannot be circumvented or overridden.
In addition, this section does not detail every asset a company may have that is
subject to misappropriation but seeks only to list those assets that appear on the
balance sheet of most entities. Companies in different industries have various
types of assets on their balance sheet. Thus there will be certain assets not
listed here. For instance, intellectual property is an asset which can be subject to
theft. However due to the complexities of issues surrounding that asset, it is not
listed in this chapter.
Case Illustration
Cash schemes are the most common form of misappropriation of assets. The
major categories include: (i) skimming and larceny of cash and (ii) fraudulent
disbursements. Fraudulent disbursements include: (i) billing schemes, (ii) payroll
schemes, (iii) expense reimbursement schemes, (iv) check theft and tampering
of checks and (v) register disbursement schemes.74
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Many asset misappropriation schemes start at the entry point of the sale. An
employee can embezzle monies by not recording the sale or full amount of the
monies received. Deterrence of skimming activities requires adequate
segregation of duties among the individuals recording the sales, receiving the
monies, and recording the sales in the books. In addition, particular attention
must be paid to those individuals, such as consultants and sales people, who
handle cash in offsite locations. These individuals often operate without
sufficient controls governing their conduct that can lead to the perpetration of this
scheme.
Case Illustration
In 2003, at least eight Southwest Airlines employees were accused of
misappropriating more than $1.1 million from the airline company using a variety
of skimming techniques. In one method, a ticket counter worker saved an old
ticket that should have been voided. The unmarked ticket then was sold to a
cash-paying customer, who used the ticket. The employee pocketed the money.
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The auditor should review the customer complaint log for complaints regarding
the misapplication or lack of payment to their receivable account balance and
follow-up on any recorded complaints with both management and the customer
to see what the nature of the problem was, how it was resolved, by whom within
the organization and finally whether the problem occurred subsequently.
The auditor should also consider performing certain analytics and noting
particular trends such as:
Finally, an auditor confronted with these high risk factors should consider:
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Lapping
Lapping generally involves converting one customers payment and then using a
subsequent payment, usually from another customer, to cover the payment
converted from the previous customer's account. For example, the perpetrator
will steals the payment intended for customer As account. When a payment is
received from customer B, the thief credits it to As account. And when customer
C pays, that money is credited to B.
Lapping tends to increase at exponential rates and lapping schemes often tend
to reveal themselves because the employee is unable to keep track or obtain
additional payments to cover up the prior skimming.75
Case Illustration
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another set to pay that second set off, and so on. In each case, the amount taken
increased and eventually totalled USD $500,000 worth of her clients'
The controls, analytical and other indicators that apply to skimming also apply to
lapping. However, one of the most effective ways to control a potential lapping
scheme is to require a daily bank deposit in addition to an independent
confirmation that the deposit was properly made. Additionally, the auditor be
aware, pay attention and inquire into any delays in the processing of payments to
customers accounts and inquire as to the reason for those delays.
Cash schemes involve the theft of revenues before they have been recorded in
the books and records of the company. Fraudulent disbursement schemes, on
the other hand, involve theft of funds already entered into the books and records.
Fraudulent disbursement schemes generally fall into five main categories:
Billing schemes;
Theft of company checks;
Payroll schemes;
Expense reimbursement schemes; and
Register disbursement schemes.
These five categories in turn can be broken down further to include a host of
other individual schemes many which, like the cash skimming schemes
discussed above are similar in their nature and means of detection.
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Once the new vendor has been approved, he or she should be entered into a
master vendor database to which only a select few individuals have authority to
enter into and change. These changes should be made in accordance with
written procedures requiring proper authorization. An independent third party
should periodically audit the database to ensure that the listed vendors are
indeed still active and not being used to process fictitious invoices.
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The same person should not be able to both request and approve purchase
orders. Likewise, only designated check signers should be able to disburse
payment.
Computer assisted auditing programs are available for many of these indicators.
The auditor should compare the master vendor database against the prior years
database. The auditor should inquire into the selection and approval process of
new vendors. Further, the auditor should match the checks issued against the
master vendor database, and investigate any payments to vendors who are not
in the master database.
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Case Illustration
A former controller of a well-known hotel misappropriated over $15 million in
cash by setting up a dummy corporation and issuing phoney invoices for services
never rendered to the hotel. The controller was able to get away with this
scheme for over 6 years because he maintained sole control over the hotel bank
account and was able to submit phoney invoices and issue checks or wire funds
to the dummy corporation controlled by him.
Deterrence and detection begin with the companys process for issuing and
reviewing refunds, credits, rebates and discounts. Does the credit/refund/rebate
process contain sufficient levels of review by independent supervisory authority?
Do cash register employees possess authority to void their own transactions?
Are only selected individuals authorized to offer rebates/discounts to vendors and
customers? Do the appropriate people verify the rebate/credit transactions or
are they merely rubber stamped? Is there adequate segregation of
incompatible functions such as approval of vendors, maintaining the vendor
master file, purchasing, processing of payments, and issuing and authorizing
disbursements? Is there an adequate segregation of duties between individuals
authorized to process checks and those in supervisory role? Is access to cash,
checks, or purchase orders, shared by many employees?
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The auditor can employ many of the procedures outlined in the fictitious vendor
discussion above. In addition, the auditor should consider whether to:
Review outgoing credits and rebates to ensure that such payments are
made in accordance with company rules and that any discount terms are
accurately recorded;
Review and question supporting documentation for voided or refunded
sales transactions;
Determine whether certain vendors are receiving preferential treatment
with respect to credits and rebates; and
Inquire of personnel in the purchasing and cash departments whether they
are aware of any vendors who maintain any sort of relationship with other
personnel in the company.
Finally, as a note, whether searching for red flags or trying to actually detect the
existence of this scheme, the auditor must always be cognizant of the existence
of related parties whom the perpetrator may be using to commit this scheme.
An over billing scheme also involves collusion between an employee and third
party. These generally involve extra illegitimate charges to a legitimate business
expense or trade payable. This scheme is similar to false credits schemes and
shares the same indicators. The auditor should be particularly wary of invoices
carrying extra or special charges as well as discrepancies between the
purchase order and invoice amount.
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Pay and return schemes involve employee perpetrators, who improperly pay a
vendor or pay an invoice twice. The employee calls the vendor and requests
return of the improperly issued or duplicate check. The employee then intercepts
and converts the incoming check to his own use. This scheme is similar to
unrecorded sales schemes and can be deterred and detected by techniques
discussed in that section above.
Cash larceny occurs when the perpetrator steals currency from the company.
The theft can be of cash or its equivalent including checks, CDs etc. Theft of
company checks is a common and easy way to accomplish cash larceny
particularly when there is a clear lack of controls and segregation of duties in
incompatible functions. Another basic but effective control is the maintenance of
pre-numbered checks. Thus, any check out of sequence will be easy to identify
and investigated immediately.
Case Illustration
In 2001, a South Dakota accountant was arrested, charged and pleaded guilty to
stealing more than $100,000 from his former employer by stealing company
checks. The evidence showed that the accountant had stolen approximately 15
checks that had been improperly entered into corporate check registers. Nine of
the checks showed the accountant as the payee, and he had endorsed 11 of
them.
In addition to the risks identified throughout this section, the auditor should be
aware of the following factors that may facilitate the perpetration of this scheme:
Lack of adequate physical safeguarding of cash or incoming checks;
Excessive amounts of voided checks;
Numerous checks payable to employees other than regular payroll
checks;
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Once the auditor has detected the possible existence of this scheme, there are
various procedures he or she can perform to confirm this possibility. The starting
point should be to review bank accounts established by company to ensure that
they have been properly authorized and that only authorized personnel are
drawing on them. Concurrent with such review, the auditor should also ensure
that the company is maintaining policies and procedures which ensure that
access to cash and bank accounts is maintained by select authorized employees
and further that all assets including company checks are adequately safeguarded
and that access is restricted to a few select employees. The next step should be
to perform reconciliations of various accounts looking for shortages or overages
and reviewing bank reconciliations for old outstanding checks that have not been
followed up on. Other potentially helpful procedures include selecting sample
checks for review of various potential indicators including:
Evidence of alterations or other tampering;
Reviewing the endorsements to ensure that endorsements have been
made by proper parties and checks are deposited into authorized bank
accounts; and
Reviewing endorsements for evidence of forgery, altered terms or other
forms of tampering
Finally, if a perpetrator is going to steal checks he will likely write them to either
himself or to entities or individuals related to him or herself. Thus, the auditor
should look for checks with payments to cash, bearer, or unknown vendors.
Similarly, the auditor should review the list of vendors for shell companies or for
companies with no apparent business purpose to determine if the vendor is
linked to employees in any manner. (See, Section 10.1.2 for indicators and
procedures to confirm the existence of shell companies.) In this regard, any
payments of excessive soft expenses to such vendors might be made with
stolen checks. The auditor should also review bank deposits to ensure that that
the control total of checks received matches the checks withdrawn.
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Payroll Fraud
Fewer and fewer companies pay employees in cash and many hire third parties
to process payroll. Ironically, while these changes have simplified the processing
of payroll, they also have increased the risk of payroll fraud.
Payroll fraud schemes generally occur in two major forms: the creation of
fictitious employees and the padding of hours to cheat on time cards. Other
payroll frauds include inflated overtime claims, the use of incorrect hourly rates,
and overpayment of expenses or underpayment of deductions.
These schemes have different indicators and different means by which they are
perpetrated. The intent of both is essentially the same; to defraud the
corporation and steal from it.
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records on it, cannot generate more than one payment for each period.
Additionally, there should be checks to ensure that all payroll data is entered
promptly, accurately and only once and in the proper accounting period. Finally,
all employees who have been terminated or have otherwise left the firm should
be promptly removed from the payroll system.
Procedures the auditor can perform to try to detect this scheme include:
Comparing a list of current and former employees to the current payroll list
to search for and verify additions to payroll;
Matching master information from the payroll file with the organizations
personnel file to determine whether there are "ghost" employees on the
payroll;
Comparing suspected employees social security numbers against list of
valid numbers and test for duplicate employees on the entire payroll file
(appending or joining payroll files if necessary.);
Reviewing direct deposit account numbers to look for duplicate deposits;
Obtaining a payroll check run to ensure that all checks are numerical;
Randomly selecting employees and trace hours worked to time sheet (to
ensure that all hours are approved by supervisor for hourly employees)
and obtain employee file to ensure all proper documentation validating
hiring of the employee is in place;
Ensuring that changes to payroll are adequately documented and
supported;
Comparing the payroll file at two dates (i.e. beginning and end of a month)
to determine whether recorded starters and leavers (hires and
terminations) are as expected and if any employees have received
unusually large salary increases;
Ensuring each employee's salary is between the minimum and maximum
for his/her position or grade; and
Comparing holidays and sick leave taken to the limits for a particular
grade or position and if there is a high rate of absenteeism for sickness
analysing by department to identify problem areas
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The most basic form of inventory theft is the physical conversion of existing
stock. Adequate physical security, which is beyond the scope of this chapter, is
the obvious solution.
Employees with the authority to write off inventory as damaged or scrap (or lack
adequate supervision) often perpetrate false write-off schemes. The company
will not detect that the inventory is missing once it is written off in the books and
records.
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False sale frauds are very similar to recording a fictitious sale in the inventory
records of the business. The false sale is never recorded as a sale in the sales
records, which are usually kept independently from the inventory records. As
there is no sale and no amount to collect or bank, the sale is never recorded
and thus never missed. Alternatively, the false credit sale may be recorded
(probably under a false name) but the amount never collected and eventually
written off. A variation of the scheme is for the perpetrator to skim the proceeds
of a valid sale to a real purchaser and not record the sale and the payment for
the sale that is misappropriated.
Sales frauds, like other misappropriation frauds, occur due to a lack of controls or
a breakdown of the controls in the sales process. Sales department employees
should be monitored. All sales should require appropriate authorization in
addition to sufficient documentation to support the sale. Furthermore, the
individuals in the sales department should not be in charge of monitoring or
writing off receivables and should have no influence over that department.
The auditor should perform observations of physical inventory and compare the
inventory account for discrepancies between physical inventory and books. The
auditor should determine whether inventory purchases are properly authorized,
reconciled, and in possession of the company. Independent departments should
authorize sales, write offs and, other debits. Inventory data should be entered
completely, accurately, and only once. Finally, the auditor should ensure that
spot checks verifying the existence of inventory are per formed on a regular basis
by departments independent of the purchasing and sales departments or by
independent third parties.
either however
recognition
corporate s
76
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Chapter Endnotes
1
Issued October, 2002
2
Securities and Exchange Commission, Annual Report, (Securities and Exchange Commission
1999.)
3
The SECs enforcement action against Edison Schools (Edison) is illustrative; SEA Rel. No.
45925, AAE Rel. No. 1555 (May, 2002.)
Edison operates public schools on behalf of local governments, which paid directly certain school
expenses. Edison Schools recognized these payments as revenue, even though they did not
flow through their accounts. The SEC launched an enforcement action notwithstanding that the
accounting technically complied with GAAP.
4
See, Accounting Research Bulletin (ARB), No. 43, Chap. 9; Also see, Accounting Technology
Bulletin No. 1
5
Arthur Levitt, The Numbers Game speech at the New York University Center for Law and
Business (Sep. 28, 1998.)
6
Id. at p.3.
7
Id.
8
October 1987. Available at www.coso.org
9
The Committee of Sponsoring Organizations of the Treadway Commission s Report on
Fraudulent Financial Reporting 1987 to 1997, (March 1999.)
10
Richard H. Walker, Behind the Numbers of the SEC's Recent Financial Fraud Cases, Speech
at 27th Annual National AICPA Conference on Current SEC Developments, (Dec. 7, 1999.)
11
PricewaterhouseCoopers LLP 2000 Securities Litigation Study.
12
PricewaterhouseCoopers LLP 2001 Securities Litigation Study.
13
Revenue Recognition Update, Christian R Bartholomew, Morgan Lewis & Bockius LLP (2002.)
14
17 CFR Part 211, Dec. 3, 1999.
15
Issued Oct. 27, 1997.
16
See e.g., Statement of Position 81-1 Accounting for Performance of Construction-Type and
Certain Production-Type Contracts, (July 15, 1981.); Also see, Statement of Financial Accounting
Standards No. 51, Financial Reporting by Cable Television Companies (Nov. 1981.)
17
Issued 1999.
18
Issued Feb. 2, 2002.
19
Effective interviewing techniques are considered in another chapter.
20
SEC SA Rel. No. 42326, AAE Rel No. 1215, (Jan. 11, 2000.)
21
Statement of Position 91-1, Software Revenue Recognition, Issued 1991. SOP 91-1 has since
been superseded by SOP 97-2, Software Revenue Recognition, Issued 1997, which retains the
basic recognition criteria of SOP 91-1.
22
Issued June 1981.
23
Id. at 6.
24
SEA Rel. No. 37847;AAE Rel No. No. 846 (Oct. 22, 1996.)
25
SA Rel No. 44305; AAE Rel No. 1393, (May 15, 2001.)
26
AAE Rel. No. 1187 (Sept. 28, 1999.)
27
SAB 101 FAQ Question No. 3.
28
Id.
29
SEA Rel. No. 37649, AAE Rel. No. 812 (Sept. 5, 1996).
30
See In the Matter of Stewart Parness, Accounting and Auditing Enforcement (AAE) Rel. No.
108 (August 5, 1986); Also see SFAC No. 5, 84(a) and SOP 97-2, 22.
31
Id.
32
SEA. Rel No. 47167; AAE Rel No. 1699 ( Jan. 13, 2003.)
33
SEA. Rel No. 43183, AAE Rel. No. 1295, (Aug. 21, 2000.)
34
SAB 101, Topic 13A, Question 2.
35
SAB 101, Topic 13A, Question 2.
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36
SEA Rel. No. 8135; AAE Rel. No. 1637 (Sept. 30, 2002.)
37
See, AICPA SOP 81-1, .23.
38
Id., .30
39
SEC Rel. No. 37746; AAE Rel. No. 833 (Sept. 30, 1996.)
40
SAS No. 45, Related Parties, AU 334.
41
Practice Alert, Auditing Related Parties and Related Party Transactions
42
See, FASB no. 57, Related Party Disclosures, Issued
43
See, Accounting and Auditing for Related Parties and Related Party Transactions, A Toolkit for
Accountants and Auditors, AICPA (Dec. 2001.)
44
Statement on Auditing Standards (SAS) No. 1 331 (Amer. Inst. of Certified Pub.
Accountants 1972); AU 331.11.
45
Id.
46
Norman C. Miller, The Great Salad Oil Swindle, New York; Howard McCann, 1965.
47
ARB No. 43, Inventory Pricing, Chap. 4, Statement 5.
48
Joseph T. Wells, So Thats Why Its Called a Pyramid Scheme, Journal of Accountancy,
October 2000.
49
SFAS No. 5, Accounting for Contingencies, (Mar. 1975.)
50
CITE CASE
51
See, SFAS 115, Accounting for Certain Investments in Debt and Equity Securities, (May
1993), at 6.
52
Id. at 7.
53
Id at 12 (a) and (b).
54
Other comprehensive income is generally defined as the change in equity of a business
enterprise during a period from all transactions and events except those resulting from
investments by owners and distributions to owners.
55
SFAS 115, 15.
56
See, SFAS No. 86, Accounting for the Costs of Computer Software to Be Sold, Leased, or
Otherwise Marketed, (Aug. 1985)
57
See, Financial Concepts No. 2, Accounting for Research and Development Costs, (Oct. 1974.)
58
Arthur Levitt, The Numbers Game speech.
59
See, In the Matter of Pinnacle Holdings, Inc., SEA Rel. No. 45135, AAE Rel No. 1476 (Dec. 6,
2001)
60
SOP 98-5, Reporting on the Costs of Start-Up Activities, (Apr. 1998)
61
Issued October, 1979
62
Issued Dec. 29, 1993.
63
Up until the issuance of new guidance by FASB, off-balance sheet vehicles were commonly
referred to as SPEs or special purpose entities. Under the new accounting rules, they are
known as variable interest entities. It must be noted that the types of entities that are likely to be
deemed VIEs are broader than those that most practitioners would have thought were SPEs.
64
Fin 46 9.
65
SEA Rel No. 46017; AAE Rel. No. 1563 (Jun. 3, 2002.)
66
See, SEC Regulation S-K 229.404, Certain Relationships and Related Transactions (1996.)
17 CFR Parts 228, 229, 232, 240, 249, 270 and 274 (Aug. 29, 2002.) 302.
67
68
The statute requires companies to disclose all material off-balance sheet transactions,
arrangements, obligations (including contingent obligations), and other relationships of the issuer
with unconsolidated entities or other persons that may have a material current or future effect on
the issuer's financial condition, results of operations, liquidity, capital expenditures, capital
resources or significant components of revenues or expenses.
69
TSC Industries, Inc. v. Northway, Inc., 426 U.S. 438, 449 (1976.)
70
Rule 1-02.
71
Statement of Financial Accounting Concepts (SFAC) No. 2, (1980.)
72
Issued August, 1999.
73
Association of Certified Fraud Examiners, Report to the Nation, (2002.)
74
Id.
75
Joseph T. Wells, Lapping It Up, Journal of Accountancy (Feb. 2002)
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76
15 U.S.C. 78dd-1, et seq (1977.)
88