In this chapter, we will examine some of the principles underlying financial statement fraud. These frauds are associated with a number of factors occurring at the same time, the most significant of which is pressure.
More specifically, the authors will examine the topic of financial reporting fraud with an emphasis on understanding the five basic schemes, detection, and deterrence. Those modules, along with the learning objectives, include the following:
In this chapter, we will examine some of the principles underlying financial statement fraud. These frauds are associated with a number of factors occurring at the same time, the most common of which is pressure on upper management to show earnings. Preparing false financial statements is made easier by the subjective nature inherent in recording business and economic transactions. The accounting profession has long recognized that accounting is a process subject to considerable professional judgment. As a result, those numbers also are subject to manipulation. After all, a debit on a company’s books can represent either an expense or an asset. A credit may be a liability or revenue. Therefore, there can be tremendous temptation—when a strong earnings showing is needed—to classify expenses as assets and liabilities as revenue.
Later in this chapter, we will explore the five major methods by which financial statement fraud is committed, but it is important to first consider three general questions that go to the heart of these crimes:
There are three main groups of people who commit financial statement fraud. In descending order of likelihood of involvement, they are as follows:
Senior managers (CEOs, CFOs, etc.) and business owners may “cook the books” for any of several reasons:
We can better deter and detect fraud if we understand the different pressures senior managers and business owners face that might drive them to commit fraud. If we understand the motivating factors behind these crimes, it stands to reason we will be in a better position to recognize the circumstances that might lead people to commit financial statement fraud. We will also increase our likelihood of detecting these crimes by knowing the most likely places to find fraud in an organization’s financials.
As with other forms of occupational fraud, financial statement schemes are generally tailored to the particular circumstances in the organization. This means that the evaluation criteria used by management’s targeted audience tend to drive management’s fraudulent behavior. For example, during the Internet boom, investors were more interested to see revenue growth from dot-com companies than high profits. This type of pressure might drive senior managers to overstate revenues, without necessarily overstating earnings. Some Internet companies did this by recording advertising revenue from barter transactions even where no market value for the advertising could be identified. Tight loan covenants might drive managers to misclassify certain liabilities as long term, rather than current, to improve the entity’s current ratio (current assets to current liabilities), without affecting reported earnings.
Following are some of the more common reasons senior management might overstate business performance:
Alternatively, senior management may understate business performance to meet certain other objectives:
There are three general ways in which fraudulent financial statements can be generated. By being aware of these three approaches, those who investigate financial statement fraud can remain alert for evidence of attempts to manipulate the accounting and financial reporting process, or to go outside it. Financial statement frauds may involve more than one of these three methods, though perpetrators commonly start with the first method and incorporate the other two methods as the fraud grows. The three general methods are as follows:
The Association of Certified Fraud Examiners’ 2016 Report to the Nations on Occupational Fraud and Abuse finds that in comparison to asset misappropriation and corruption, financial reporting fraud (FRF) is the most costly form of occupational fraud. Beasley et al. find that negative consequences associated with FRF reach beyond financial losses and may include loss of reputation, bankruptcy, delisting from stock exchanges, and asset divestiture.20 The authors also observed a 24% abnormal stock price decline during the time between the initial news disclosure and the announcement of a government investigation. Beyond these costs, FRF instances often result in extensive damage to employees, customers, and suppliers, litigation costs and settlements, regulatory fines, and other negative outcomes.
Most research on FRF examines only public companies largely due to lack of data on private companies; yet, private companies represent a significant portion of the economy. Fleming et al. examined FRF at public companies versus private organizations, in an attempt to refine auditor efforts in detecting financial statement fraud.21 Using data spanning 2002–2013 from the ACFE Report to the Nations on Occupational Fraud and Abuse, and made available through the Institute for Fraud Prevention (IFP), the authors examined private company FRF cases in comparison to those at public companies and found several key differences:
Over the years, businesses have found ingenious ways to overstate their true earnings and assets. As a result, a number of accounting guidelines, or generally accepted accounting principles (GAAP), have been developed. The Financial Accounting Standards Board (FASB), an independent public watchdog organization responsible for standard setting, has codified most historic accounting principles. Statement on Auditing Standards (SAS) No. 69, “The Meaning of Present Fairly in Conformity with Generally Accepted Accounting Principles,” indicates the primary sources of generally accepted accounting principles—FASB Standards and Interpretations, APB Opinions, and American Institute of Certified Public Accountants (AICPA) Accounting Research Bulletins. Although accounting students should be familiar with these concepts, we will review them here with the emphasis on fraud. The following is a conceptual framework for financial reporting:
The premise of the economic entity assumption is that the activity of a business enterprise should be kept separate and distinct from its owners and other business entities. The entity concept does not rely on legal criteria but rather on substance. The concept of the entity is becoming ever more difficult to define. Companies with subsidiaries, joint ventures, or special-purpose entities (SPEs), such as those established by Enron, have raised further questions about how to account for the entity in order to prevent fraudulent manipulation of the financial statements.
In valuing a firm’s assets for financial statement purposes, it is assumed that the business is one that will continue into the future. That is because the worth of any good business will be higher than the value of its hard assets. For example, if you wanted to buy a business that paid you a 10% return, then you would pay up to a million dollars for an investment that earned $100,000 a year. The value of the actual assets underlying the business, if they were sold at auction, would typically not total nearly a million dollars. The going-concern concept assumes that the business will go on indefinitely into the future. If there is serious doubt about whether a business can continue, this must be disclosed in the auditor’s report and in a note to the financial statements.
Fraud, in the going-concern context, usually results from attempts by an entity to conceal its terminal business condition. For example, assume a company is in the computer parts manufacturing business. Last year the company earned $100,000 after taxes. This year management is aware that new technology will make its business totally obsolete, and that by next year the business will likely close. The company’s auditors might not know this. And when they prepare the financial statements for their company, management has the duty to inform the accountants of the business’s future ability to earn money. The auditors, in turn, must insist that the financial statements for the current period reflect this future event.
To measure and analyze financial transactions, a common standard is necessary. In our society, that common denominator is money. The U.S. dollar has remained reasonably stable, but some countries, as a result of persistent economic volatility, use “inflation accounting” to adjust for price-level changes in their currency. International companies that deal with foreign currency transactions may be subject to fraudulent abuse of monetary exchange rates.
This “time period” assumption uses the principle of dividing economic activity into specific time intervals, such as monthly, quarterly, and annually. With shorter reporting periods, however, the data tend to be subject to greater human error and manipulation and, therefore, less reliable.
Generally accepted accounting principles require that assets be carried on the financial statements at the price established by the exchange transaction. This figure is referred to as historical or acquisition cost, and this is generally the most conservative and reliable method. However, there are some exceptions to the historical-cost principle. For example, if inventory is worth less than its cost, this lower value is reported on the financials. This approach is referred to as the lower of cost or market.
In recent years, there has been a movement in the accounting profession to move toward fair market value. For example, many investments are reported at fair value. There are a number of valuation methods that may be selected to be compliant with generally accepted accounting principles.
The net realizable value (NRV) of an asset is the amount of money that would be realized upon the sale of the asset, less the costs to sell it (i.e., the cash equivalent). The problem arises in attempting to establish a sales value for the asset without selling it. If a company was required to place a sales value on every asset to determine net income, the resulting figure would be materially affected by opinion. The potential for fraud, in this case, is evident. Similar arguments have been made against using replacement value. Accounts receivable are also reported at the more conservative NRV to take into account that percentage which will likely be uncollected.
As noted, historical cost was favored because of its reliability and presumed objectivity—historical cost could be traced to invoices and other acquisition documents. As transitions to fair value (fair market value) occur—where more subjectivity is inherent in the measurement process—increased levels of professional judgment will be required, which creates greater opportunity for abuse and manipulation.
According to generally accepted accounting principles, the accrual basis of accounting should be used for financial reporting. In this method, revenues are recognized and reported in the period in which they are earned. Intentional manipulation of the timing for revenues earned is a potential area for fraudulent abuse. Further, while conceptually, “recognizing revenues in the period earned” is straightforward, professional guidance is extensive and implementation can be complex.
The matching concept requires that the books and records, and the resultant financial statements, match revenue and expense in the proper accounting period. Fraud can occur when purposeful attempts are made to manipulate the matching concept. For example, through controlling the year-end cutoff in financial figures, many companies boost their current net income by counting revenue from the following year early, and by delaying the posting of this year’s expenses until the following year. This is a fairly common method of financial statement manipulation. As a routine test, auditors examine the cutoff dates of significant transactions for revenues and expenses to ensure that they are recorded in the proper period.
The principle behind disclosure is that any material information required to understand the numbers presented in the financial statements, and any deviation from generally accepted accounting principles, must be explained to the reader of the financial information. In addition, any known event that could have a material impact on future earnings must be explained or disclosed. For example, as discussed earlier, suppose a company is aware that competitors are making its principal manufacturing method for computer parts obsolete. Such information must be disclosed. If a company is being sued and is likely to be required to pay a material monetary judgment that too must be disclosed. In actuality, any potential adverse event of a material nature must be disclosed in the financials. Many major financial frauds have resulted from the purposeful omission of note disclosures in the financial statements.
In formulating standards for financial reporting, the FASB considers the trade-off between the cost of providing certain information and the related benefit to be derived by the users of the information. The specific costs and benefits, however, are not always readily apparent. Some costs, such as the cost to collect, distribute, and audit data, are more easily measured than, for example, the costs associated with disclosure when important information may be used by competitors to gain an unfair advantage. This limitation should not be construed as an excuse to purposely and fraudulently omit material information from the financial statements.
Financial statements are not meant to be perfectly accurate, only reasonable and fair. There are probably many small errors and omissions in the books of corporations of all sizes, but what does it really mean in terms of the big picture? The answer is that it depends on who is looking at the financial statements and making decisions based on them. If a company’s estimated earnings are given as $1 million a year on its financial statements, and it turns out that the figure is actually $990,000 (or $1,010,000), does it really impact decision making? Maybe not? But suppose that $1 million in purported earnings on the financial statements is actually $500,000—half of what the company shows. Then a lot of people—investors and lenders, primarily—would care a great deal.
Materiality, then, according to GAAP, is a user-oriented concept. If a misstatement is so significant that reasonable, prudent users of the financial statements would make a different decision than they would if they had been given correct information, then the misstatement is material and requires correction.
A typical issue involving materiality and fraud is asset misappropriations. Taken separately, they may be quite small and not material to the financial statements as a whole. But what of the aggregate? If many small amounts are stolen, the result could indeed be material.
Reporting practices within certain industries may deviate from generally accepted accounting principles as a matter of fair and clear presentation. For example, the utility industry, due to its highly capital-intensive nature, lists noncurrent assets first on the balance sheet rather than listing the assets in the order of their liquidity. In the event of deviations from GAAP, a determination should be made regarding whether there is justification for the departure.
The conservatism constraint requires that, when there is any doubt, one should avoid overstating assets and income and understating liabilities and expenses. The purpose of this principle is to provide a reasonable guideline in a questionable situation. If there is no doubt concerning the accuracy of a valuation, this constraint need not be applied. An example of conservatism in accounting is the use of the “lower of cost or market” rule as it relates to inventory valuation. That simply means that if a company paid one dollar for a widget and at a later date the price fell to fifty cents, then the lower of those two prices should be carried on the balance sheet; the resulting price fall should then be recorded on the income statement. Another example relates to the valuation of accounts receivable. Because 100% of receivables are unlikely to be collected in most cases, an allowance for these uncollectible amounts should be deducted from the gross receivables. The resulting amount is referred to as the net realizable value (NRV). If a company’s financial statements violate the conservatism constraint, they could be fraudulent.
Qualitative Characteristics of Accounting Information,” outlined in Statement of Financial Accounting Concepts No. 2, identifies relevance and reliability as two primary qualities of usefulness for decision making. Relevance implies that certain information will make a difference in arriving at a decision. Reliability, on the other hand, means that the user can depend on the accuracy of the information. It is precisely when the accuracy of information is intentionally compromised to influence a decision by the user of the financial statements that fraud occurs.
For financial information to be useful for analytical purposes, it must possess the secondary qualitative characteristics of comparability and consistency. For example, one easy way for the value of assets and income to be inflated is through the depreciation methods that companies use on capital assets. Assume that a valuable piece of equipment was purchased by a company for $99,000 and was expected to last three years, with no salvage value at the end of its useful life. That means under straight-line depreciation, the write-off in the first year would be $33,000. Using the double-declining-balance method of depreciation, the write-off would be $66,000 in the first year. By switching depreciation methods from one year to the next, the company could influence its net income by as much as $33,000. If income is manipulated in this manner, the user is comparing apples and oranges. So if a company changes the way it keeps its books from one year to the next, and if these changes have a material impact on the financial statements, they must be disclosed in a note. Fraud occurs when consistency is intentionally avoided to show false profits.
Financial statements are the responsibility of company management. Therefore, it is hard to fathom how financial statement fraud can be committed without some knowledge or consent of management. However, financial statement fraud can be perpetrated by anyone who has the opportunity and the motive to omit or misstate data in furtherance of his or her own nefarious goals. For example, a department manager whose compensation is based partly on the sales of his unit might be motivated to falsely increase his department’s sales to increase his pay.
Recall that fraud is generally instigated by members of management or, at the least, by persons under the direction and control of management. If management does not investigate suspected frauds, how can management assure itself that fraud will be deterred and, if fraud does occur, that it will be detected?
A company’s board of directors and senior management are supposed to set the code of conduct for the company. This code is often referred to as the company’s “ethic,” the standard by which all employees should conduct themselves. As applied to the board and senior management, the ethic is referred to as the “tone at the top.” It stands to reason, therefore, that if the company’s ethic and tone is of high integrity, the company’s employees may operate in a more honest manner. If the ethic and tone are corrupt, employees may view that as a license to be dishonest. Remember, ethics should not be situational and must be applied consistently.
An unimpeachable company ethic does not, in and of itself, ensure that financial statement fraud will not occur. Additional measures are required for management to discharge its responsibilities with respect to deterrence and detection of fraudulent financial reporting. Recent trends have moved away from “tone at the top” merely referring to talking a good story, and instead have emphasized the need for the board and senior management to act with integrity. Many believe that the tone within an organization trickles down and is evidenced by the “mood in the middle” and the “buzz at the bottom.”
As we have made clear, financial statement fraud schemes are most often perpetrated against potential users of financial statements by management. The users of financial statements may include the company’s owners, lenders, vendors, and even customers. Fraudulent statements are used for a number of reasons; the most common is to increase the apparent prosperity of the organization in the eyes of potential and current investors. This not only may induce new investment but it can also help keep current investors satisfied. Fraudulent financial statements can be used to dispel negative perceptions of an organization in the open market. Company management often uses financial statements to judge employee or manager performance. Employees may be tempted to manipulate statements to ensure continued employment and bonuses that may be tied to performance. Certain internal goals, such as meeting budgets, contribute added pressure to the manager responsible. Figure 7-1 displays the role of financial information and statements in the decision-making process of users.
According to Statement on Auditing Standards (SAS) No. 62, published by the AICPA Auditing Standards Board, financial statements include presentations of financial data and accompanying notes prepared in conformity with generally accepted accounting principles or some other comprehensive basis of accounting. The following is a list of the financial statements:
Although not specifically noted in SAS 62, financial statements also typically include other financial data presentations, such as
Other comprehensive bases of accounting, according to SAS 62, include
As we see from the preceding lists, the term financial statement includes almost any financial data presentation prepared according to generally accepted accounting principles or another comprehensive basis of accounting. Throughout this chapter and the next, the term financial statements is assumed to include the above forms of reporting financial data, as well as the accompanying notes and management’s discussion.
Financial statement frauds can be broken down into five distinct categories: concealed liabilities and expenses, fictitious revenues, improper asset valuations, improper disclosures, and timing differences. These categories are shown on the ACFE’s fraud tree. Concealed liabilities and expenses and fictitious revenues imply income overstatement. The fraud tree also recognizes that liabilities, expenses, and revenues (along with assets, disclosures, and timing differences) can also be manipulated to reduce reported income. The distribution of these scheme types has been shown to be fairly uniform in ACFE studies, with the first three categories and income overstatement being the most common. Timing differences were the least frequent scheme observed among the financial statement frauds in the ACFE research cases.
In recent years, financial statement fraud has become an important subject in the media, to regulators (such as the SEC and PCAOB), to antifraud organizations (such as the ACFE), and to academics trying to understand and research commonalities across schemes. Some of the high-profile scandals and criminal actions that have challenged the corporate responsibility and integrity of major companies include Lucent, Xerox, Rite Aid, U.S. Foodservice, Waste Management, MicroStrategy, Raytheon, Sunbeam, Enron, World-Com, Global Crossing, Adelphia, Qwest, Satyam, and Tyco, all of whom have been alleged by the SEC to have committed fraud. High-profile manipulations—such as the Madoff and Stanford Ponzi schemes—have also plagued investors. While these frauds did not necessarily include financial reporting fraud, fraudulent statements were integral to the perpetration and concealment of the schemes. Occurrences of financial statement fraud by high-profile companies, coupled with the demise of the Big Five accounting firm, Arthur Andersen, raised concerns about the integrity, transparency, and reliability of the financial reporting process and have challenged the role of corporate governance and audit functions in deterring and detecting financial statement fraud.
One of the highest-profile financial reporting fraud cases of recent vintage was a liability omission scheme involving Adelphia Communications. John Rigas, Adelphia’s founder, purchased a small cable company in Coudersport, Pennsylvania, for the sum of $300 in 1952. By 2002, it had grown to become the nation’s sixth-largest cable television company, with more than five million subscribers and $10 billion in assets.
Rigas, of Greek heritage, named his company Adelphia Communications Corporation, after the Greek word for “brothers.” He and his brother Gus ran the company as their own. It was a style that came back to haunt him after the company went public. Later his three sons, Tim, Michael, and James—along with his son-in-law, Peter Venetis—became active in Adelphia’s management. The family controlled the majority of the company’s voting stock and constituted the majority on the board of directors. Accordingly, the family used Adelphia’s money as their own. They also used company assets as their own. Three corporate jets took family members on exotic vacations, including African safaris. John Rigas was particularly egregious in his spending. At one time, he racked up personal debt of $66 million, forcing his son Timothy, who held the position of Adelphia CFO, to put his father on a “budget” of $1 million a month in personal draws.
As CFO, Timothy Rigas engineered the financial manipulations. He was in charge of manipulating the books to inflate the stock price to meet analysts’ expectations. Investigators later discovered that the family members had looted the company to the tune of approximately $3 billion. The money transfers were made by journal entries that gave Adelphia debt that was not disclosed. Among other things, the Rigas family used the funds to
The Rigas family’s problems started with overexpansion in the late 1990s when they purchased Century Communications for $5.2 billion. By 2002, Adelphia’s stock had fallen to historic lows, and the company was unable to make payments on the debt it incurred from its acquisitions.
In July 2002, the SEC charged Adelphia with, among other crimes, fraudulently excluding over $2.3 billion in bank debt from its consolidated financial statements. According to the complaint filed by the SEC, Adelphia’s founder and his three sons fraudulently excluded the liabilities from the company’s annual and quarterly consolidated financial statements by deliberately shifting those liabilities onto the books of Adelphia’s off-balance sheet unconsolidated affiliates. Failure to record this debt violated GAAP requirements and precipitated a series of misrepresentations about those liabilities by Adelphia and the defendants. These included (1) sham transactions backed by fictitious documents to give the false appearance that Adelphia had actually repaid debts when, in truth, it had simply shifted them to unconsolidated entities controlled by its founder and (2) misleading financial statements that, in their notes, gave the false impression that liabilities listed in the company’s financials included all outstanding bank debt. This led to a free fall of Adelphia’s stock, and less than three months later, the company filed for bankruptcy.
The definition of financial statement fraud can be found in a number of authoritative reports (e.g., The Treadway Commission 1987; SAS 99 2002). Financial statement fraud is defined as the use of deliberate misstatements or omissions of amounts or disclosures of financial statements to deceive financial statement users, particularly investors and creditors. Financial statement fraud may involve the following schemes:
Statement on Auditing Standards (SAS) No. 99/No. 113 (subsequently codified as AU 316), titled “Consideration of Fraud in a Financial Statement Audit” and issued by the Auditing Standards Board (ASB) of the AICPA in November 2002, defines two types of misstatements relevant to an audit of financial statements and subject to auditors’ consideration of fraud.23 The first type arises from fraudulent financial reporting and is defined as “intentional misstatements or omissions of amounts or disclosures in financial statements designed to deceive financial statement users.”24 The second type arises from misappropriation of assets and is commonly classified as theft or defalcation. (For reasons that are unclear, the definitions did not list corruption as a separate type of fraud.)
The primary focus of this chapter is on misstatements arising from fraudulent reporting that directly causes financial reports to be misleading and deceptive to investors and creditors. Fraudulent financial statements can be used to unjustifiably sell stock, obtain loans or trade credit, and/or improve managerial compensation and bonuses. The important issues addressed in this chapter are how to effectively and efficiently deter, detect, and counteract financial statement fraud.
Published statistics on the possible costs of financial statement fraud are estimates at best. It is impossible to determine the actual total costs because not all fraud is detected, not all detected fraud is reported, and not all reported fraud is legally pursued. The reported statistics, however, are astonishing.
Albrecht and Searcy25 state that more than 50% of U.S. corporations in 2000 were victims of fraud, with a loss of more than $500,000 on average for each company. The collapse of Enron’s house of cards is estimated to have caused a loss of about $70 billion in market capitalization to investors, employees, and pensioners. Cotton26 reports that shareholders lost $460 billion in the Enron, WorldCom, Qwest, Global Crossing, and Tyco debacles.
These studies and their related statistics provide only estimated direct economic losses resulting from financial statement fraud. Other fraud costs are legal costs; increased insurance costs; loss of productivity; adverse impacts on employees’ morale, customers’ goodwill, and suppliers’ trust; loss of employment and pension savings and negative stock market reactions.
An important indirect cost of financial statement fraud is the loss of productivity due to dismissal of the fraudsters and hiring of their replacements. Although these indirect costs are difficult to estimate with accuracy, they should be taken into consideration in assessing the consequences of financial statement fraud. Loss of public confidence in the quality and reliability of financial statements, caused by alleged fraudulent activities, is the most damaging and costly effect of fraud.
Financial statement fraud is harmful in many ways:
Fictitious or fabricated revenue schemes involve the recording of sales of goods or services that did not occur. Fictitious sales most often involve fake or phantom customers, but can also involve legitimate customers. For example, a fictitious invoice may be prepared (but not mailed) for a legitimate customer; however, the goods are not delivered, nor the services rendered. At the beginning of the next accounting period, the sale might be reversed to conceal the fraud, but this may lead to a revenue shortfall in the new period, creating the need for more fictitious sales. Another method is to use legitimate customers and artificially inflate or alter invoices to reflect higher amounts or quantities than were actually sold. Fictitious revenues are among the favorite schemes to inflate earnings.
Generally speaking, revenue is recognized when it is (1) realized or realizable and (2) earned. In December 2003, the SEC issued Staff Accounting Bulletin No. 104, “Revenue Recognition” (SAB 104), to update existing guidance on revenue recognition criteria. SAB 104 states that revenue is typically considered realized or realizable and earned when all of the following criteria are met:
SAB 104 concedes that revenue may be recognized in some circumstances where delivery has not occurred, but sets out strict criteria limiting the ability to record such transactions as revenue.
At present, there are approximately 200 sources of standards and guidance on revenue recognition in U.S. GAAP, not all of which are based on consistent concepts. The conceptual guidelines for revenue recognition are found in FASB Concepts Statement No. 5, “Recognition and Measurement in Financial Statements of Business Enterprises,” and FASB Concepts Statement No. 6, “Elements of Financial Statements.” Concepts Statement No. 6 defines revenue as “inflows or other enhancements of assets of an entity or settlements of its liabilities (or a combination of both) from delivering or producing goods, rendering services, or other activities that constitute the entity’s ongoing major or central operations.”
One example details a typical use of fictitious revenue. A publicly traded company engineered sham transactions for more than seven years to inflate their financial standing. The company’s management utilized several shell companies supposedly making a number of favorable sales. The sales transactions were fictitious, as were the supposed customers. As the amounts of the sales grew, so did the suspicions of internal auditors. The sham transactions included the payment of funds for assets with the same funds being returned to the parent company as receipts on sales. The management scheme went undetected for so long that the company’s books were eventually inflated by more than $80 million. The scheme was finally discovered and the perpetrators were prosecuted in both civil and criminal courts.
A sample entry from this type of case is shown below. A fraudulent entry records a purported purchase of fixed assets. This entry debits fixed assets for the amount of the alleged purchase and the credit is to cash for the payment:
Date | Description | Ref. | Debit | Credit |
12/01/09 | Fixed assets | 104 | 350,000 | |
Cash | 101 | 350,000 |
A fictitious sales entry is then made for the same amount as the false purchase, debiting accounts receivable and crediting the sales account. The cash outflow that supposedly paid for the fixed assets is “returned” as payment on the receivable account, though in practice the cash might never have moved if the fraudsters didn’t bother to falsify that extra documentary support.
Date | Description | Ref. | Debit | Credit |
12/01/09 | Accounts receivable | 120 | 350,000 | |
Sales | 400 | 350,000 | ||
12/15/09 | Cash | 101 | 350,000 | |
Accounts receivable | 120 | 350,000 |
The result of the completely fabricated sequence of transactions is an increase in both company assets and yearly revenue. The debit could alternatively be directed to other accounts, such as inventory or accounts payable, or it could simply be left in accounts receivable if the fraud were committed close to year-end and the receivable could be left outstanding without attracting undue attention.
Updated guidance on revenue recognition can be found in the FASB Accounting Standards Codification (ASC) 605, Revenue Recognition, and ASC 606, Revenue from Contracts with Customers.
Sales with conditions are a form of fictitious revenue scheme in which a sale is booked even though some terms have not been completed and the rights and risks of ownership have not passed to the purchaser. These transactions do not qualify for recording as revenue, but they may nevertheless be recorded in an effort to fraudulently boost a company’s revenue. These types of sales are similar to schemes involving the recognition of revenue in improper periods, since the conditions for sale may become satisfied in the future, at which point revenue recognition would become appropriate. Premature recognition schemes will be discussed later in this chapter in the context of timing differences.
External pressures to succeed that are placed on business owners and managers by bankers, stockholders, families, and even communities often provide the motivation to commit fraud. In one example, a real estate investment company arranged for the sale of shares that it held in a nonrelated company. The sale occurred on the last day of the year and accounted for 45% of the company’s income for that year.
A 30% down payment was recorded as received, with a corresponding receivable recorded for the balance. With the intent to show a financially healthier company, the details of the sale were made public in an announcement to the press, but the sale of the stock was completely fabricated. To cover the fraud, off-book loans were made in the amount of the down payment. Other supporting documents were also falsified. The $40 million misstatement was ultimately uncovered, and the real estate company owner faced criminal prosecution.
In a similar instance, a publicly traded textile company engaged in a series of false transactions designed to improve its financial image. Receipts from the sale of stock were returned to the company in the form of revenues. The fraudulent management team even went so far as to record a bank loan on the company books as revenue. At the time that the scheme was uncovered, the company books were overstated by approximately $50,000, a material amount to this particular company.
Pressures to commit financial statement fraud may also come from within a company. Departmental budget requirements including income and profit goals can create situations in which financial statement fraud is considered as an option. In one case, the accounting manager of a small company misstated financial records to cover its financial shortcomings. The financial statements included a series of entries made by the accounting manager designed to meet budget projections and to cover up losses in the company’s pension fund. As a result of dismal financial performance in recent months, the accountant needed to overstate period revenues to achieve his objectives. To cover his scheme, he debited liability accounts and credited the equity account. The perpetrator finally resigned, leaving a letter of confession. He was later prosecuted in criminal court.
Any of the following circumstances should sound the alarm for the potential of fraud.
As we mentioned earlier, financial statement fraud may also involve timing differences, that is, the recording of revenue and/or expenses in improper periods. This can be done to shift revenues or expenses between one period and the next, increasing or decreasing earnings as desired.
Remember, according to generally accepted accounting principles, revenues and corresponding expenses should be recorded or matched in the same accounting period; failing to do so violates GAAP’s matching principle. Accounting principles champion a two-step process: Step 1—using revenue recognition principles, record revenues in the appropriate period; Step 2—match expenses associated with those revenues in the same period. For example, suppose a company accurately records sales that occurred in the month of December but fails to fully record expenses incurred as costs associated with those sales until January—in the next accounting period. The effect of this error would be to overstate the net income of the company in the period in which the sales were recorded and also to understate net income in the subsequent period when the expenses are reported.
The following example depicts a sale transaction in which the cost of sales associated with the revenue is not recorded in the same period. A journal entry is made to record the billing of a project, which is not complete. Although a contract has been signed for this project, goods and services for the project have not been delivered and the project is not scheduled to start until January. In an effort to boost revenues for the current year, the following sales transaction is recorded fraudulently before year-end:
Date | Description | Ref. | Debit | Credit |
12/31/Y1 | Accounts receivable | 120 | 17,000 | |
Sales—Project C | 401 | 17,000 | ||
To record sale of product and services for Project C | ||||
Fiscal Year-End—2009 |
In January, the project is started and completed. The entries below show accurate recording of the $15,500 of costs associated with the sale:
Date | Description | Ref. | Debit | Credit |
01/31/Y2 | Cost of sales—Project C | 702 | 13,500 | |
Inventory | 140 | 13,500 | ||
To record relief of inventory for Project C | ||||
01/31/Y2 | Labor costs—Project C | 550 | 2,000 | |
Cash | 101 | 2,000 | ||
To record payroll expense for Project C |
If recorded correctly, the entries for the recognition of revenue and the costs associated with the sales would be recorded in the accounting period in which they actually occur: January. The effect on the income statement for the company is shown in the table on the next page.
This example depicts exactly how nonadherence to GAAP’s matching principle can cause material misstatement in yearly income statements. When the income and expenses were stated in error, year 1 yielded a net income of $17,000 while year 2 produced a loss ($13,400). Correctly stated, revenues and expenses are matched and recorded together within the same accounting period, showing moderate, yet accurate, net incomes of $0 and $3,600.
Incorrectly Stated | Correctly Stated | |||||||
Income Statements | Year 1 | Year 2 | Year 1 | Year 2 | ||||
Sales Revenue | ||||||||
Project B | 25,000 | 25,000 | ||||||
Project C | 17,000 | 17,000 | ||||||
Project D | 26,500 | 26,500 | ||||||
Total Sales | 42,000 | 26,500 | 25,000 | 43,500 | ||||
Cost of Sales | ||||||||
Project B | 22,500 | 22,500 | ||||||
Project C | 15,500 | 15,500 | ||||||
Project D | 21,400 | 21,400 | ||||||
Total Cost of Sales | 22,500 | 36,900 | 22,500 | 36,900 | ||||
Gross Margin | 19,500 | (10,400) | 2,500 | 6,600 | ||||
G&A Expenses | 2,500 | 3,000 | 2,500 | 3,000 | ||||
Net Income | 17,000 | (13,400) | 0 | 3,600 |
Generally, revenue should be recognized in the accounting records when a sale is complete, that is, when title is passed from the seller to the buyer. This transfer of ownership completes the sale and is usually not final until all obligations surrounding the sale are complete and the four criteria set out in SEC Staff Accounting Bulletin No. 104 have been satisfied. Again, those four criteria are as follows:
Note that when revenues are recorded in the wrong period, they inflate net income in the period in which they are reported, and under-report income in the period in which they should have been reported but were not.
The following case details how early recognition of revenue not only leads to financial statement misrepresentation but also can serve as a catalyst to further fraud. A retail drugstore chain’s management got ahead of itself in recording revenue. In a scheme that was used repeatedly, management would enhance its earnings by recording unearned revenue prematurely, resulting in the impression that the drugstores were much more profitable than they actually were. When the situation came to light and was investigated, several embezzlement schemes, false expense reports, and instances of credit card fraud were also uncovered.
In another case, the president of a not-for-profit organization was able to illicitly squeeze out the maximum amount of private donations by cooking the company books. To enable the organization to receive additional funding, which was dependent on the amounts of already-received contributions, the organization’s president recorded “promised” donations before they were actually received. By the time the organization’s internal auditor discovered the scheme, the fraud had been perpetrated for more than four years.
When managers recognize revenues prematurely, one or more of the criteria set forth in SEC Staff Bulletin No. 104 are typically not met. Examples of common problems associated with premature revenue recognition are set out below.
Long-term contracts often pose special challenges for revenue recognition. Long-term construction contracts, for example, use either the completed-contract method or the percentage-of-completion method, depending partly on the circumstances. In the completed-contract method revenue is not recorded until the project is 100% complete. Construction costs are held in an inventory account until completion of the project. The percentage-of-completion method recognizes revenues and expenses as measurable progress on a project is realized, but this method is particularly vulnerable to manipulation. Managers can manipulate the percentage of completion and the estimated costs to complete a construction project to recognize revenues prematurely and conceal contract cost overruns.
Another difficult area of revenue recognition is channel stuffing, which is also known as trade loading. This refers to the sale of an unusually large (and unnecessary) quantity of a product to distributors/retailers, who are encouraged to overbuy through the use of deep discounts and/or extended payment terms. In the past, this practice has been especially attractive in industries with high gross margins (such as cigarettes, pharmaceuticals, perfume, soda concentrate, and branded consumer goods) because it can increase short-term earnings. The downside is that stealing from the next period’s sales makes it harder to meet sales goals in the next period, and this sometimes leads to increasingly disruptive levels of channel stuffing and ultimately a restatement. High-profile company examples in recent years include Coca Cola and Bristol Myers Squibb.
Although orders are received in a channel stuffing scheme, the terms of the order might raise some question about the collectability of accounts receivable, and there may be side agreements that grant a right of return, or delayed payment terms, effectively qualifying the sales as consignment sales (as defined in the accounting literature). There may be a greater risk of returns for certain products if they cannot be sold before their shelf life expires. This is particularly a problem for pharmaceuticals because retailers will not accept drugs with a short shelf life remaining. As a result, channel stuffing should be viewed skeptically, and in certain circumstances, it may constitute fraud.
The following article about Snap-on Incorporated—a designer, manufacturer, and marketer of high-end tools and equipment for professional use in the transportation industry—appeared in the March 23, 2018, edition of The Capitol Forum, an investigative online journal.
Vol. 6 No. 105
March 23, 2018
Snap-on’s deferred subscription revenue, as part of its other accrued liabilities on the balance sheet, decreased 9.5% to $38.9 million in 2017 from $43.0 million in 2016. This decline raises questions about whether Snap-on franchisees are successfully selling the Zeus—a new diagnostic tool that costs over $10,000—to end customers, according to accounting experts we interviewed.
During its last earnings call, Snap-on CEO Nicholas Pinchuk touted the sale of both its new diagnostic product, the Zeus, and the data package, which he described as three years of subscriptions. “We never really sold subscriptions with a launch before, and that’s happening at record level,” the company said during the call.
In addition, Pinchuck said, “The big factor – the good news in the quarter, I think is associated with the Zeus, the effect of the Zeus and its sale off of the vans, which is very encouraging for us.”
Notably, the company books sales of its products when they are sold to franchisees. Software subscriptions, on the other hand, are not sold until the end customer purchases the device and activates the subscription, according to a former franchisee. Although Snap-on reports deferred subscription revenue in its annual filings, the company does not break out software subscription sales within its segment revenue.
If end customers were purchasing the Zeus equipment and related subscription service at a brisk pace, one would expect to see deferred subscription revenue increasing, not decreasing, according to Mary-Jo Kranacher, the ACFE Endowed Professor of Fraud Examination and an accounting professor at York College, CUNY. She is also a coauthor of the Forensic Accounting and Fraud Examination textbook.
“What’s probably happening,” according to Kranacher, “is that franchisees are buying the product, whether by choice or coercion, but there’s an open question as to whether they are able to sell to end customers.”
All things being equal, you would be more likely to see a significant increase in deferred subscription revenue with increased Zeus sales as opposed to a significant decrease, said Erik Gordon, a professor at the University of Michigan Ross School of Business.
However, Gordon also cautioned that many different things could affect deferred subscription revenue, including the timing of when end customers purchased and paid for subscriptions. We have previously highlighted issues with the company pushing diagnostic products onto its franchisees and the build-up of diagnostic products on franchisees’ trucks.
Snap-on did not respond to our request for comment.
The one-year Zeus software subscription is more expensive than the software subscription for other Snap-on diagnostic products, according to a Snap-on pricing book and a customer service representative we spoke with. Zeus Live, which includes a three-year software subscription, costs $4,860.
In the revenue recognition section of its 10-K, the company states, “In instances where the product and/or services are performed over an extended period, as is the case with subscription agreements or the providing of ongoing support, revenue is generally recognized on a straight-line basis over the term of the agreement, which generally ranges from 12 to 60 months.”
On the most recent earnings call, the company confirmed that revenue from the Zeus software subscription was amortized over the course of the subscription term. “Well, the data software package sells for thousands of dollars because it’s three years and that gets financed, but it doesn’t get recognized at the Tools Group, except on a monthly basis, amortized like a subscription.”
In 2017, Repair and Information Systems Group segment sales rose 14.2% to $1,347 million and Tool Segment Sales fell 0.5% to $1,625 million.
The timely recording of expenses is often compromised due to pressures to meet budget projections and goals, or lack of proper accounting controls. As the expensing of certain costs is pushed into periods other than the ones in which they actually occur, they are not properly matched against the income that they help produce; This is a violation of the matching principle. Note that recording expenses in the wrong period can be used to inflate net income in the period in which they were omitted or under-report income in the period in which they were wrongfully included.
Consider a case in which supplies were purchased and applied to the current-year budget but were actually used in the following accounting period. A manager at a publicly traded company completed eleven months of operations remarkably under budget in comparison with total-year estimates. He, therefore, decided to get a head start on the next year’s expenditures. In order to spend all current-year budgeted funds allocated to his department, the manager bought $50,000 in unneeded supplies. The supplies expense transactions were recorded against the current year’s budget. Staff auditors noticed the huge leap in expenditures and inquired about the situation. The manager came clean, explaining that he was under pressure to meet budget goals for the following year. Because the manager was not attempting to keep the funds for himself, no legal action was taken.
The correct recording of these transactions would be to debit supplies (asset) for the original purchase and, subsequently, expense the items out of the account as they are used up. The sample journal entries below reflect the correct method of expensing the supplies over time.
Date | Description | Ref. | Debit | Credit |
01/31/09 | Supplies inventory | 109 | 50,000 | |
Accounts payable | 201 | 50,000 | ||
To record the purchase of supplies | ||||
Record in | Supplies expense | 851 | 2,000 | |
Period used | Supplies inventory | 109 | 2,000 | |
To record supplies consumed in current period |
Similar entries should be made monthly, as the supplies are used, until they are consumed and $50,000 in supplies expense is recorded.
Auditors and company monitors should be alert for any of the following signs of fraud relating to timing differences:
As previously discussed, understating liabilities and expenses is one of the ways financial statements can be manipulated to make a company appear more profitable. Because pretax income will increase by the full amount of the expense or liability not recorded, this financial statement fraud method can have a significant impact on reported earnings with relatively little effort by the fraudster. This method requires much less effort than falsifying many sales transactions. Missing transactions are generally harder for auditors to detect than improperly recorded ones because there is no audit trail.
There are three common methods for concealing liabilities and expenses:
The preferred and easiest method of concealing liabilities/expenses is simply to fail to record them. Multimillion-dollar judgments against the company from a recent court decision might be conveniently ignored. Rather than being posted into the accounts payable system, vendor invoices might be thrown away (they’ll send another later) or stuffed into drawers, increasing reported earnings by the full amount of the invoices. In a retail environment, debit memos might be created for charge-backs to vendors, supposedly to claim permitted rebates or allowances, but sometimes just to create additional income. These items may or may not be properly recorded in a subsequent accounting period, but that does not change the fraudulent nature of the current financial statements.
Perpetrators of liability and expense omissions commonly believe that they can conceal their fraud in future periods. They often plan to compensate for their omitted liabilities with visions of other income sources such as incremental revenues from future price increases.
Because they are so easy to conceal, omitted liabilities are probably one of the most difficult types of financial statement frauds to uncover. A thorough review of all poststatement date transactions, such as accounts payable increases and decreases, can aid in the discovery of omitted liabilities in financial statements, as can a computerized analysis of expense records. Examination of cash disbursements in the subsequent period via canceled checks and associated invoices is another technique for discovering unrecorded expenses and liabilities (note that these are often timing differences, as discussed above). Additionally, if the auditor requests and is granted unrestricted access to the client’s files, a physical search could turn up concealed invoices and unposted liabilities. Probing interviews of accounts payable staff and other personnel can reveal unrecorded or delayed items too.
Capital expenditures are costs that provide a benefit to a company over more than one accounting period. Manufacturing equipment is an example of this type of expenditure. Revenue expenditures or expenses, on the other hand, directly correspond to the generation of current revenue and provide benefits for only the current accounting period. An example of expenses is labor costs for one week of service. These costs correspond directly to revenues billed in the current accounting period.
Capitalizing revenue-based expenses is another way to increase income and assets since they are amortized over a period of years rather than taken immediately. If expenditures are capitalized as assets and not recognized during the current period, income will be overstated. As the assets are depreciated, income in subsequent periods will be understated. Improper capitalization of expenses was one of the key methods of financial statement fraud allegedly used by WorldCom, Inc. in its high-profile fraud episode that came to light in early 2002.
Just as capitalizing expenses is improper, so is expensing costs that should be capitalized. An organization may want to minimize its net income due to tax considerations, or to increase earnings in future periods. Expensing an item that should be depreciated over a period of time would help accomplish just that—net income is reduced, in the period the expense is taken, and so are taxes.
Improper recording of sales returns and allowances occurs when a company fails to properly record or present the expense associated with sales returns and customer allowances stemming from customer dissatisfaction. It is inevitable that a certain percentage of products sold will, for one reason or another, be returned. When this happens, management should record the related expense as a contra-sales account, which reduces the amount of net sales presented on the company’s income statement.
Likewise, when a company offers a warranty on product sales, it should estimate the amount of warranty expense it reasonably expects to incur over the warranty period and accrue a liability for that amount. In warranty liability fraud, the warranty liability is usually either omitted or substantially understated. Another similar area is the liability resulting from defective products (product liability).
Any of the following conditions should raise a red flag regarding the possibility of financial statement fraud:
As discussed earlier, accounting principles require that financial statements and the related notes include all the information necessary to prevent a reasonably discerning user of the statements from being misled. The notes should include narrative disclosures, supporting schedules, and any other information required to avoid misleading potential investors, creditors, or any other users of the financial statements.
Management has an obligation to disclose all significant information appropriately in the financial statements and in management’s discussion and analysis. In addition, the disclosed information must not be misleading. Improper disclosures relating to financial statement fraud usually involve the following:
Typical omissions include the failure to disclose loan covenants or contingent liabilities. Loan covenants are agreements—in addition to, or part of, a financing arrangement—that a borrower has promised to observe as long as the financing is in place. The agreements can contain various types of covenants, including certain financial ratio limits and restrictions on other major financing arrangements. Contingent liabilities are potential obligations that will materialize only if certain events occur in the future. A corporate guarantee of personal loans taken out by an officer or a private company controlled by an officer is an example of a contingent liability. The company’s potential liability, if material, must be disclosed.
Events occurring or becoming known after the close of the period may have a significant effect on the financial statements and should be disclosed. Fraudsters often avoid disclosing court judgments and regulatory decisions that undermine the reported values of assets, that indicate unrecorded liabilities, or that adversely reflect on management integrity. Public record searches can often reveal this information.
Management has an obligation to disclose to the shareholders any acts of fraud committed by officers, executives, and others in positions of trust. Withholding such information from auditors would likely involve lying to them, an illegal act.
Related-party transactions occur when a company does business with a person or entity whose management or operating policies can be controlled or significantly influenced by the company or by some other party in common. There is nothing inherently wrong with related-party transactions as long as they are disclosed. If the transactions are not conducted on an arm’s-length basis, the company may suffer economic harm, injuring shareholders.
The financial interest that a company official might have may not be readily apparent. Examples of related parties are common directors of two companies that do business with each other, any corporate general partner and the partnerships with which it does business, and any controlling shareholder of the corporation with which he/she/it does business. Family members can also be considered related parties. These relationships include all lineal descendants and ancestors, without regard to financial interests. Related-party transactions are sometimes referred to as “self-dealing.” While these transactions are sometimes conducted at arm’s length, they often are not.
Statement of Financial Accounting Standards No. 154 (SFAS 154), “Accounting Changes and Error Corrections,” describes three types of accounting changes that must be disclosed to avoid misleading the user of financial statements: accounting principles, estimates, and reporting entities. Although the required treatment for each type of change is different, they are all susceptible to manipulation by the determined fraudster. For example, fraudsters may fail to properly retroactively restate the financial statements for a change in accounting principle if the change causes the company’s financial statements to appear weaker. Likewise, they may fail to disclose significant changes in estimates, such as the useful lives and estimated salvage values of depreciable assets, or the estimates underlying the determination of warranties or other liabilities. They may even secretly change the reporting entity, by adding entities owned privately by management or excluding certain company-owned units, to improve reported results.
Any of the following should alert interested parties of potentially improper disclosures.
Generally accepted accounting principles require that most assets be recorded at their historical (acquisition) cost. Under the “lower of cost or market value” rule, when an asset’s cost exceeds its current market value (as happens often with obsolete technology), it must be written down to market value. With the exception of certain securities, asset values are not increased to reflect current market value. Recent trends in accounting require valuation using (estimated) fair market value.
It is often necessary to use estimates in accounting. For example, estimates are used in determining the residual value and the useful life of a depreciable asset, the uncollectible portion of accounts receivable, liabilities associated with returns and defective products (e.g., warranties), or the excess or obsolete portion of inventory. Whenever estimates are used, there is an additional opportunity for fraud through manipulation of those estimates.
Many schemes are used to inflate current assets at the expense of long-term assets. The net effect is seen in the current ratio. The misclassification of long-term assets as current assets can be of critical concern to lending institutions that require the maintenance of certain financial ratios. This is of particular consequence when the loan covenants are on unsecured or under-secured lines of credit and other short-term borrowings. Sometimes these misclassifications are referred to as “window dressing.”
Most improper asset valuations involve the fraudulent overstatement of inventory or receivables. Other improper asset valuations include manipulation of the allocation of the purchase price of an acquired business to inflate future earnings, misclassification of fixed and other assets, and improper capitalization of inventory or startup costs. Improper asset valuations usually fall into one of the following categories:
Since inventory must be valued at the acquisition cost, except when the cost is determined to be higher than the current market value, inventory should be written down to its current value, or written off altogether if it has no value. Failing to write down inventory will result in overstated assets and the mismatching of cost of goods sold with revenues. Inventory can also be improperly stated through the manipulation of the physical inventory count, by inflating the unit costs used to price inventory, by failing to reduce inventory for costs of goods sold, or by other methods. Fictitious inventory schemes usually involve the creation of fake documents such as inventory count sheets and receiving reports. Companies have even programmed computers to produce special reports of inventory for auditors that incorrectly total the line item values to inflate the overall inventory balance. Big data and data analytic techniques can significantly help auditors detect many of these fraudulent inventory techniques. One case involved an inventory valuation scheme in which the fraud was committed through tampering with the inventory count. During a routine audit of a publicly traded medical supply company, the audit team found a misstatement of the inventory value that could hardly be classified as routine. The client’s inventory was measured in metric volumes, and apparently as the count was taken, an employee arbitrarily moved the decimal point. This resulted in the inventory being grossly overstated. The discovery forced the company to restate its financial statements, resulting in a write-down of the inventory amount by more than $1.5 million.
One of the most popular methods of overstating inventory is through fictitious (phantom) inventory. In one example, a CFE conducting a systems control review at a large cannery and product wholesaler in the Southwest observed a forklift driver constructing a large façade of finished product in a remote location of the warehouse. The inventory was cordoned off and a sign indicated it was earmarked for a national food processor. The cannery was supposedly warehousing the inventory until requested by the customer. When the CFE investigated, he discovered that the inventory held for the food processor was later resold to a national fast-food supplier.
A review of the accounts receivable aging report indicated sales of approximately $1.2 million to this particular customer in prior months, and the aging also showed that cash receipts had been applied against those receivables. An analysis of ending inventory failed to reveal any improprieties because the reduction of inventory had been properly recorded with cost of sales. Copies of all sales documents to this particular customer were then requested. The product was repeatedly sold free on board (FOB) shipping point and title had passed. But bills of lading indicated that only $200,000 of inventory had been shipped to the original purchaser. There should have been a million dollars of finished product on hand for the food processor. However, there was nothing behind the façade of finished products. A comparison of bin numbers on the bill of lading with the sales documents revealed that the same product had been sold twice.
The corporate controller was notified and the plant manager questioned. He explained that “he was doing as he was told.” The vice president of marketing and the vice president of operations both knew of the situation but felt there was “no impropriety.” The CFO and president of the company felt differently and fired the vice presidents. The company eventually was forced into bankruptcy.
Accounts receivable are subject to manipulation in the same manner as sales and inventory, and in many cases, the schemes are conducted together. The two most common schemes involving accounts receivable are fictitious receivables and failure to write off accounts receivable as bad debts (or failure to establish an adequate allowance for bad debts). Fictitious receivables commonly arise from fictitious revenues, which were discussed earlier. Accounts receivable should be reported at net realizable value, that is, the amount of the receivable less amounts expected not to be collected.
Fictitious accounts receivable are common among companies with financial problems, as well as among managers who receive commission based on sales. The typical scheme for fictitious accounts receivable is to debit (increase) accounts receivable and credit (increase) sales. Of course, these schemes are more common around the end of the accounting period, since accounts receivable should be paid in cash within a reasonable time. Fraudsters commonly attempt to conceal fictitious accounts receivable by providing false confirmations of balances to auditors. They get the audit confirmations because the mailing address they provide for the phony customers is typically either a mailbox under their control, a home address, or the business address of a co-conspirator. Such schemes can be detected by checking business credit reports, public records, or even the telephone book to identify significant customers with no verifiable physical existence or no apparent business need for the product sold to them.
Companies are required to accrue losses on uncollectible receivables if a loss is probable and can be reasonably estimated (in accordance with FASB ASC 450-20-25-2), and to record impairment of long-lived assets (under ASC 360-10), of inventory (under ASC 330), and of goodwill (under ASC350). Companies struggling for profits and income may be tempted to omit the recognition of such losses because of the negative impact on income.
Companies are required to allocate the purchase price they have paid to acquire another business to the tangible and intangible assets of that business. Any excess of the purchase price over the value of the acquired assets is treated as goodwill. Changes in goodwill accounting have decreased the incentive for companies to allocate an excessive amount to purchased assets, to minimize the amount allocated to goodwill that previously should have been amortized and that reduced future earnings. However, companies may still be tempted to over-allocate the purchase price to in-process research and development assets, in order to write them off immediately. Or they may establish excessive reserves for various expenses at the time of acquisition, intending to quietly release those excess reserves into earnings at a future date.
Long-term assets are subject to manipulation through several different schemes. Some of the more common schemes are
One of the easiest methods of asset misrepresentation is the recording of fictitious assets. This false creation of assets affects account totals on a company’s balance sheet. The corresponding account commonly used is the owners’ equity account. Because company assets are often physically found in many different locations, this fraud can sometimes be easily overlooked. One of the most common fictitious asset schemes is simply to create fictitious documents. In one instance, a real estate development and mortgage financing company produced fraudulent statements that included fictitious and inflated asset amounts and illegitimate receivables. The company also recorded expenses that actually were for personal rather than business use. To cover the fraud, the company raised cash through various illegal securities offerings, guaranteeing over $110 million with real estate projects. They subsequently defaulted. The company declared bankruptcy shortly before the owner passed away.
In other cases, equipment is leased, not owned, and this fact is not disclosed during the audit of long-lived assets. Bogus long-lived assets can sometimes be detected because the long-lived asset addition makes no business sense.
Long-lived assets should be recorded at cost. Although assets may appreciate in value, this increase in value generally should not be recognized on company financial statements. Many financial statement frauds have involved the reporting of long-lived assets at market values instead of the lower acquisition costs, or at even higher inflated values with phony valuations to support them. Further, companies may falsely inflate the value of these assets by failing to record impairments of long-lived assets (as required by ASC 360-10) and of goodwill (as required by ASC 350). Misrepresentation of asset values frequently goes hand-in-hand with other schemes.
One of the highest-profile asset valuation fraud cases of recent years involved the collapse of Enron, the energy-trading company. Enron was created in 1985 as a merger between Houston Natural Gas and InterNorth, a Nebraska pipeline company. Although Enron began as a traditional natural gas supplier, under the lead of employee Jeffrey Skilling, it quickly developed a new and innovative strategy to make money: the creation of a “gas bank,” where the company would buy gas from a network of suppliers and sell to a network of consumers. Its profits would be derived from contractually guaranteeing both the supply and the selling price, charging a fee for its services.
This new business segment required Enron to borrow enormous amounts of money, but by 1990 the company was the market leader. Kenneth Lay, Enron’s CEO, created Enron Finance Corp. (EFC) to handle the new business and picked Skilling to run it. Based on the initial success of EFC and with the assistance of Skilling’s new protégé, Andrew Fastow, the company’s “gas bank” concept was expanded to include trading in electricity and in futures contracts for coal, paper, water, steel, and other commodities.
Since Enron was either a buyer or a seller in every transaction, the company’s credit was crucial. Eventually, in 2000, Enron expanded into the telecommunications business by announcing plans to build a high-speed broadband network and to trade network capacity (bandwidth) in the same way it traded other commodities. Enron sunk hundreds of millions of dollars in borrowed money for this new venture, which quickly failed to produce the expected profits.
The money that Enron borrowed to finance its various ventures was kept off of its balance sheet by Fastow, using an accounting treatment called special-purpose entities (SPEs). Under accounting rules in place at the time, Enron could contribute up to 97% of an SPE’s assets or equity. Then the SPE could borrow its own money, which would not show up on Enron’s financial statements. But Enron could claim its profits (or losses).
In most of the SPEs established by Enron, the asset contributed was company stock. But since the stock contributions would have diluted earnings per share, Enron used another treatment, “mark-to-market accounting,” to boost profits. Mark-to-market accounting required a company to book both realized and unrealized gains and losses on energy-related and other “derivative” contracts at the end of each quarter. Because there were no hard-and-fast rules on how to value such contracts, Enron consistently valued them to show gains, which would offset the effect of issuing more stock to fund the SPEs. Moreover, the accounting treatment that allowed Enron to keep the debt off of its balance sheet also allowed the company to claim the income from unrealized holding gains, which increased the return on assets. By 1999, Enron had derived more than half of its $1.4 billion pretax net income from unrealized holding gains.
Fastow became the master of the SPE, eventually creating thousands of them for various purposes. However, when the economic boom of the 1990s started to wane, Enron’s unrealized holding gains on its “derivative” contracts started turning into losses. To keep these losses from showing up on Enron’s income statement, Fastow created SPEs to hide them. And in the process of creating SPEs, Fastow paid himself over $30 million in management fees. His wife was paid another $17 million.
One of the six transactions in the SEC’s complaint against Fastow involved a special-purpose entity named Raptor I and a public company called Avici Systems Inc. According to the complaint, Enron and the Fastow-controlled partnership, LJM2, engaged in complex transactions with Raptor I to manipulate Enron’s balance sheet and income statement, as well as to generate profits for LJM2 and Fastow, at Enron’s expense. In September 2000, Fastow and others used Raptor I to effectuate a fraudulent hedging transaction, and thus avoid a decrease in the value of Enron’s investment in the stock of Avici Systems Inc. Specifically, Fastow and others back-dated documents to make it appear that Enron had locked in the value of its investment in Avici in August 2000, when Avici’s stock was trading at its all-time high price.
The various deals that Enron cooked up should have been properly disclosed in the notes to its financial statements. But a number of analysts questioned the transparency of those disclosures. One said, “The notes just don’t make any sense, and we read notes for a living.”
Like other profits that are built on paper and risky deals, Enron was unable to continue without massive infusions of cash. When that didn’t materialize, Enron in October 2001 was forced to disclose it was taking a $1 billion charge to earnings to account for poorly performing business segments. It also had to reverse $1.2 billion in assets and equities booked as a result of the failed SPEs. Later that month, it announced restatements that added $591 million in losses and $628 million in liabilities for the year ended in 2000.
The bubble had burst. On December 2, 2001, Enron filed for bankruptcy. Enron’s auditor, Andersen & Co., closed its doors on August 30, 2002, for failing to discover the fraud. In the end, sixteen people pled guilty to crimes related to the scandal, and five others were convicted at trial. Many of the company’s top executives were sentenced to jail time for their part in the fraud, including Fastow, Skilling, and former treasurer Ben Glisan, Jr. Ken Lay was also found guilty of six counts of fraud, but he died of a heart attack before his sentencing.
In some cases, as with certain government-related or regulated companies where additional funding is based on asset amounts, it may be advantageous to understate assets. This understatement can be done directly or through improper depreciation. In one example, the management of a company falsified its financial statements by manipulating the depreciation of the long-term assets. The depreciation reserve was accelerated by the amount of $2.9 million over a six-month period. The purpose of the scheme was to avoid cash contributions to a central government capital asset acquisition account.
Excluded from the cost of a purchased asset are interest and finance charges incurred in the purchase. For example, as a company finances a capital equipment purchase, monthly payments include both principal liability reduction and interest payments. On initial purchase, only the original cost of the asset should be capitalized. The subsequent interest payments should be charged to interest expense—not to the asset. Without reason for intensive review, fraud of this type can go unchecked. In one case, a new investor in a closely held corporation sued for rescission of purchase of stock, alleging that the company compiled financial information that misrepresented the financial history of the business. A fraud examination uncovered assets that were overvalued because of capitalization of interest and other finance charges. Also discovered was the fact that one of the owners was understating revenue by $150,000 and embezzling the funds. In a civil fraud case, the parties subsequently settled out of court.
To meet budget requirements, and for various other reasons, assets are sometimes misclassified into general ledger accounts in which they don’t belong. The manipulation can skew financial ratios and help in complying with loan covenants or other borrowing requirements. In a case where an employee from the purchasing department at a retail jewelry firm feared being called to the carpet for some bad jewelry purchases, rather than taking the blame for bad margins on many items, the employee arbitrarily redistributed costs of shipments to individual inventory accounts. The cover-up did not work, because the company’s CFO detected the fraud after he established changes to control procedures.
When the CFO created a separation of duties between the buying function and the costing activities, the dishonest employee’s scheme was detected and the employee was terminated.
The following circumstances should raise suspicions regarding the propriety of asset valuation.
In the highly publicized Tyco fraud case, which broke in 2002, the SEC charged former top executives of the company, including its former CEO, L. Dennis Kozlowski, with failing to disclose to shareholders hundreds of millions of dollars of low-interest and interest-free loans they took from the company. Moreover, Kozlowski forgave $50 million in loans to himself and another $56 million in loans for fifty-one favored Tyco employees. Tyco’s board approved none of the loans or the write-offs.
Kozlowski also engaged in undisclosed nonarm’s-length real estate transactions with Tyco or its subsidiaries and received undisclosed compensation and perks, including rent-free use of large New York City apartments, and personal use of corporate aircraft at little or no cost. The SEC complaint alleged that three former executives, including Kozlowski, also sold restricted shares of Tyco stock valued at $430 million dollars while their self-dealing remained undisclosed.
In addition, Kozlowski participated in numerous improper transactions to fund an extravagant lifestyle. In January 2002, several empty boxes arrived at Tyco’s headquarters in Exeter, New Hampshire. They were supposed to contain art worth at least $13 million to decorate the modest two-story facility. In fact, the art—consisting of original works by Renoir and Monet—was actually hanging on the walls of Kozlowski’s lavish Fifth Avenue corporate apartment; the empty-box ruse was an effort to avoid New York state sales tax of 8.25%.
Less than six months later, Kozlowski resigned (just before being accused of evading payment of taxes on the art). But the art—paid for by Tyco—was just the tip of the iceberg. A subsequent investigation would accuse Kozlowski and CFO Mark Schwartz of systematically looting their employer of more than $170 million. Both men were later found guilty of twenty-two charges and sentenced to up to twenty-five years in prison.
Most of the stolen money was simply charged to Tyco even though it personally benefited Kozlowski. For example, his compensation was reported at $400 million, but in addition, Tyco paid for such charges as
Although Kozlowski’s embezzlements were not material to the financial statements as a whole, they were, nonetheless, substantial and vividly portray corporate greed.
Comparative financial statements provide information for current and past accounting periods. Accounts expressed in whole-dollar amounts yield a limited amount of information. The conversion of these numbers into ratios or percentages allows the reader of the statements to analyze them based on their relationship to each other, as well as to major changes in historical totals. In fraud detection and investigation, determination of the reasons for relationships and changes in amounts can be revealing. Such determinations are the red flags that point an examiner in the direction of possible fraud. If large enough, a fraudulent misstatement will affect the financial statements in such a way that relationships between the numbers become questionable. Many schemes are detected because the financial statements, when analyzed closely, do not make sense. Financial statement analysis includes
There are traditionally two methods of percentage analysis of financial statements. Vertical analysis is a technique for analyzing the relationships between the items on an income statement, balance sheet, or statement of cash flows by expressing components as percentages. This method is often referred to as “common sizing” of financial statements. In the vertical analysis of an income statement, net sales is assigned 100%; for a balance sheet, total assets is assigned 100% on the asset side, and total liabilities and equity is expressed as 100%. All other items in each of the sections are expressed as a percentage of these numbers.
Horizontal analysis is a technique for analyzing the percentage change in individual financial statement items from one year to the next. The first period in the analysis is considered the base, and the changes to subsequent periods are computed as a percentage of the base period. If more than two periods are presented, each period’s changes are computed as a percentage of the preceding period. Like vertical analysis, this technique will not work for small, immaterial frauds.
Following are examples of financial statements that are analyzed using both vertical and horizontal analysis.
Balance Sheet | Vertical Analysis | Horizontal Analysis | ||||||||||
Year 1 | Year 2 | Change | % Change | |||||||||
Assets | ||||||||||||
Current assets | ||||||||||||
Cash | 45,000 | 14% | 15,000 | 4% | (30,000) | −67% | ||||||
Accts. receivable | 150,000 | 45% | 200,000 | 47% | 50,000 | 33% | ||||||
Inventory | 75,000 | 23% | 150,000 | 35% | 75,000 | 100% | ||||||
Long-term assets (net) | 60,000 | 18% | 60,000 | 14% | 0% | |||||||
Total | 3 330,000 | 100% | 425,000 | 100% | 95,000 | 29% | ||||||
Accts. payable | 95,000 | 29% | 215,000 | 51% | 120,000 | 126% | ||||||
Long-term debt | 60,000 | 18% | 60,000 | 14% | – | 0% | ||||||
Stockholder’s equity— | ||||||||||||
Common stock | 25,000 | 8% | 25,000 | 6% | – | 0% | ||||||
Paid-in capital | 75,000 | 23% | 75,000 | 18% | – | 0% | ||||||
Retained earnings | 75,000 | 23% | 50,000 | 12% | (25,000) | −33% | ||||||
Total | 330,000 | 100% | 425,000 | 100% | 95,000 | 29% |
Income Statement | Vertical Analysis | Horizontal Analysis | ||||
Year 1 | Year 2 | Change | % Change | |||
Net sales | 250,000 | 100% | 450,000 | 100% | 200,000 | 80% |
Cost of goods sold | 125,000 | 50% | 300,000 | 67% | 175,000 | 140% |
Gross margin | 125,000 | 50% | 150,000 | 33% | 25,000 | 20% |
Operating expenses | ||||||
Selling expenses | 50,000 | 20% | 75,000 | 17% | 25,000 | 50% |
Administrative expenses | 60,000 | 24% | 100,000 | 22% | 40,000 | 67% |
Net income Additional Information |
15,000 | 6% | (25,000) | −6% | (40,000) | −267% |
Average net receivables | 155,000 | 210,000 | ||||
Average inventory | 65,000 | 130,000 | ||||
Average assets | 330,000 | 425,000 |
Vertical analysis indicates the relationship or percentage of component part items with respect to a specific base item. In the vertical analysis of the income statement above, net sales are the base amount and all other items are analyzed as a percentage of that total. Vertical analysis emphasizes the relationships among statement items within each accounting period. These relationships can be used with historical averages to identify statement anomalies.
In the above example, we observe that accounts payable is 29% of total liabilities and stockholders’ equity. We may find that historically this account averages slightly over 25%. In year 2, accounts payable rose to 51%. Although the change in the accounts payable total may be explainable as being correlated with a rise in sales, this significant increase might be a starting point in a fraud examination. Source documents should be examined to determine the basis for the rise in this percentage. With this type of examination, fraudulent activity can sometimes be detected. The same type of change can be seen in the decline of selling expenses as a part of sales in year 2 from 20 to 17%. Again, this change may be explainable by higher-volume sales or another legitimate influence. But close examination may point a fraud examiner to fictitious sales since accounts payable total rose significantly with no corresponding increase in selling expenses.
Horizontal statement analysis uses percentage comparisons from one accounting period to the next. The percentage change is calculated by dividing the amount of increase or decrease for each item by the base period amount. It is important to consider the amount of change as well as the percentage in horizontal comparisons. A 5% change in an account with a very large dollar amount may be much more significant than a 50% change in an account with much less activity.
In the above example, it is very obvious that the 80% increase in sales corresponds to a much greater increase in cost of goods sold, 140%. These accounts are often used to hide fraudulent expenses, withdrawals, or other illegal transactions.
Ratio analysis is a means of measuring the relationship between two different financial statement amounts. Traditionally, financial statement ratios are used in comparison to an entity’s industry average. They can be very useful in detecting red flags for a fraud examination. When the financial ratios highlight a significant change in key areas of an organization from one year to the next, or over a period of years, it indicates that there may be a problem. As in all other analyses, specific changes can often be explained by changes in the business operations. Changes in key ratios are not, in and of themselves, proof of any wrongdoing.
Whenever a change in specific ratios is detected, the appropriate source accounts should be researched and examined in detail to determine if fraud has occurred. For instance, a significant decrease in a company’s current ratio may be the result of an increase in current liabilities or a reduction in assets, either of which could be used to conceal fraud.
Like vertical and horizontal analysis, ratio analysis is limited by its inability to detect fraud on a small, immaterial scale. Key financial ratios include:
Many other kinds of financial ratios are analyzed in industry-specific situations, but the ratios listed above are analytical tools that may lead to discovery of fraud. The following calculations are based on the sample financial statements presented earlier.
RATIO ANALYSIS | |||||||
Ratio | Calculation | Year 1 | Year 2 | ||||
Current ratio | Current assets | 270,000 | 2.84 | 365,000 | |||
Current liabilities | 95,000 | = | 215,000 | = | 1.7 | ||
Quick ratio | Cash + Securities + Receivables | 195,000 | = | 2.05 | 215,000 | = | 1 |
Current liabilities | 95,000 | 215,000 | |||||
Receivables turnover | Net sales on account | 250,000 | = | 1.61 | 450,000 | = | 2.14 |
Average net receivables | 155,000 | 210,000 | |||||
Collection ratio | 365 | 365 | = | 226.30 | 365 | = | 170.56 |
Receivables turnover | 1.61 | 2.14 | |||||
Inventory turnover | Cost of goods sold | 125,000 | = | 1.92 | 300,000 | = | 2.31 |
Average inventory | 65,000 | 130,000 | |||||
Average number of days inventory is in stock | 365 | 365 | = | 190.10 | 365 | = | 158.01 |
Inventory turnover | 1.92 | 2.31 | |||||
Debt to equity | Total liabilities | 155,000 | = | 0.89 | 275,000 | = | 1.83 |
Total equity | 175,000 | 150,000 | |||||
Assets to equity | Assets | 330,000 | = | 1.89 | 425,000 | = | 2.83 |
Total equity | 175,000 | 150,000 | |||||
Gross margin | Gross Profit | 125,000 | = | 0.50 | 150,000 | = | 0.33 |
Net sales | 250,000 | 450,000 | |||||
Profit margin | Net income | 15,000 | = | 0.06 | -25,000 | = | -0.06 |
Net sales | 250,000 | 450,000 | |||||
Return on Assets | Net income | 15,000 | = | 0.05 | -25,000 | = | -0.06 |
Assets | 330,000 | 450,000 | |||||
Return on Equity | Net income | 15,000 | = | 0.09 | -25,000 | = | -0.17 |
Total Equity | 175,000 | 150,000 | |||||
Asset turnover | Net sales | 250,000 | = | 0.76 | 450,000 | = | 1.06 |
Assets | 330,000 | 425,000 |
Interpretation of Financial Ratios
The current ratio—current assets divided by current liabilities—is probably the most-used ratio in financial statement analysis. This comparison measures a company’s ability to meet present obligations from its liquid assets. The number of times by which current assets exceed current liabilities has long been a convenient measure of financial strength.
In detecting fraud, this ratio can be a prime indicator of manipulation of accounts. Embezzlement will cause the ratio to decrease. Liability concealment will cause the ratio to appear more favorable.
In the present example, the drastic change in the current ratio from year 1 (2.84) to year 2 (1.70) should cause the examiner to look at these accounts in more detail. For instance, a billing scheme will usually result in a decrease in current assets—cash—which will in turn decrease the ratio.
The quick ratio, often referred to as the acid-test ratio, compares assets that can be immediately liquidated. In this calculation the total of cash, securities, and receivables is divided by current liabilities. This ratio is a measure of a company’s ability to meet sudden cash requirements. In turbulent economic times, it is used more extensively, giving the analyst a worst-case look at the company’s working capital situation.
An examiner may analyze this ratio for fraud indicators. In year 1 of the example, the company balance sheet reflects a quick ratio of 2.05. This ratio drops in year 2 to 1.00. In this situation, a possible type of fraud is fictitious accounts receivable that may have been added to inflate sales in the first year. The ratio calculation will be abnormally high and there will not have been an offset of current liabilities.
Receivables turnover is defined as net sales divided by average net receivables. It measures the number of times accounts receivable is turned over during the accounting period. In other words, it measures the time between credit sales and collection of funds. This ratio uses both income statement and balance sheet account information in its analysis. If the fraud involves fictitious sales, this is bogus income that will never be collected. As a result, the turnover of receivables will decrease.
Accounts receivable aging is measured by the collection ratio. The ratio divides 365 days by the receivables turnover ratio to arrive at the average number of days used to collect receivables. In general, the lower the collection ratio, the faster receivables are collected. A fraud examiner may use this ratio as a first step in detecting fictitious receivables or larceny and skimming schemes. Normally, this ratio will stay fairly consistent from year to year, but changes in billing policies or collection efforts may cause a fluctuation. The example shows a favorable reduction in the collection ratio from 226.3 in year 1 to 170.56 in year 2. This means that the company is collecting its receivables more quickly in year 2 than in year 1.
The relationship between a company’s cost of goods sold and average inventory is shown through the inventory turnover ratio. This ratio measures the number of times inventory is sold during the period. This ratio is a good determinant of purchasing, production, and sales efficiency. In general, a higher inventory turnover ratio is considered more favorable. However, if cost of goods sold has increased due to theft of inventory (for example, ending inventory has declined, but not through sales), then this ratio will be abnormally high. In the present example, inventory turnover increases in year 2, signaling the possibility that an embezzlement is buried in the inventory account. An examiner should study the changes in the components of the ratio to determine where to look to uncover possible fraud.
The average number of days inventory is in stock is a restatement of the inventory turnover ratio expressed in days. This rate is important for several reasons. An increase in the number of days inventory stays in stock causes additional expenses, including storage costs, risk of inventory obsolescence, and market price reductions, as well as interest and other expenses incurred from tying up funds in inventory stock. Inconsistency or significant variances in this ratio is a red flag for fraud investigators. Examiners may use this ratio to examine inventory accounts for possible larceny schemes. Purchasing and receiving inventory schemes can also affect the ratio, and false debits to cost of goods sold will result in an increase in the ratio. A significant change in the inventory turnover ratio is a good indicator of possible fraudulent inventory activity.
The debt-to-equity ratio is computed by dividing total liabilities by total equity. This ratio is one that is heavily studied by lending institutions. It provides a clear picture of the comparison between the long-term and short-term debt of the company, and of the owner’s financial injection plus earnings to date. This balance of the resources provided by creditors and what the owners provide is crucial for analyzing the financial status of a company. Debt-to-equity requirements are often included as borrowing covenants in corporate lending agreements. The example displays a year 1 ratio of 0.89 and a year 2 ratio of 1.83. The increase in the ratio corresponds with the rise in accounts payable. Sudden changes in this ratio may prompt an examiner to look for fraud.
The assets to equity ratio is calculated as total assets compared to total equity. The ratio is similar to the debt to equity ratio in that it provides a perspective on the capitalization of the company. In other words, the metric offers insight into how the company’s assets are funded—with debt or equity. Because the ratio indirectly measures the financing of the organization (debt), the metric provides insight into the risks and challenges of the organization. This ratio is particularly helpful when examined across time for the same company, or in comparison to industry averages and key industry competitors. Further, the ratio is used in the “Dupont Expression” discussed below.
The gross margin ratio is calculated as gross profits compared to net sales and is one of the metrics calculated as part of a vertical analysis. The gross margin represents the percent of net sales that the company retains after deducting the costs of goods sold, direct costs associated with producing the goods and services that were sold. In general, the higher the gross margin, the more the company retains on each dollar of sales.
The profit margin ratio is defined as net income divided by net sales. This ratio is often referred to as the efficiency ratio, as it reveals profits earned per dollar of sales. The ratio of net income to net sales relates not only to the effects of gross margin changes, but also to changes in sales and administrative expenses. Over time, this ratio should remain fairly consistent. As fraud is committed, artificially inflated sales will not have an accompanying increase in cost of goods sold, net income will be overstated, and the profit margin ratio will be abnormally high. False expenses and fraudulent disbursements will cause an increase in expenses and a decrease in the profit margin ratio.
The return on assets (ROA) is computed as net income compared to total assets. ROA represents the percent of net income that the company created, as a result of its investment in assets. The metric can be used to evaluate how effectively a company is generating income through the utilization of its assets.
The return on equity (ROE) is defined as net income divided by the total investments made by the company’s shareholders. Because shareholders are a key stakeholder in the company, their return is monitored closely. If the return to shareholders fall below reasonable amounts, shareholders are likely to move their investment to alternative investments that offer better returns, relative to the risks assumed.
Net sales divided by average operating assets is the calculation used to determine the asset turnover ratio. This ratio determines the efficiency with which asset resources are utilized. The present example reflects a greater use of assets in year 2 than in year 1.
The Dupont Expression is an analytical approach that dissects the income returns into its component parts. While the Dupont analysis is often applied to return on equity, the approach can also be used to examine return on assets. Depending on the source, one can find many derivations of the Duport expression. At this time, we’ll examine two, one for return on equity and one for return on assets.
Return on equity can be examined as a function of leverage risk (assets to equity), effectiveness (asset turnover), and efficiency (profit margin) while return on assets is a function of effectiveness (asset turnover) and efficiency (profit margin). Note that ROA and ROE are mathematically related through leverage risk associated with liabilities in the balance sheet. The following table provides the Dupont expressions for return on equity and assets as follows:
Dupont Expression for Return on Equity | |||||
Formula | Return on equity = | Assets to equity X | Asset turnover X | Profit margin | |
Net income | Assets | Net sales | Net income | ||
Total equity | Total equity | Assets | Net sales | ||
Year 1 | 15,000 | 330,000 | 250,000 | 15,000 | |
175,000 | 175,000 | 330,000 | 250,000 | ||
0.09 | 1.89 | 0.76 | 0.06 | ||
Year 2 | −25,000 | 425,000 | 450,000 | −25,000 | |
150,000 | 150,000 | 425,000 | 450,000 | ||
−0.17 | 2.83 | 1.06 | −0.06 | ||
Dupont Expression for Return on Assets | |||||
Formula | Return on assets = | Asset turnover X | Profit margin | ||
Net income | Net sales | Net income | |||
Total assets | Assets | Net sales | |||
Year 1 | 15,000 | 250,000 | 15,000 | ||
330,000 | 330,000 | 250,000 | |||
0.05 | 0.76 | 0.06 | |||
Year 2 | −25,000 | 450,000 | −25,000 | ||
450,000 | 425,000 | 450,000 | |||
−0.06 | 1.06 | −0.06 |
Financial statement fraud—particularly those that overstate income, but also including income understatement—often creates an unexpected and irreconcilable difference between income and cash flows, especially cash flows from operations. Prior research has examined the earnings, accruals, and cash flows of businesses in the period of the fraud and the period just before the fraud:
The take-away is that cash flows should be examined in relation to a company’s reported income over time and in comparison to competitors in the industry and industry averages.
Accountants are experts at examining and evaluating financial numbers. However, most internal operational analyses also require the assessment of relevant nonfinancial numbers. For example, retail sales are often affected by extremes in weather. A snow storm in the northeast or hurricane along the coast will often shutter retail establishments. The same applies to restaurants. A construction contractor working outdoors may face operational impacts in cases of weather conditions that are highly favorable or unfavorable. For accountants to understand the numbers behind an organization’s financial performance, they must consider not only financial information but also relevant nonfinancial information.
A growing body of literature offers evidence that nonfinancial measures (NFMs) can provide valuable analytical information to supplement a company’s financial statement data. NFMs, such as employee headcount and production space, are operational measures that are not presented in the financial statements but may be disclosed in financial reports (e.g., Annual reports, 10Ks, Management’s Discussion and Analysis). Further, forensic accountants may have access to NFM data via the litigation discovery process or because they are conducting internal examinations. Once obtained, forensic accountants may use NFMs to evaluate reported financial information.
When analyzing data to identify financial reporting fraud, examiners will likely be leery of relying on internal / published financial statements and related account balances because the amounts may have been manipulated. Accordingly, some researchers suggest that forensic accountants should consider information sources that are less prone to manipulation by management.38 Along those lines, NFMs including production facilities, retail outlets, production capacity, weather data, and the number of employees may be less vulnerable to manipulation. Another consideration is that available NFMs often are produced and reported by independent sources (e.g., industry research reports, financial magazines and news sources, trade journals, and related websites). Such data, obtained from independent sources, can be very valuable for the forensic accountant in an examination.
As noted by Brazel et al., for NFMs to serve as an effective benchmark for evaluating financial statement data, they must correlate with the performance. Several research studies conclude that such relationships exist.39
All of these should serve to increase the overall likelihood of fraud detection.42
Brazel et al.43 completed two experiments to consider the use of NFMs by auditors. In the first experiment, auditors developed an expectation for a client sales balance. In that setting the average auditor failed to identify an inconsistency between the sales and relevant NFMs. In the second experiment, the auditors were prompted to use the NFM; in that setting, auditors were more likely to recognize the inconsistency. According to the authors, their results suggest the following:
Examination of NFMs is often relevant and informative in other forensic accounting contexts.
Deterring financial statement fraud is more complex than deterring asset misappropriation and similar frauds. Because of the breadth of the subject matter, this section cannot cover all possible deterrence measures. But it is clear that adding traditional internal controls alone is unlikely to be effective. As noted earlier, the 2010 COSO study indicated that either the CEO or the CFO was involved in 89% of the financial statement frauds studied. Although this study is several years old, there are no current data to indicate that the trends have changed substantially. Those at the executive level can use their authority to override most internal controls, so those controls are often of limited value in preventing financial statement fraud. A different approach is needed.
Following the principles of the fraud triangle, a general approach to reducing financial statement fraud is the following:
We have eight types of assignments for instructors to choose from:
Read the following articles or other related articles regarding the Phar-Mor case and then answer the questions below:
Assume that Alpha and Omega compete in the same four-digit SIC code industry and offer comparable products and services. The following table contains their reported financial performance and condition for the last two years:
Alpha Company | Omega Company | ||||||||||||
Balance Sheet | Year 1 | Year 2 | Analysis | Year 1 | Year 2 | Analysis | |||||||
Assets—Cash | 250 | 480 | 92% | 250 | 480 | 92% | |||||||
Assets—Accounts Receivable | 250 | 330 | 32% | 250 | 530 | 112% | |||||||
Assets—Long-Term | 500 | 900 | 80% | 500 | 900 | 80% | |||||||
Assets | 1,000 | 1,710 | 71% | 1,000 | 1,910 | 91% | |||||||
Liabilities—Current | 400 | 750 | 88% | 400 | 750 | 88% | |||||||
Liabilities—Long-Term | 200 | 375 | 88% | 200 | 375 | 88% | |||||||
Liabilities | 600 | 1,125 | 88% | 600 | 1,125 | 88% | |||||||
Stockholders’ Equity | 400 | 585 | 46% | 400 | 785 | 96% | |||||||
Liabilities and Stockholders’ Equity | 1,000 | 1,710 | 71% | 1,000 | 1,910 | 91% | |||||||
Income Statement | |||||||||||||
Revenues | 1,200 | 2,200 | 83% | 1,200 | 2,400 | 100% | |||||||
Costs of Goods Sold | 500 | 925 | 85% | 500 | 925 | 85% | |||||||
Gross Profit | 700 | 1,275 | 82% | 700 | 1,475 | 111% | |||||||
Operating Expenses | 600 | 1,090 | 82% | 600 | 1,090 | 82% | |||||||
Operating Income | 100 | 185 | 85% | 100 | 385 | 285% | |||||||
Statement of Cash Flows | |||||||||||||
Operating Income | 100 | 185 | 85% | 100 | 385 | 285% | |||||||
Depreciation * Operating Cash | 25 | 45 | 80% | 25 | -155 | -720% | |||||||
Operating Cash Flows | 125 | 230 | 84% | 125 | 230 | 84% |
Alpha Company | Omega Company | ||||||||||||
Ratios | Year 1 | Year 2 | Industry | Year 1 | Year 2 | Industry | |||||||
Current Ratio | 0.63 | 0.64 | 1.15 | 0.63 | 0.64 | 1.15 | |||||||
Debt-to-Assets Ratio | 0.600 | 0.658 | 0.625 | 0.600 | 0.589 | 0.625 | |||||||
Return on Assets | 10% | 11% | 10% | 10% | 20% | 10% | |||||||
Gross Margin | 58% | 58% | 58% | 58% | 61% | 58% | |||||||
Operating Cash Flow/Income | 125% | 124% | 125% | 125% | 60% | 125% | |||||||
Dupont Expression Ratios | |||||||||||||
Risk—Assets-to-Equity | 2.50 | 2.92 | 2.75 | 2.50 | 2.43 | 2.75 | |||||||
Revenue Generation—Asset Turn | 1.20 | 1.29 | 1.25 | 1.20 | 1.26 | 1.25 | |||||||
Profits—Profit Margin | 8% | 8% | 8% | 8% | 16% | 8% | |||||||
Return on Equity | 25% | 32% | 27% | 25% | 49% | 27% |
Alpha Company | Omega Company | ||||||||||||
Analysis of Nonfinancial Metrics | Year 1 | Year 2 | Analysis | Year 1 | Year 2 | Analysis | |||||||
Retail Square Footage | 57,000 | 105,000 | 84% | 57,000 | 105,000 | 84% | |||||||
# Employees | 1,140 | 2,075 | 82% | 1,140 | 2,075 | 82% | |||||||
# Store Locations | 95 | 170 | 79% | 95 | 170 | 79% |
The following is the “inventory” of items received to continue the examination at Johnson Real Estate. The goal is to focus on the missing deposits: who, what, when, where, and how.
Documents subpoenaed from Internal Revenue Service:
These items will be provided by the course instructor.
Assignment:
Continuing to focus on evidence associated with the act, concealment, and conversion, use the evidentiary material to continue the investigation. In addition, as the examiner also starts to think of terms of who, what (did the person(s) do), when (during what period?), where (physical place, location in books and records), and how (perpetrated, hidden, and did the perpetrator benefit).
Case background: See Chapter 1.
Question: Does Fairmont have any contactor personnel whose are being paid but are not on the payroll master file?
Student task: Students should (a) present a listing of any payroll disbursements last are not listed in the payroll master file and (b) discuss the finding and recommend investigative next steps.
Student Material for step-by-step screenshots for completing the assignment are available from your instructor.
Case tableau background: See Chapter 1.
As noted in assignment 6, the forensic audit revealed that against strict company policy, several payroll disbursements were processed on Saturday.
Question: Can you create a graphic that highlights the employee who payroll was processed on Saturday and the dates of the process?
Student task: Students should (a) present a graphic that highlights the employee whose payroll was processed on Saturday and the dates of the process and (b) discuss the finding and recommend investigative next steps.
Student Material for step-by-step screenshots for completing the assignment are available from your instructor.
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