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7
Financial Statement Fraud

WorldCom and Time Magazine’s “Person of the Year”: Cynthia Cooper

In the 1990s, WorldCom became one of the dominant players in the telecommunications industry through acquisitions.¹ Between 1991 and 1997, WorldCom spent almost $60 billion in the acquisition of as many as 65 companies, accumulating more than $40 billion of debt in the process.² Acquisitions of MFS Communications and MCI were particularly important. Through MFS Communications, WorldCom obtained UUNet, a major supplier of Internet services to business. With MCI Communications, WorldCom was able to tap the residential phone market. By 1997, WorldCom’s stock had risen to more than $60 a share. As a result, the company and its CEO, Bernie Ebbers, became the darlings of Wall Street.³ Ebbers was a self-made man; a one-time high school coach, club bouncer, and milkman, his entrepreneurial spirit and propensity to take risks propelled WorldCom to its height of success.

Then in 2000, for antitrust reasons, the U.S. government refused to allow WorldCom to acquire Sprint, another successful giant in the telecom industry. Acquisitions had been the fuel and mainstay of WorldCom’s revenue and profits growth. Unable to achieve growth through acquisitions, WorldCom foresaw the possibility of disappointing Wall Street. Rather than reorganize, develop a new strategy, or “come clean,” Ebbers, Scott Sullivan (WorldCom’s CFO), and others perpetrated a fraud estimated to be worth more than $11 billion.

Three internal auditors: Cynthia Cooper and two of her direct reports, Gene Morse and Glyn Smith, completed a clandestine examination during nonoffice hours to discover the defalcation. Based on initial red flags including an email complaint regarding bad debt reserves, Cooper decided that the internal audit group would examine WorldCom’s financial reporting.⁴

The team found public disclosure of $2 billion in capital expenditures but could not locate approval in the Board of Directors’ meeting minutes. Additional work suggested that the $2 billion might be operating costs capitalized as fixed assets. Sanjeev Sethi, a director of financial planning, described the transactions as “prepaid capacity,” a term not defined in accounting principles. In reality, the “prepaid capacity” represented line lease costs required to “rent” telephone network capacity needed for WorldCom’s daily operations. The lease costs had no future value and should have been expensed as incurred. The effect of the capitalized lease costs increased net income by reducing expenses and improved the appearance of WorldCom’s financial condition.⁵ Similarly, $500 million in computer expenses had also been capitalized as fixed assets.⁶

Capitalizing expenditures with no future value as assets is a violation of generally accepted accounting principles. Yet, according to the SEC complaint, it occurred for at least five quarters. By the first week of June, Morse, using his information technology skills, had identified a total of $2 billion in questionable accounting entries. Concerned that the company might attempt to destroy his electronic evidence, Morse used his own money to purchase the technology on which to save the incriminating files.⁷

In mid-June, Cynthia Cooper and Glyn Smith began internal interviews to deepen their understanding of the seemingly improper accounting transactions. The pair started with Betty Vinson, director of management reporting. Vinson admitted to making the entries, but confessed that she did not have any support for them. Next they approached Buddy Yates, Director of Accounting, who pled ignorance and sent them to David Meyers.⁸ WorldCom’s Controller Meyers, feeling the pressure of the scheme, admitted that the accounting treatment did not comply with generally accepted accounting principles. Myers indicated that the entries should not have been made, but that once it had started, it was virtually impossible to stop.⁹

On June 20, Cynthia Cooper and Glyn Smith flew to Washington, D.C. to brief WorldCom’s audit committee. At the meeting, Farrell Malone, engagement partner for WorldCom’s newly appointed auditor KPMG, described how WorldCom appeared to have capitalized line costs as fixed assets and told the audit committee that he didn’t believe that the accounting treatment complied with generally accepted accounting principles.¹⁰

The audit committee allowed Scott Sullivan, CFO, the weekend to defend his company’s accounting choices. Sullivan constructed a white paper that argued that the accounting treatment was proper, matching the line lease excess capacity costs to future revenues.¹¹ In reality, while generally accepted accounting principles does have a matching principle, Sullivan’s arguments did not comply with that principle nor did his arguments comply with the basic definition of an asset: a resource controlled by the company with future value.

On June 24, the audit committee told Mr. Sullivan and Mr. Myers that they would be terminated if they didn’t resign. Scott Sullivan refused and was fired. David Myers complied. The next evening, WorldCom announced that it had inflated profits by $3.8 billion over the previous five quarters. On June 26, the SEC filed a civil fraud suit against the company, and trading of WorldCom’s stock was halted. Ultimately, the company was delisted by the Nasdaq Stock Market¹² and in July 2002, WorldCom filed for bankruptcy protection. For the period from 1999 through the first quarter of 2002, WorldCom admitted to a $9 billion financial reporting fraud.

In March 2002, Cynthia Cooper, WorldCom’s vice president of internal audit, began investigating red flags in WorldCom’s accounting. By the end of June 2002, Cooper and her internal audit team had “blown the whistle” on one of the largest corporate frauds in U.S. history—$11 billion.¹³

Cooper says she first suspected something might be wrong at WorldCom when her gut feelings changed from curiosity, to discomfort, to suspicion, based on some accounting entries she and her team had identified. She also noted odd reactions from some of WorldCom’s finance executives. For example, Scott Sullivan, WorldCom’s CFO, requested that she delay an audit of capital expenditures. Later, Cooper received an e-mail from the Controller, David Meyers, suggesting that she was wasting her time auditing fixed asset transactions.¹⁴

Cooper experienced just how difficult it was to convince others that the leadership of a Fortune 500 company may be perpetrating fraud. When Cooper shared evidence of WorldCom’s multi-billion dollar fraud with the company’s external auditor, the audit partner initially was unconvinced. Similarly, the audit committee offered CFO Sullivan the opportunity to support WorldCom’s accounting treatment even though the evidence suggested that his likelihood of success was low.¹⁵

In a January 2004 speech, Cooper noted that her suspicions grew and she felt fearful that she was in danger of physical harm. As a result, her team began working at night and behind closed doors because they didn’t want to be detected.¹⁶ Internal audit IT specialist Gene Morse was running so many data queries of the accounting system that it was starting to crash. When Controller Meyers was finally confronted, he confessed.¹⁷ According to Cooper, he felt better than he had in years.¹⁸

Cooper says that exposing WorldCom’s fraud was “the most difficult thing I’ve ever been through in my life.” “Sometimes,” she adds, “doing the right thing has a cost, and that cost can be severe.” After leaving WorldCom, Cooper formed Cynthia Cooper Consulting and started speaking to corporations, associations, and universities about ethics and leadership.¹⁹

The leaders and some lower-level personnel received fines and penalties:

Bernie Ebbers, 63 years old at the time, was sentenced to twenty-five years in prison and forfeited the bulk of his estate including a $45 million mansion.
Scott Sullivan, CFO, was sentenced to five years in prison.
Controller David Meyers and Director of Accounting Buddy Yates each received one-year prison term.
Betty Vinson, accounting department manager, was sentenced to five months in prison and five months of home detention.

Cynthia Cooper was named one of Time Magazine’s 2002 Persons of the Year.

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:

Module 1 briefly introduces the topic of financial reporting fraud. The objective of this module is for the reader to be able to describe three basic attributes of financial statement fraud: Who, Why, and How.
Module 2 reviews the conceptual framework of accounting including the concepts and principles that guide preparers of financial statements. The goal in this module is for readers to identify and be able to apply the accounting framework with regard to accounting facts, circumstances, choices and judgments, and apply the skills to case scenarios.
Module 3 takes a closer examination of the five major methods for perpetrating financial reporting fraud: revenue manipulation, timing differences, concealed (unrecorded/unreported) liabilities and expenses, inappropriate asset valuations, and inadequate or improper disclosures. The objective is for readers to be able to apply their knowledge of schemes in the context of red flags of financial reporting fraud.
Module 4 looks at the primary methods and techniques used in practice to detect financial reporting irregularities. Operational variation in the normal course of business drives variation in financial reporting and causes many red flags. The goal here is for readers to be able to apply their detection skills in case scenarios in an effort to discern anomalies with reasonable explanations from those associated with fraud.
Module 5 addresses the human factor, particularly as it relates to the deterrence of fraudulent financial reporting. The take-away from module 5 will be the reader’s ability to adjust his or her application of antifraud methodology to conditions ripe for misreported financial performance and condition. This approach provides a deeper understanding of fraud perpetrators and offers a potentially more effective antifraud approach.

Module 1: Financial Reporting Fraud: Who, Why, and How

Financial Statement Fraud

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:

Who commits financial statement fraud?
Why do people commit financial statement fraud?
How do people commit financial statement fraud?

Who Commits Financial Statement Fraud?

There are three main groups of people who commit financial statement fraud. In descending order of likelihood of involvement, they are as follows:

Senior management. According to a 2010 study of approximately 347 financial statement frauds from 1998 to 2007 conducted by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), senior management is the group most likely to commit financial statement fraud. The CEO was involved in 72% of these frauds, and the CFO was involved in 65%. Either the CEO or the CFO was involved in 89% of the cases. Motives for senior managers to commit financial statement fraud are varied and are described below.
Mid- and lower-level employees. This category of employees may falsify financial statements for their respective area of responsibility (subsidiary, division, or other unit) to either conceal their poor performance or to earn bigger bonuses based on higher performance numbers.
Organized criminals. This group may use such a scheme to obtain fraudulent loans from a financial institution, or to hype a stock they are selling as part of a Ponzi or “pump-and-dump” scheme.

Why Do People Commit Financial Statement Fraud?

Senior managers (CEOs, CFOs, etc.) and business owners may “cook the books” for any of several reasons:

To conceal true business performance. The objective may be to overstate or understate results
To preserve personal status/control. Senior managers with strong egos may be unwilling to admit that their strategy has failed and that business performance is bad, since it may lead to their termination
To maintain personal income/wealth flowing from salary, bonus, stock, and stock options

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:

To meet or exceed the earnings or revenue growth expectations of stock market analysts
To comply with loan covenants
To increase the amount of financing available from asset-based loans
To meet a lender’s criteria for granting/extending loan facilities
To meet corporate performance criteria set by the parent company
To meet personal performance criteria
To trigger performance-related compensation or earn-out payments
To support the stock price in anticipation of a merger, acquisition, or sale of personal stockholding
To show a pattern of growth to support a planned securities offering or sale of the business

Alternatively, senior management may understate business performance to meet certain other objectives:

To defer “surplus” earnings to the next accounting period. If current period budgets have been met and there is no reward for additional performance, corporate managers may prefer to direct additional earnings into the next period to help meet their new targets
To take all possible write-offs in one “big bath” now so future earnings will be consistently higher
To reduce expectations now so future growth will be better perceived and rewarded
To preserve a trend of consistent growth and avoid volatile results
To reduce the value of an owner-managed business for purposes of a divorce settlement
To reduce the value of a corporate unit whose management is planning a buyout

How Do People Commit Financial Statement Fraud?

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:

Playing the accounting system. In this approach, the fraudster uses the accounting system as a tool to generate the desired results. For example, to increase or decrease earnings to a selected figure, a fraudster might manipulate the assumptions used to calculate depreciation charges, allowances for bad debts, or allowances for excess and obsolete inventory. If the goal is to avoid recognizing expenses and liabilities, vendor invoices might not be recorded on a timely basis, or genuine sales might be recorded prematurely. Transactions recorded in the accounting system have a basis in fact, even if they are improperly recorded. There is a documentary trail to support the results reported in the financial statements, though the assumptions shown in some of those documents may be questionable.
Beating the accounting system. In this approach, the fraudster feeds false and fictitious information into the accounting system to manipulate reported results by an amount greater than can be achieved by simply “playing the accounting system.” Fictitious sales may be recorded to the accounts of legitimate or phony customers. Inventory and receivables figures may be fabricated, with documents later forged to support the claimed numbers. Senior financial management might determine allowances for bad debts and for excess and obsolete inventory without regard to the formulae or methods historically used in the entity to determine these amounts. Journal entries might be disguised in an attempt to conceal their fraudulent intent (e.g., splitting big round-sum adjustments into many smaller entries of odd amounts), or transactions may be hidden through the use of intercompany accounts to conceal the other side of a transaction. Some transactions recorded in the accounting system may have no basis in fact, and some that do may be improperly recorded. There will be no documentary trail to support certain transactions or balances unless the fraudster prepares forged or altered documents to help support the fraud.
Going outside the accounting system. In this approach, the fraudster produces whatever financial statements he or she wishes, perhaps using just a personal computer and a printer. These financial statements could be based on the results of an accounting and financial reporting process for an operating entity, with additional manual adjustments to achieve the results desired by the fraudster. Alternatively, they could just be printed using phony numbers supplied by the perpetrator. In some cases, fraudsters may go back and enter false data in the accounting system to support the phony financial statements. In other cases, they may not bother or there might be no accounting system. Not all transactions may be recorded in an accounting system, and some or all transactions may have no basis in fact. To catch this type of fraud, it is usually necessary to start by tracing the published financial statements back to the output of the accounting system. As in the previous situation, there will be no documentary trail to support certain transactions or balances reported in the financial statements unless the fraudsters prepare forged or altered documents to help support this fraud.

Public versus Private Company Financial Reporting Fraud

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:

A stronger antifraud environment in public companies appears to lead public company FRF perpetrators to use timing differences perhaps to make the fraud less obvious, rather than other fraud schemes, such as fictitious revenues.
Public company fraud, on average, involves larger fraud teams to circumvent the stronger controls typically found in the public company environment.
Somewhat surprising, public company frauds are larger than those in private companies, perhaps reflecting a risk/reward consideration where the fraud needs to be large enough to offset the risks involved with circumventing strong public company controls.
The larger size of public company FRF cases may make them more likely to be detected by formal means, rather than by accident.

Module 2: Accounting Principles and Fraud

Conceptual Framework for Financial Reporting

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:

Recognition and Measurement Concepts
1. Assumptions
  1. Economic entity
  2. Going concern
  3. Monetary unit
  4. Periodicity
2. Principles
  1. Historical cost
  2. Revenue recognition
  3. Matching
  4. Full disclosure
3. Constraints
  1. Cost–benefit
  2. Materiality
  3. Industry practice
  4. Conservatism
Qualitative Characteristics
1. Relevance and Reliability
2. Comparability and Consistency

Economic Entity

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.

Going Concern

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.

Monetary Unit

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.

Periodicity

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.

Historical Cost

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.

Revenue Recognition

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.

Matching

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.

Transparent Disclosure

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.

Cost−Benefit

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.

Materiality

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.

Industry Practice

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.

Conservatism

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.

Relevance and Reliability

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.

Comparability and Consistency

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.

Responsibility for Financial Statements

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.”

Users of Financial Statements

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.

Types of Financial Statements

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:

Balance sheet
Statement of income or statement of operations
Statement of retained earnings
Statement of cash flows
Statement of changes in owners’ equity
Statement of assets and liabilities that does not include owners’ equity accounts
Statement of revenue and expenses
Summary of operations
Statement of operations by product line
Statement of cash receipts and disbursements

Although not specifically noted in SAS 62, financial statements also typically include other financial data presentations, such as

Prospective financial information
Pro forma financial statements
Proxy statements
Interim financial information
Current-value financial representations
Personal financial statements
Bankruptcy financial statements
Registration statement disclosures

Other comprehensive bases of accounting, according to SAS 62, include

Government or regulatory agency accounting
Tax basis accounting
Cash receipts and disbursements, or modified cash receipts and disbursements
Any other basis with a definite set of criteria applied to all material items, such as the price-level basis of accounting

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.

Types of Fraudulent Financial Statement Schemes

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.

Case Study: That Way Lies Madness

“I’m Crazy Eddie!” a goggle-eyed man screams from the television set, pulling at his face with his hands. “My prices are insane!” Eddie Antar got into the electronics business in 1969, with a modest store called Sight and Sound. Less than twenty years later, he had become Crazy Eddie, a millionaire many times over and an international fugitive from justice. He was shrewd, daring, and self-serving; he was obsessive and greedy. But he was hardly insane. A U.S. Attorney said, “He was not Crazy Eddie. He was Crooked Eddie.”

The man on the screen wasn’t Eddie at all. The face so dutifully watched throughout New Jersey, New York, and Connecticut—that was an actor, hired to do a humiliating but effective characterization. The real Eddie Antar was not the kind of man to yell and rend his clothes. He was busy making money, and he was making a lot of it illegally. By the time his electronics empire folded, Antar and members of his family had distinguished themselves with a fraud of massive proportions, reaping more than $120 million. A senior official at the Securities and Exchange Commission (SEC) quipped, “This may not be the biggest stock fraud of all time, but for outrageousness it is going to be very hard to beat.” The SEC was joined by the FBI, the Postal Inspection Service, and the U.S. Attorney in tracking Eddie down. They were able to show a multipronged fraud in which Antar

Listed smuggled money from foreign banks as sales
Made false entries to accounts payable
Overstated Crazy Eddie, Inc.’s inventory by breaking into and altering audit records
Took credit for merchandise as “returned” while also counting it as inventory
“Shared inventory” from one store to boost other stores’ audit counts
Arranged for vendors to ship merchandise and defer the billing, while also claiming discounts and advertising credits
Sold large lots of merchandise to wholesalers, and then spread the money to individual stores as retail receipts

It was a long list and a profitable one for Eddie Antar and the inner circle of his family. The seven action items were designed to make Crazy Eddie’s look like it was booming. In fact, it was. It was the single biggest retailer of stereos and televisions in the New York metropolitan area, with a dominant and seemingly impregnable share of the market. That wasn’t enough for Eddie. He took the chain public, and then he made some real money. Shares that initially sold at $8 each would later peak at $80, thanks to the Antar team’s masterful tweaking of company accounts.

Inflating Crazy Eddie’s stock price wasn’t the first scam that Antar had pulled. In the early days, as Sight and Sound grew into Crazy Eddie’s and spawned multiple stores, Eddie was actually underreporting his earnings. Eddie’s cousin, Sam Antar, remembered learning how the company did business by watching his father during the early days. “The store managers would drop off cash to the house after they closed at ten o’clock, and my father would make one bundle for deposit into the company account, and several bundles for others in the family,” Sam Antar said. “Then he would drive over to their houses and drop off their bundles at two in the morning.” For every few dollars to the company, the Antars took a dollar for themselves. The cash was secreted away into bank accounts at Bank Leumi of Israel. Eddie smuggled some of the money out of the country himself, by strapping stacks of large bills across his body. The Antars sneaked away with at least $7 million over several years. Skimming the cash meant tax-free profits and one gargantuan nest egg waiting across the sea.

But entering the stock market was another story. Eddie anticipated the initial public offering (IPO) of shares by quietly easing money from Bank Leumi back into the operation. The company really was growing, but injecting the pilfered funds as sales receipts made the growth look even more impressive. Now this looks sweet: skim the money and beat the tax man, then draw out funds as you need them to boost sales figures—keeps the ship running smoothly.

But Paul Hayes, a special agent who worked the case with the FBI, pointed out Crazy Eddie’s problem. “After building up the books, they set a pattern of double-digit growth, which they had to sustain. When they couldn’t sustain it, they started looking for new ways to fake it,” Hayes said.

Eddie, his brothers, his cousins, and several family loyalists all owned large chunks of company stock. No matter what actually happened at the stores, they wanted that stock to rise. So the seven-point plan was born. There was the skimmed money waiting overseas, being brought back and disguised as sales. But there were limits to how much cash the family had available and could get back into the country, so they turned to other methods of inflating the company’s financials. In a daring part of the expanded scam, Antar’s people broke into auditors’ records and boosted the inventory numbers. With the stroke of a pen, 13 microcassette players became 1,327.

Better than that, the Antars figured out how to make their inventory do double work. Debit memos were drawn up showing substantial lots of stereos or VCRs as “returned to manufacturer.” Crazy Eddie’s was given a credit for the wholesale cost due back from the manufacturer. But the machines were kept at the warehouse to be counted as inventory. In another variation of the inventory scam, at least one wholesaler agreed to ship Crazy Eddie’s truckloads of merchandise, deferring the billing to a later date. That way Crazy Eddie’s had plenty of inventory volume plus the return credits listed on the account book. And what if auditors got too close and began asking questions? Executives would throw the records away. A “lost” report was a safe report.

Eddie Antar didn’t stop at simple bookkeeping and warehouse games; he “shared inventory” among his nearly forty stores. After auditors had finished counting a warehouse’s holdings and had gone for the day, workers tossed the merchandise into trucks. The inventory was hauled overnight to an early morning load-in at another store. When the auditors arrived at that store, they found a full stockroom waiting to be counted. Again, this ruse carried a double payoff. The audit looked strong because of the inventory items counted multiple times. And the bookkeeping looked good because only one set of invoices was entered as payable to Eddie’s creditors. Also, the game could be repeated for as long as the audit route demanded.

Eddie’s trump card was the supplier network. He had considerable leverage with area wholesalers because Crazy Eddie’s was the biggest and baddest retail outlet in the region. Agent Paul Hayes remembers Eddie as “an aggressive businessman: He’d put the squeeze on a manufacturer and tell them he wasn’t going to carry their product. Now, he was king of what is possibly the biggest consolidated retail market in the nation. Japanese manufacturers were fighting each other to get into this market. So when Eddie made a threat, it was a threat with serious potential impact.”

Suppliers gave Crazy Eddie’s buyers extraordinary discounts and advertising rebates. If they didn’t, the Antars had another method: they made up the discount. For example, Crazy Eddie’s might owe George-Electronics $1 million; by claiming $500,000 in discounts or ad credits, the bill was cut in half. Sometimes there was a real discount, sometimes there wasn’t. (It wasn’t easy, after Eddie’s fall, to tell what a shrewd business deal was and what was fraud. “They had legitimate discounts in there,” says Hayes, “along with the criminal acts. That’s why it was tough to know what was smoke and what was fire.”)

Eddie had yet another arrangement with manufacturers. For certain high-demand items, high-end stereo systems, for example, a producing company would agree to sell only to Crazy Eddie’s. Eddie placed an order big enough for what he needed, and then added a little more. The excess he sold to a distributor who had already agreed to send the merchandise outside Crazy Eddie’s tri-state area. And then the really good part: By arrangement, the distributor paid for the merchandise in a series of small checks—$100,000 worth of portable stereos would be paid off with ten checks of $10,000 each. Eddie sprinkled this money into his stores as register sales. He knew that Wall Street analysts used comparable store sales as a bedrock indicator. New stores are compared with old stores, and any store open more than a year is compared with its performance during the previous term. The goal is to outperform the previous year. So the $10,000 injections made Eddie’s “comps” look fantastic.

As the doctored numbers circulated in enthusiastic financial circles, CRZY stock doubled its earnings per share during its first year on the stock exchange. The stock split two-for-one in both of its first two fiscal terms as a publicly traded company. As chairman and chief executive, Eddie Antar used his newsletter to trumpet soaring profits, declining overhead costs, and a new 210,000-square-foot corporate headquarters. Plans were underway for a home-shopping arm of the business. Besides the electronics stores, there was now a subsidiary, Crazy Eddie Record and Tape Asylums, in the Antar fold. At its peak, the operation included 43 stores and reported sales of $350 million a year. This was a long way from the Sight and Sound storefront operation where it all began.

It was almost eerie how deliberately the Antar conspirators manipulated investors, and how directly their crimes impacted brokers’ assessments. At the end of Crazy Eddie’s second public year, a major brokerage firm issued a gushing recommendation to “buy.” The recommendation was explicitly “based on 35 percent EPS [earnings per share] growth” and “comparable store sales growth in the low double-digit range.” These double-digit expansions were from the “comps” that Eddie and his gang had cooked up with wholesalers’ money and by juggling inventories. CRZY stock, the report predicted, would double and then some during the next year. As if following an Antar script, the brokers declared, “Crazy Eddie is the only retailer in our universe that has not reported a disappointing quarter in the last two years. We do not believe that is an accident… . We believe Crazy Eddie is becoming the kind of company that can continually produce above-average comparable store sales growth.” But what the analysts failed to do was ask a very basic but very pertinent question: what magic did Crazy Eddie’s possess that was not available to its competitors?

The brokers could not have known what Herculean efforts were needed to yield just that impression. The report praised Eddie’s management skills. “Mr. Antar has created a strong organization beneath him that is close-knit and directed… . Despite the boisterous (less charitable commentators would say obnoxious) quality of the commercials, Crazy Eddie management is quite conservative.”

Well, yes, in a manner of speaking. They were certainly holding tightly to the money as it flowed through the market. According to federal indictments, the conspiracy inflated the company’s value during the first year by about $2 million. By selling off shares of the overvalued stock, the partners pocketed over $28.2 million. The next year they illegally boosted income by $5.5 million and retail sales by $2.2 million. This time the group cashed in their stock for a cool $42.2 million windfall. In the last year before the boom went bust, Eddie and his partners inflated income by $37.5 million and retail by $18 million. They didn’t have that much stock left, though, so despite the big blowup they cashed in for only about $8.3 million.

Maybe he knew the end was at hand, but with takeovers looming, Eddie kept fighting. He had started his business with one store in Brooklyn almost twenty years before, near the neighborhood where he grew up, populated mainly by Jewish immigrants from Syria. Despite these humble beginnings, he would one day be called “the Darth Vader of capitalism” by a prosecuting attorney, referring not just to his professional inveigling but to his personal life as well. Eddie’s affair with another woman broke up his marriage and precipitated a life-long break with his father. Eventually he divorced his wife and married his lover. Rumors hinted that Eddie had been unhappy because he had five daughters and no sons from his first marriage. Neighbors said the rest of the family sided with the ex-wife. Eddie and his brothers continued in business together, but they had no contact outside the company. Allen Antar, a few years younger, should have been able to sympathize—he had also been estranged from the family when he filed for a divorce and married a woman who wasn’t Jewish. (Allen eventually divorced that woman and remarried his first wife.) Later at trial, the brothers Antar were notably cold to one another. Even Eddie’s own lawyer called him a “huckster.”

But this Darth Vader had a compassionate side. Eddie was known as a quiet and modest man. He was seldom photographed and almost never granted interviews. He was said to have waited hours at the bedside of a dying cousin, Mort Gindi, whose brother, also named Eddie, was named as a defendant in the Antars’ federal trial. His cousin Sam remembers him as “a leader, someone I looked up to since I was a kid. Eddie was strong; he worked out with weights. When the Italian kids wanted to come into our neighborhood and beat up on the Jewish kids, Eddie would stop them. That was when we were kids. Later, it turned out different.”

Eddie had come a long way. He had realized millions of dollars by selling off company stock at inflated prices. This money was stashed in secret accounts around the world, held under various assumed identities. In fact, Eddie had done so well that he was left vulnerable as leader of the retail empire. When Elias Zinn, a Houston businessman, joined with the Oppenheimer-Palmieri Fund and waged a proxy battle for Crazy Eddie’s, the Antars had too little shareholders power to stave off the bid. They lost. For the first time, Crazy Eddie’s was out of Eddie’s hands.

The new owners didn’t have long to celebrate. They discovered that their ship was sinking fast. Stores were alarmingly understocked; shareholders were suing; and suppliers were shutting down credit lines because they were either paid late or never paid. An initial review showed the company’s inventory had been overstated by $65 million—a number later raised to over $80 million. In a desperate maneuver, the new management set up a computerized inventory system and established lines of credit. They made peace with the vendors and cut 150 jobs to reduce overhead. But it was too late. Less than a year after the takeover, Crazy Eddie’s was dead.

Eddie Antar, on the other hand, was very much alive. But nobody knew where. He had disappeared when it became apparent that the takeover was forcing him out. He had set up dummy companies in Liberia, Gibraltar, and Panama, along with well-supplied bank accounts in Israel and Switzerland. Sensing his days as Crazy Eddie were numbered, he fled the United States, traveling the world with faked passports and calling himself, at different times, Harry Page Shalom and David Cohen. Shalom was a real person, a longtime friend of Eddie’s, another in a string of chagrined and erstwhile companions.

It was as David Cohen that Eddie ended his flight from justice and reality. After twenty-eight months on the run, he stalked into a police station in Bern, Switzerland, but not to turn himself in. “David Cohen” was demanding help from the police. He was mad because bank officials refused to let him at the $32 million he had on account there. The bank wouldn’t tell Cohen anything, just that he couldn’t access those funds. But officials discreetly informed police that the money had been frozen by the U.S. Department of Justice. Affidavits in the investigation had targeted the account as an Antar line. It didn’t take long to realize that David Cohen, the irate millionaire in the Bern police station, was Eddie Antar. It was the last public part Crazy Eddie would play for a while. He eventually pled guilty to racketeering and conspiracy charges and was sentenced to eighty-two months in prison with credit for time served. This left him with about three and a half years of jail time. He was also ordered to repay $121 million to bilked investors. Almost $72 million was recovered from Eddie’s personal accounts. “I don’t ask for mercy,” Eddie told the judge at his trial. “I ask for balance.”

Eddie’s brother, Mitchell, was first convicted and given four and a half years, with $3 million in restitution burdens, but his conviction was overturned because of a prejudicial remark by the judge in the first trial. Mitchell later pled guilty to two counts of securities fraud, and the rest of the charges were dropped. Allen Antar was acquitted at the first trial, but he and his father, Sam, were both later found guilty of insider trading and ordered to pay $11.9 million and $57.5 million, respectively, in disgorgement and interest.

What happened to the Crazy Eddie’s stores? In 1998, Eddie’s nephews attempted to revive the legacy and held a grand opening for a new electronics store in New Jersey. At the beginning of the new millennium, the store’s doors closed and Crazy Eddie’s shifted focus to become a dot-com retailer. But by 2004, the company had once again faltered and closed, this time amid allegations of reselling unauthorized products online.

From the Fraudster’s Perspective

Adapted from the whitecollarfraud.com blog by Sam E. Antar,

Sunday, December 10, 2006.

Hiding Your Dirty Laundry in the Notes: Anatomy of the Crazy Eddie’s Accounts Payable Fraud

Financial statements are often accompanied by notes that are seldom read and often not thoroughly analyzed by investors. One of the many frauds committed by me at Crazy Eddie’s involved manipulating just two words in our notes.

Prior to 1987, Crazy Eddie’s accounting policy for purchase discounts and allowances was: Purchase discounts and trade allowances are recognized when received. This accounting policy meant that even if Crazy Eddie’s had “earned” a discount it could not be recognized as income until a credit was received from the vendor.

In fiscal year 1987, I changed Crazy Eddie’s accounting policy (as reflected in the notes) to: Purchase discounts and trade allowances are recognized when earned. Now, in theory, Crazy Eddie could recognize a discount as income when it is earned (e.g., when we reached the manufacturer’s benchmark of buying 10,000 units to qualify for a volume rebate) and not have to wait for a credit from the vendor. I could simply write a debit memo (an offset to what I owed the vendor) to recognize the discount and increase our reported profits.

A change of accounting policy would normally give rise to a separate disclosure about its effect on earnings. However, in the Crazy Eddie’s fraud, we made no such disclosure, and the auditors made no relevant computations despite the change in accounting principle. The auditors simply ignored the effects of the change in accounting for discounts.

By now being able to recognize discounts “when earned” instead of having to wait for credits to be received from vendors, I had the opportunity to add $20 million on phony debit memos (phony discounts and trade allowances) charged to vendors.

Crazy Eddie’s accounts payable was reduced from about $70 million to $50 million through the use of phony debit memos, and this was facilitated by our change in accounting policies for purchase discounts and trade allowances from changing just two words in our notes.

How Did We Do It and How Could the Auditors Allow This to Happen?

The staff auditor primarily responsible for the accounts payable part of the audit had no retail accounts payable audit experience and only six months experience in auditing. He did not know what a debit memo was until he came to Crazy Eddie’s audit.

We engaged in a scheme of obstruction by distraction. Most staff accountants feel that audits are boring, and they really are. As soon as the young, relatively inexperienced staff members walked into our premises, my staff was instructed to be overly friendly so that they could be distracted from their work. We would constantly take the auditors out for long coffee breaks and lunches and engage in friendly conversations about mutual topics of interest unrelated to the audit in an effort to distract them from their work.

About two weeks before the audit was due to be completed and the accountants should have completed about 85% of their work, they would have only about 25% of their work done. During the remaining two weeks, they would scramble to finish the audit on time.

When people “cram” or rush, they make mistakes and tend to skimp on their work. In addition, the auditors could not blame the overly friendly Crazy Eddie’s staff for obstructing them. Therefore, in a mad scramble to “cover their asses” they covered ours. In the process, they left out some very important audit procedures.

In fiscal year 1987, the staff auditor assigned to analyze accounts payable did not begin his work until the very day his firm had signed off on Crazy Eddie’s “clean” audit opinion. The actual audit of the accounts payable was concluded weeks after the auditors signed off on our financial statements and gave our Board of Directors their approval for its release.

Lessons to Be Learned from the Crazy Eddie’s Accounts Payable Fraud

Even sophisticated investors do not read notes. Had the auditors read the notes carefully, perhaps the proper critical questions would have been asked. All too often audits are used as training grounds for relatively inexperienced staff accountants who are not adequately supervised.
The audit was poorly planned, executed, and supervised. The auditors abandoned their requisite professional skepticism and objectivity by permitting Crazy Eddie’s staff to distract them from their work by “bonding” with them. They did not follow basic audit procedures and permitted deadlines to guide the quality of their work.
Crazy Eddie’s had weak internal controls over the issuance of debit memos. There was no documentation from external sources supporting any of the phony discounts. Sarbanes–Oxley would have required the auditors to evaluate our internal controls.
Finally, as Joseph T. Wells (retired founder and chairman of the Association of Certified Fraud Examiners) wrote in his award-winning article “So That’s Why They Call It a Pyramid Scheme,” published in the Journal of Accountancy in October 2000, “Were the auditors stupid? No, just too trusting. After all, no one wants to think the client is a crook. But it happens too often. That’s why the profession requires the auditor to be skeptical.”

Written by

Sam E. Antar (former Crazy Eddie’s CFO and convicted felon)

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.

Module 3: Fraudulent Financial Statement Schemes

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

Acquire other cable companies not owned by Adelphia
Pay debt service on investments
Purchase a controlling interest in the Buffalo Sabres hockey team
Pay $700,000 in country club memberships
Buy luxury vacation homes in Cancun, Beaver Creek (Colorado), and Hilton Head Island and two apartments in Manhattan
Purchase a $13 million golf course

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.

Defining Financial Statement Fraud

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:

Falsification, alteration, or manipulation of material financial records, supporting documents, or business transactions
Material, intentional omissions or misrepresentations of events, transactions, accounts, or other significant information from which financial statements are prepared
Deliberate misapplication of accounting principles, policies, and procedures used to measure, recognize, report, and disclose economic events and business transactions
Intentional omissions of disclosures or presentation of inadequate disclosures regarding accounting principles and policies and related financial amounts²²

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.

Costs of 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:

It undermines the reliability, quality, transparency, and integrity of the financial reporting process. An increasing number of required financial restatements and enforcement acts by the SEC against big corporations (e.g., Enron, WorldCom, Xerox, ImClone, Global Crossing, Qwest, Halliburton, Bristol-Myers, Tyco, Dynegy, Adelphia Communications, ComputerAssociates) for alleged financial statement fraud has severely undermined the public confidence in the veracity of financial reports.
It jeopardizes the integrity and objectivity of the auditing profession, especially auditors and auditing firms. Arthur Andersen, one of the former Big Five CPA firms, dismantled its international network and allowed officers to join rival firms after it became embroiled in a scandal involving its shredding of documents related to its audit work for Enron. Although the Supreme Court ultimately overruled Andersen’s conviction for obstruction of justice, it was too late; the accounting firm had irreparably crumbled in the wake of the document destruction scandal.
It diminishes the confidence of the capital markets, as well as market participants, in the reliability of financial information. The capital market and market participants, including investors, creditors, employees, and pensioners, are affected by the quality and transparency of the financial information they use in making investment decisions.
It makes the capital markets less efficient. Auditors reduce the information risk that is associated with the published financial statements and thus make them more transparent. Information risk is the likelihood that financial statements are inaccurate, false, misleading, biased, and deceptive. By applying the same financial standards to diverse businesses and by reducing the information risk, accountants contribute to the efficiency of our capital markets.
It adversely affects the nation’s economic growth and prosperity. Accountants are expected to make financial statements among corporations more comparable by applying the same set of accounting standards to diverse businesses. This enhanced comparability makes business more transparent, the capital markets more efficient, the free enterprise system more attainable, and the economy more vibrant and prosperous. The efficiency of capital markets depends on objective, reliable, and transparent financial information. Thus, the accounting profession, especially independent auditors, plays an important role in our free enterprise system and capital markets. However, the Enron, WorldCom, and Global Crossing debacles provide evidence that the role of accountants can be compromised.
It results in huge litigation costs. Corporations and their auditors are being sued for alleged financial statement fraud and related audit failures by a diverse group of litigants, including small investors bringing class action suits and the U.S. Justice Department. Investors are also given the right to sue and recover damages from those who aided and abetted securities fraud.
It destroys the careers of the individuals involved. For example, top executives of firms involved in financial statement fraud are barred from serving on the board of directors of any public company, and the auditors are barred from the practice of public accounting.
It leads to bankruptcy or substantial economic losses by the company. WorldCom, with $107 billion in assets and $41 billion in debt, filed for Chapter 11 bankruptcy protection on July 21, 2002. At the time, WorldCom was the largest U.S. bankruptcy ever, almost twice the size of Enron’s.
It encourages regulatory intervention. Regulatory agencies (e.g., the SEC and the PCAOB) have considerable influence over the financial reporting process and related audit functions. The loss of public confidence in the financial reporting process and audit functions ultimately emboldened lawmakers to introduce accounting reform legislation (e.g., Sarbanes–Oxley Act of 2002; the Dodd-Frank Act). The Sarbanes–Oxley Act drastically changed the accounting profession’s self-regulating environment to oversight by the SEC via the PCAOB.
It is devastating to the normal operations and performance of companies. Financial statement frauds at Enron, WorldCom, Global Crossing, and Adelphia caused these high-profile companies to file for bankruptcy; their top executives were fined and, in some cases, indicted and imprisoned for violation of securities laws.
It raises serious doubts about the efficacy of financial statement audits. The financial community is demanding higher-quality audits, and auditors need to effectively address this issue to ensure the desired public confidence.
It erodes public confidence and trust in the accounting and auditing profession. One message that comes through loud and clear in response to the number of financial restatements and alleged financial statement fraud is that the public’s confidence in the financial reporting process and related audit functions has eroded.

Fictitious Revenues

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:

Persuasive evidence of an arrangement exists
Delivery has occurred or services have been rendered
The seller’s price to the buyer is fixed or determinable
Collectability is reasonably assured

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

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.

Pressures to Boost Revenues

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.

Red Flags Associated with Fictitious Revenues

Any of the following circumstances should sound the alarm for the potential of fraud.

Rapid growth or unusual profitability, especially compared with other companies in the same industry
Recurring negative cash flows from operations or an inability to generate cash flows from operations despite reported earnings and earnings growth
Significant transactions with related parties or special-purpose entities not in the ordinary course of business or where those entities are not audited or are audited by another firm
Significant, unusual, or highly complex transactions, especially those close to period end, that pose difficult “substance over form” questions
Unusual growth in the number of days’ sales in receivables
A significant volume of sales to entities whose substance and ownership are not known
An unusual surge in sales by a minority of units within a company, or in sales recorded by corporate headquarters

Timing Differences

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.

Matching Revenues with Expenses

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

Revenue Recognition

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:

Persuasive evidence of an arrangement exists.
Delivery has occurred or services have been rendered.
The seller’s price to the buyer is fixed or determinable.
Collectibility is reasonably assured.

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.

Persuasive Evidence of an Arrangement Does Not Exist

No written or verbal agreement exists.
A verbal agreement exists, but a written agreement is customary.
A written order exists but is conditional upon sale to end users (such as a consignment sale).
A written order exists but contains a right of return.
A written order exists, but a side letter alters the terms in ways that eliminate the required elements for an agreement.
The transaction is with a related party, the fact of which has not been disclosed.

Delivery Has Not Occurred or Services Have Not Been Rendered

Shipment has not been made and the criteria for recognizing revenue on “bill-and-hold” transactions set out in SEC Staff Accounting Bulletin No. 104 have not been met.
Shipment has been made not to the customer but to the seller’s agent, to an installer, or to a public warehouse.
Some but not all of the components required for operation were shipped.
Items of the wrong specification were shipped.
Delivery is not complete until installation and customer testing and acceptance has occurred.
Services have not been provided at all.
Services are being performed over an extended period, and only a portion of the service revenues should have been recognized in the current period.
The mix of goods and services in a contract has been misstated in order to improperly accelerate revenue recognition.

The Seller’s Price to the Buyer Is Not Fixed or Determinable

The price is contingent on some future event(s).
A service or membership fee is subject to unpredictable cancellation during the contract period.
The transaction includes an option to exchange the product for others.
Payment terms are extended for a substantial period and additional discounts or upgrades may be required to induce continued use and payment as opposed to switching to alternative products.

Collectibility Is Not Reasonably Assured

Collection is contingent on some future event(s) (e.g., resale of the product, receipt of additional funding, or litigation).
The customer does not have the ability to pay (e.g., it is financially troubled, it has purchased far more than it can afford, or it is a shell company with minimal assets).

Long-Term Contracts

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.

Channel Stuffing

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.

The Capital Forum

Vol. 6 No. 105

March 23, 2018

Snap-on: Declining Deferred Subscription Revenue Raises Questions About End-Customer Demand for Diagnostic Products

Company Update

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.

A Closer Look at Subscription Pricing and Revenue Recognition

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.

Recording Expenses in the Wrong Period

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.

Red Flags Associated with Timing Differences

Auditors and company monitors should be alert for any of the following signs of fraud relating to timing differences:

Rapid growth or unusual profitability, especially compared with other companies in the same industry
Recurring negative cash flows from operations or an inability to generate cash flows from operations while reporting earnings and earnings growth
Significant, unusual, or highly complex transactions, especially those close to period end that pose difficult “substance over form” questions
Unusual increase in gross margin or margin in excess of industry peers
Unusual growth in the number of days’ sales in receivables
Unusual decline in the number of days’ purchases in accounts payable

Case Study: The Importance of Timing

What about a scheme in which nobody gets any money? One that was never intended to enrich its players or to defraud the company they worked for? It happened in Huntsville, Alabama, on-site at a major aluminum products plant with more than $300 million in yearly sales. A few shrewd men cooked the company’s books without taking a single dime for themselves. Several names may have been changed to preserve anonymity.

Terry Isbell was an internal auditor making a routine review of accounts payable. He was running a computer search to look at any transactions over $50,000 and found among the hits a bill for replacing two furnace liners. The payments went out toward the end of the year, to an approved vendor, with the proper signatures from Steven Leonyrd, a maintenance engineer, and Doggett Stine, the sector’s purchasing manager. However, there was nothing else in the file. Maintenance and repair jobs of this sort were supposed to be done on a time-and-material basis. So there should have been work reports, vouchers, and inspection sheets in the file along with the paid invoices. But there was nothing.

Isbell talked with Steven Leonyrd, who showed him the furnaces, recently lined and working to perfection. So where was the paperwork? “It’ll be in the regular work file for the first quarter,” Leonyrd replied. “The bill was for last year, November and December,” Isbell pointed out. That was because the work was paid for in “advance payments,” according to Leonyrd. There wasn’t room in the work schedule to have the machines serviced in November, so the work was billed to that year’s nonrecurring maintenance budget. Later, sometime after the beginning of the year, the work was actually done.

Division management gave approval to Isbell to make an examination. He found $150,000 in repair invoices without proper documentation. The records for materials and supplies, which were paid for in one year and received in the next, totaled $250,000. A check of later records and an inspection showed that everything paid for had in fact been received, just later than promised.

So it was time to revisit Leonyrd, who said the whole thing was simple. “We had this money in the budget for maintenance and repair, supplies outside the usual scope of things. It was getting late in the year, looked like we were just going to lose those dollars, you know, they’d just revert back to the general fund. So we set up the work orders and made them on last year’s budget. Then we got the actual stuff later.” Who told Leonyrd to set it up that way? “Nobody. Just made sense, that’s all.”

Nobody, Isbell suspected, was the purchasing manager who handled Leonyrd’s group, Doggett Stine. Stine was known among the people who worked for him as “a domineering-type guy,” a kind of storeroom bully. Isbell asked him about the arrangement with Leonyrd. “That’s no big deal,” Stine insisted. “Just spent the money while it was there. That’s what it was put there for, to keep up the plant. That’s what we did.” It wasn’t his idea, said Stine, but it wasn’t really Leonyrd’s either, just a discussion and an informal decision. The storeroom receiving supervisor agreed it was a grand idea, and made out the documents as he was told. Accounting personnel processed the invoices as they were told. A part-time bookkeeper said to Isbell she remembered some discussion about arranging to spend the money, but she didn’t ask any questions.

Isbell was in a funny position, a little bit like Shakespeare’s Malvolio, who spends his time in the play Twelfth Night scolding the other characters for having such a good time. Leonyrd hadn’t pocketed anything, and neither had Stine; and being a bully was hardly a fraudulent offense. There was about $6,000 in interest lost, supposing the money had stayed in company bank accounts, but that wasn’t exactly the point. More seriously, this effortless cash flow diversion represented a kink in the handling and dispersal of funds. Isbell’s concern wasn’t with rules for their own sake or standing on ceremony—money this easy to come by just meant the company had gotten a break. However, the next guys might not be so civic-minded and selfless; they might start juggling zeros and signatures instead of dates.

Under Isbell’s recommendation, the receiving department started reporting directly to the plant’s general accounting division, and its supervisor was assigned elsewhere. Doggett Stine, meanwhile, had retired. Steven Leonyrd was demoted and transferred to another sector; he was fired a year later in connection with an unrelated scheme. He had approached a contractor to replace the roof on his house, with the bill to be charged against “nonrecurring maintenance” at the plant. But the contractor alerted plant officials to their conniving employee, who was also known to be picking up extra money for “consulting work” with plant-related businesses. “Rats,” Leonyrd must have thought, “foiled again.”

Concealed Liabilities and Expenses

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:

Liability/expense omissions
Capitalized expenses
Failure to disclose warranty costs and liabilities

Liability/Expense Omissions

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.

Capitalized Expenses

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.

Expensing Capital Expenditures

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.

Returns and Allowances and Warranties

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).

Red Flags Associated with Concealed Liabilities and Expenses

Any of the following conditions should raise a red flag regarding the possibility of financial statement fraud:

Recurring negative cash flows from operations or an inability to generate cash flows from operations while reporting earnings and earnings growth
Assets, liabilities, revenues, or expenses based on significant estimates that involve subjective judgments or uncertainties that are difficult to corroborate
Nonfinancial management’s excessive participation in, or preoccupation with, the selection of accounting principles or the determination of significant estimates
Unusual increase in gross margin or margin in excess of industry peers
Allowances for sales returns, warranty claims, and so on that are shrinking in percentage terms or are otherwise out of line with industry peers’ results
Unusual reduction in the number of days’ purchases in accounts payable
Reducing accounts payable while competitors are stretching out payments to vendors

Improper Disclosures

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:

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

Liability Omissions

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.

Subsequent Events

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 Fraud

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

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.

Accounting Changes

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.

Red Flags Associated with Improper Disclosures

Any of the following should alert interested parties of potentially improper disclosures.

Domination of management by a single person or small group (in a nonowner-managed business) with no compensating controls
Ineffective board of directors or audit committee oversight of the financial reporting process and internal control
Ineffective communication, implementation, support, or enforcement of the entity’s values or ethical standards by management or the communication of inappropriate values or ethical standards
Rapid growth or unusual profitability, especially compared to other companies in the same industry
Significant, unusual, or highly complex transactions, especially those close to period end that pose difficult “substance over form” questions
Significant related-party transactions not in the ordinary course of business or with related entities not audited or audited by another firm
Significant bank accounts or subsidiary or branch operations in tax-haven jurisdictions for which there appears to be no clear business justification
Overly complex organizational structure involving unusual legal entities or managerial lines of authority
Known history of violations of securities laws or other laws and regulations, or claims against the entity, its senior management, or board members alleging fraud or violations of laws and regulations
Recurring attempts by management to justify marginal or inappropriate accounting on the basis of materiality
Formal or informal restrictions on the auditor that inappropriately limit access to people or information, or the ability to communicate effectively with the board of directors or the audit committee.

Improper Asset Valuation

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:

Inventory valuation
Accounts receivable
Business combinations
Long-term assets

Inventory Valuation

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

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

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.

Failure to Write Down

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.

Business Combinations

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

Long-term assets are subject to manipulation through several different schemes. Some of the more common schemes are

Booking fictitious assets
Misrepresenting asset valuation
Improperly capitalizing inventory and startup costs

Booking Fictitious Assets

One of the easiest methods of asset misrepresentation is the recording of fictitious assets. This false creation of assets affects account totals on a company’s balance sheet. The corresponding account commonly used is the owners’ equity account. Because company assets are often physically found in many different locations, this fraud can sometimes be easily overlooked. One of the most common fictitious asset schemes is 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.

Misrepresenting Asset Value

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.

Understating Assets

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.

Capitalizing Nonasset Cost

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.

Misclassifying Assets

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.

Red Flags Associated with Improper Asset Valuation

The following circumstances should raise suspicions regarding the propriety of asset valuation.

Recurring negative cash flows from operations or an inability to generate cash flows from operations while reporting earnings and earnings growth
Significant declines in customer demand and increasing business failures in either the industry or the overall economy
Assets, liabilities, revenues, or expenses based on significant estimates that involve subjective judgments or uncertainties that are difficult to corroborate
Nonfinancial management’s excessive participation in, or preoccupation with, the selection of accounting principles or the determination of significant estimates
Unusual increase in gross margin or margin in excess of industry peers
Unusual growth in the number of days’ sales in receivables
Unusual growth in the number of days’ purchases in inventory
Allowances for bad debts, excess and obsolete inventory, and similar measures that are shrinking in percentage terms or are otherwise out of line with those of their industry peers
Unusual change in the relationship between long-term assets and depreciation
Adding to assets while competitors are reducing capital tied up in assets

Module 4: Detection of Fraudulent Financial Statement Schemes

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

a $16.8 million apartment in New York City for Kozlowski
$13 million in original art
a $7 million apartment for Kozlowski’s ex-wife
an umbrella stand that cost $15,000
a $17,000 traveling toilette box
$5,960 for two sets of sheets
a $6,300 sewing basket
a $6,000 shower curtain
half sponsorship of a $2.1 million birthday party for his wife
up to $80,000 a month in personal credit card charges.

Although Kozlowski’s embezzlements were not material to the financial statements as a whole, they were, nonetheless, substantial and vividly portray corporate greed.

Financial Statement Analysis

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

Vertical analysis
Horizontal analysis
Ratio analysis
Analysis of cash flows
Analysis of nonfinancial numbers

Percentage Analysis—Vertical and Horizontal

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 Discussion

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 Analysis Discussion

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

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:

Current ratio
Quick ratio
Receivables turnover
Collection ratio
Inventory turnover
Average number of days inventory is in stock
Debt to equity
Assets to equity
Gross margin
Profit margin
Return on assets
Return on equity
Asset turnover

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 ratio	Current liabilities	95,000	=	2.84	215,000	=	1.7
Quick ratio	Cash + Securities + Receivables	195,000	=	2.05	215,000	=	1
Quick ratio	Current liabilities	95,000	=	2.05	215,000	=	1
Receivables turnover	Net sales on account	250,000	=	1.61	450,000	=	2.14
Receivables turnover	Average net receivables	155,000	=	1.61	210,000	=	2.14
Collection ratio	365	365	=	226.30	365	=	170.56
Collection ratio	Receivables turnover	1.61	=	226.30	2.14	=	170.56
Inventory turnover	Cost of goods sold	125,000	=	1.92	300,000	=	2.31
Inventory turnover	Average inventory	65,000	=	1.92	130,000	=	2.31
Average number of days inventory is in stock	365	365	=	190.10	365	=	158.01
Average number of days inventory is in stock	Inventory turnover	1.92	=	190.10	2.31	=	158.01
Debt to equity	Total liabilities	155,000	=	0.89	275,000	=	1.83
Debt to equity	Total equity	175,000	=	0.89	150,000	=	1.83
Assets to equity	Assets	330,000	=	1.89	425,000	=	2.83
Assets to equity	Total equity	175,000	=	1.89	150,000	=	2.83
Gross margin	Gross Profit	125,000	=	0.50	150,000	=	0.33
Gross margin	Net sales	250,000	=	0.50	450,000	=	0.33
Profit margin	Net income	15,000	=	0.06	-25,000	=	-0.06
Profit margin	Net sales	250,000	=	0.06	450,000	=	-0.06
Return on Assets	Net income	15,000	=	0.05	-25,000	=	-0.06
Return on Assets	Assets	330,000	=	0.05	450,000	=	-0.06
Return on Equity	Net income	15,000	=	0.09	-25,000	=	-0.17
Return on Equity	Total Equity	175,000	=	0.09	150,000	=	-0.17
Asset turnover	Net sales	250,000	=	0.76	450,000	=	1.06
Asset turnover	Assets	330,000	=	0.76	425,000	=	1.06

Interpretation of Financial Ratios

Current ratio = \frac{Current assets}{Current liabilities}

$Current ratio = \frac{Current assets}{Current liabilities}$

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.

Quick ratio = \frac{Cash + Securities + Receivables}{Current liabilities}

$Quick ratio = \frac{Cash + Securities + Receivables}{Current liabilities}$

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 = \frac{Net sales on account}{Average net receivables}

$Receivables turnover = \frac{Net sales on account}{Average net receivables}$

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.

Collection ratio = \frac{365}{Receivables turnover}

$Collection ratio = \frac{365}{Receivables turnover}$

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.

Inventory turnover = \frac{Cost of goods sold}{Average inventory}

$Inventory turnover = \frac{Cost of goods sold}{Average inventory}$

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.

Average number of days inventory is in stock = \frac{365}{Inventory turnover}

$Average number of days inventory is in stock = \frac{365}{Inventory turnover}$

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.

Debt to equity = \frac{Total liabilities}{Total equity}

$Debt to equity = \frac{Total liabilities}{Total equity}$

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.

Assets to equity = \frac{Total assets}{Total equity}

$Assets to equity = \frac{Total assets}{Total equity}$

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.

Gross margin = \frac{Gross profits}{Net sales}

$Gross margin = \frac{Gross profits}{Net sales}$

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.

Profit margin = \frac{Net income}{Net Sales}

$Profit margin = \frac{Net income}{Net Sales}$

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.

Return on assets = \frac{Net income}{Total assets}

$Return on assets = \frac{Net income}{Total assets}$

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.

Return on equity = \frac{Net income}{Total equity}

$Return on equity = \frac{Net income}{Total equity}$

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

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
Formula	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

Analysis of Cash Flows

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:

Dechow et al. takes a two-period look at accruals: the year prior to the fraud and the year of the fraud, and finds that firms that intentionally overstate reported earnings have higher total accruals. The results are consistent with the notion that cash flows in the prefraud and fraud periods are lower than reported income.²⁷
Beneish (1997) compares companies subject to SEC enforcement actions to those with elevated levels of discretionary accruals. The author’s findings suggest that GAAP violators are more likely to have consecutive elevated levels of accruals in years prior to and including the year of GAAP violation. Beneish argues that GAAP violation occurs because firms have exhausted alternatives for improving reported performance.²⁸
Lee et al. examine the relationship between earnings, cash flows, and fraud and assume that frauds affected the financial statements in the years immediately prior to discovery. “Accrual measurement concepts indicate that financial statement fraud should be associated with elevated levels of earnings relative to operating cash flow.” (p. 749) The authors find that “the difference between earnings and cash flows is extreme in most fraud cases in years immediately prior to fraud discovery. In most cases, the magnitude of the difference is extreme (in the 90th percentile) relative to the differences for firms for which fraud has not been discovered or reported.” (p. 757) The authors conclude that earnings in relations to operating cash flow are not an unambiguous signal.²⁹
Rosner suggests that failing firms may be motivated to engage in fraudulent financial reporting to conceal their distress. As bankrupt firms (that do not appear to be distressed) approach bankruptcy, their financial statements reflect significantly greater material income-increasing accruals than do control firms. Rosner states that “managers of failing firms, optimistically expecting their firms’ troubles to be temporary, are motivated to engage in income-increasing earnings management to conceal the deteriorating financial conditions until they improve.” A failing firm may succeed in concealing its failing condition for a while. If the condition is temporary and the firm’s financial health improves, the auditor may never find out. However, if the firm’s financial condition deteriorates, Rosner argues that the auditor will eventually detect a going-concern problem and scrutinize that financial statements more carefully. Rosner finds that net income considerably exceeds cash flows in nongoing-concern firm-years of SEC fraud and nonstressed bankrupt subsamples, indicating that while manipulated accrual-based numbers conceal distress, cash flows reveal it.³⁰
Graphically, Richardson et al. present trends in accruals, return on net operating assets, sales growth, and changes in asset turnover for SEC Enforcement Actions for alleged earnings overstatements. The data were shown for an eleven-year period—five years prior to the SEC Enforcement Action alleging fraudulent activity, the year the Action was brought, through five years after. The graphical results suggest that accruals are above average in the year of alleged earnings overstatement, as well as the two preceding years. Accruals then tend to decline below the average after the fraud year.³¹
Perols and Lougee show that the likelihood of fraud is significantly higher for firms that have previously managed earnings, even when there is no evidence of inflated revenue and when they do not meet or beat analysts’ forecasts.³² The authors suggest that firms with income-increasing accruals over time must either deal with the consequences of the accrual reversals or commit fraud to offset the reversals.³³,³⁴,³⁵ Prior year income-increasing discretionary accruals might also cause firms to run out of ways to manage earnings.³⁶,³⁷
In the opposite direction, some financially troubled companies may reflect reported earnings that are less than operating cash flows. This would be consistent with Arthur Levett’s “Big Bath,” where companies take large write-offs in years of poor financial performance to get it over with, and in an effort to boost future years’ earnings.

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.

Analysis of Nonfinancial Numbers

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

Ittner and Larcker find that one form of NFM—customer satisfaction—is significantly related to future accounting performance and is partially reflected in current accounting book values. Consistent with this research, audit guidance suggests that auditors can expect NFMs, such as production capacity, to be correlated with sales reported on the income statement.⁴⁰
Brazel et al.⁴¹ add to this research stream by finding that fraud firms exhibit inconsistencies between their sales growth and contemporaneous growth in NFMs. For fraud firms, financial statement revenue growth substantially exceeds growth in relevant NFMs. However, for a matched sample of nonfraud competitors, the relationship between sales and NFM growth is quite consistent. The authors suggest that Identifying inconsistencies between financial data and related NFMs should serve as a red flag, leading to further courses of action:
- Asking pointed questions of management
- Increasing professional skepticism
- Taking steps to corroborate and test management’s explanations for variability between NFMs and financial statement amounts with reliable evidence
- Assigning forensic specialists to the examination

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:

A minority of auditors use NFMs as an information source for testing and do not increase their reliance on NFMs when the NFMs point to a fraud red flag;
The presence of high fraud risk alone is insufficient to increase auditor consideration of inconsistent NFMs;
Auditors are able to react appropriately to an inconsistency if they are effectively prompted; and
The influence of a prompt on auditor reliance on NFMs and account balance expectations is stronger when fraud risk is assessed as high.

Examination of NFMs is often relevant and informative in other forensic accounting contexts.

Module 5: Deterrence of Financial Statement Fraud

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:

Reduce pressures to commit financial statement fraud
Reduce the opportunity to commit financial statement fraud
Reduce grounds for rationalizing financial statement fraud

Reduce Pressures to Commit Financial Statement Fraud

Establish effective board oversight of the “tone at the top” created by management
Board and senior management should offer their own actions as examples of appropriate conduct
Avoid setting unachievable or unreasonable financial goals
Avoid applying excessive pressure on employees to achieve unrealistic goals
Change goals if changed market conditions require it
Ensure compensation systems are fair and do not create unwarranted incentives to commit fraud
Discourage excessive external expectations of future corporate performance
Remove operational obstacles to effective performance

Reduce the Opportunity to Commit Financial Statement Fraud

Maintain accurate and complete internal accounting records
Carefully monitor the business transactions and interpersonal relationships of suppliers, buyers, purchasing agents, sales representatives, and others who participate in the transactions between financial units
Establish a physical security system to secure company assets, including finished goods, cash, capital equipment, tools, and other valuable items
Divide important functions among employees, sharing control of one area
Maintain accurate personnel records, including background checks on new employees
Encourage strong supervisory relationships and leadership within groups to promote enforcement of accounting procedures
Establish clear and uniform accounting procedures with no exception clauses

Reduce Grounds for Rationalizing Financial Statement Fraud

Promote strong values, based on integrity, throughout the organization
Have policies that clearly define prohibited behavior with respect to accounting and financial statement fraud
Provide regular training to all employees and communicate prohibited behavior
Establish confidential advice and reporting mechanisms for communicating inappropriate behavior
Have senior executives communicate to employees that integrity takes priority and that goals must never be achieved through fraud
Ensure that management practices what it preaches and sets an example by promoting honesty in the accounting area. Dishonest acts by management, even if they are directed at someone outside the organization, create an environment of corruption that can spread to other business activities and to other employees—internal and external
Clearly define the consequences of violating the rules

Case Study: All on the Surface

In this example, several names may have been changed to preserve anonymity.

Michael Weinstein chuckled a lot. He smoked big cigars and laughed at the people who used to think that he was just a chubby schmo. Forbes and BusinessWeek stoked the fire with adoring articles. BusinessWeek called Weinstein’s Coated Sales, Inc. “the fourth fastest growing company in the country” and predicted greater returns to come. Of Coated Sales’ twenty competitors, eleven were either defunct or absorbed. “The survivors,” observed a writer in Forbes, “are more likely to cower than laugh when they see Weinstein.” In a few years’ time, revenues at Coated had jumped from $10 to $90 million per year. The stock was peaking at eight times its opening price. “One of my goals,” Weinstein stated dramatically, “is to see us be almost alone.”

And that didn’t take long.

Weinstein’s auditors walked out on him. The Big Six accounting firm resigned and announced publicly they had no trust in the management of Coated Sales. Senior management scrambled en masse to clear out. Weinstein was suspended. New people started looking at the books. Within two months, Coated Sales was filing for bankruptcy. The last laugh rang hollow down the empty hallways.

Michael Weinstein was once the All-American Businessman. At 19 he borrowed $1,000 from his father and bought into a drugstore. At 31 he had a chain of stores, which he sold, reaping several million dollars in take-home pay. Weinstein remembered thinking, “I have a problem.” Just when all his contemporaries were reaching their 30-something years, starting careers, and raising families, he was retiring. What to do with all that time?

His buddy Dick Bober talked him into the coated fabrics business. Weinstein didn’t know anything about coated fabrics. But neither was he a pharmacist, and that venture had proved fortuitous. Coating fabrics, he learned, was a crucial step in the manufacture of lots of products, from conveyer belts to bulletproof vests. Things, such as parachutes, helmet liners, and camouflage suits, all use coated fabrics. So there were some bulky government contracts waiting to be served. Uniforms and equipment have to be stain-proofed, fungus-proofed, waterproofed, and dyed. According to one estimate, coating adds from 10 to 50% to the base value of raw material, lending the luster of money to an otherwise mundane industry.

Weinstein threw himself into the business and eventually into the manufacturing process. As a pilot, he had hated the life vests stowed on commercial airliners. “They had always bugged me,” he said. “They [are] heavy and expensive to make,” he told Coated researchers. They designed a prototype using coated nylon, which was 60% lighter than the standard and 70% cheaper to make. Before his company’s untimely demise, Weinstein could boast that every Western-based airline carried life vests manufactured with materials made by Coated Sales.

The Coated Sales laboratory helped develop a superproofed denim to protect oil rig workers, firemen, and people handling hazardous materials. Coated Sales employees worked on aircraft emergency slides, radiator hoses, telephone earpieces, a sewage filtration fabric, marine diver suits, backpacks, and, just for flair, they made a portion of the sailcloth for the Stars & Stripes, the schooner Dennis Conner piloted to victory in the America’s Cup. Weinstein must have had a charm wound up and running in his favor. Just two years before the crash, he became the first coated fabrics operator to own a large-scale finishing plant, a $27 million facility without rival in the industry.

At the same time, Weinstein’s darling was digging its own grave. Expanding into new markets, developing cutting-edge product lines, herding new companies into the fold—all this takes money. Especially when the CEO and senior management like to live large and let people know about it. There’s a constant cash crunch. Larger scale means larger crunch. Inside the workings of Coated Sales, shipments of fabric and equipment were being bought and sold quickly, often at a loss, just to get the short-term money.

For years Coated had used Main Hurdman for auditing, with no signs of trouble. But when Main Hurdman was acquired by Peat-Marwick (now KPMG), the new auditors came away with a very different picture. One associate called a luggage manufacturer to ask about 750,000 pieces of merchandise purchased from Coated. The luggage company said they never placed an order like that. No idea. When audit team members spoke about their concerns, Coated sent in its legal counsel to talk with the auditors. Philip Kagan tried to get them to make a deal, to forge ahead, and let the financial statement slide; there were some problems, he admitted, but nothing beyond repair. The matter was being taken care of. No way, said the auditors, who then walked out.

Within a two-month period, the company that once flew higher than the rest had fallen into bankruptcy. Early estimates put shareholder losses at more than $160 million. Coated’s top twenty creditors claimed they were out at least $17 million. The bankruptcy court appointed Coopers & Lybrand’s insolvency and litigation practice to work with the debtor in possession. Besides the usual assessments, the group was to determine what went wrong—and just how wrong, in dollar amounts, it had gone. CFE Harvey Creem says, “We knew there was something of concern with a loan and how the money was used. Once we started poking around, the iceberg got larger.” Creem worked with the debtor’s lawyers, who determined that the proceeds of a bank loan had been transferred to a brokerage account, one no longer carried in the ledgers. It was a supposedly dormant account from the company’s first public offering, used for temporary investments until it was zeroed out. During the most recent fiscal year, there had been some activity in the account. Proceeds from a loan had been deposited into the brokerage account, transferred out to a cash account, and listed as if they were payments from customers against their accounts receivable. Coated Sales was due a lot of money, their receivables growing by $20 million a year. But a lot of the payments on those receivables were being made with Coated’s own money, part of which originated from bank loans. The broad outline of the fraud was clear. “When you find a single check for, say $2 million, used to pay off several different accounts, you know something’s up. Usually each customer sends their own check to pay off their own debt. In this case, a check listed under one name was used to pay off debts for several different people. Now, a company that not only pays its own debts, but the debts of other companies, too—that’s not impossible, but it’s not likely. The basics of the operation took two or three hours to break,” says Creem. “Then it was tracking the scope of what happened.” Creem describes how he and his colleagues started at the bankruptcy filing date and “went in and analyzed the receivables in-depth. Large chunks of them were totally fallacious; they had nothing supporting them.” The tracking effort was helped along by a number of lower-level employees: “Some of them didn’t really know what was happening and they were willing to help. Some may have known, but they were repentant, so they were willing to talk.” In about three years of scamming, Weinstein and his management had inflated their sales and profits, resulting in overstated equity of $55 million. They used these phony numbers to get loans from several banks, including a $52 million line of credit from BancBoston and a $15 million line from First Fidelity in Newark, New Jersey.

The rigged loans solved the cash flow problem, plus there were very pleasant side effects. Stock in Coated Sales—traded under the ticker symbol RAGS—had been headed through the roof. Huge leaps in revenue and a monstrous control of the market had propelled the stock to $12 a share, eight times more than what it opened for. The company’s upper echelon, including Ernest Glantz (president) and Weinstein’s long-time partner Dick Bober (vice president), were benefiting in a big way. Weinstein himself made more than $10 million in a short-term selling spree. What’s more, one of the myriad lawsuits filed against him accused Weinstein of departing with $968,000 in company cash.

Creem followed the trail of rigged profits into several intriguing corners. “To float this past the auditors for as long as they did, they found several ways to create the fiction that customers were actually paying the fake receivables. They would create a fake receivable, say $10,000 due from a company. They’d hold it as long as they could, sometimes doctoring the dates on the aging, so it looked more recent than it was.” Creem says the next step was “rigging a way to pay the account off: They’d transmit their own cash to a vendor. The vendor presumably was in on the scheme, too, since they had submitted a fake invoice for the $10,000. This vendor keeps 1 to 2% for their trouble, and sends the rest back to Coated. That money would be reflected as a payment against the phony receivable.”

Guys like Bernard Korostoff made the vendor trick work. Korostoff used his Kaye Mills International Corporation to create false invoices for several big Coated orders. Weinstein’s team, having used their phony financials to get loans, sent out the money to Korostoff as if they were paying off a debt. Korostoff kept 1.5% for making the transaction possible, turning the rest back to Coated to pay off the falsified receivables. “I never really understood that,” says Creem. “These guys are doing this for a measly little percentage. Why would they bother for no more than that? Maybe it was connected in other ways to the business.”

The business, as it was being run, was a labyrinth of finagling and deception. Weinstein was faking how much he owed people in order to pay off receivables, which were also being faked. He was using receivables to get million-dollar loans and plowing chunks of the proceeds back into the system to keep suspicious eyes unaware. The false sales not only brought in loan dollars but also created portfolio dollars by driving RAGS stock higher and higher. To support the scam, Weinstein had three ways to keep his circle of money in motion: He could move loan money from the hidden brokerage account to wherever it was needed, he could use fake vendor invoices to launder funds back into the company, or he and his associates could sell off their own stock in the company and apply some of the proceeds to the delinquent receivables.

Four years of this action and Weinstein had demolished Coated Sales. The company exaggerated its accounts receivable by millions, fictionalizing half or more of its sales at any given point. At the time, it was the largest stock fraud ever perpetrated in the state of New Jersey. Weinstein and nine other senior managers were charged with planning, executing, and profiting from the scheme. Weinstein—called “a tall, plump man with a domineering personality” by Forbes—owned more than ten airplanes and several helicopters. He had two Rolls-Royces, one at each of his two residences, plus five other luxury automobiles scattered here and there. He and the other conspirators had used some of the proceeds to buy themselves smaller companies. As for flambuoyance, there was no better, and as for gall, he was unrivaled. After Coated went belly up and federal charges joined the pile of lawsuits against him, Weinstein bought a 13,000-square-foot house in Boca Raton, Florida, valued at $2 million and sitting on a $1 million property. Three different yachts were docked along the Florida coast in case Weinstein needed to get away from all the hassle.

But Weinstein wouldn’t slip past this one. He and his inner circle were presented with a forty-six-page indictment. Bruce Bloom, Coated’s chief financial officer, pled guilty and pointed at his cohorts. Coated’s lead counsel, Philip Kagan, first declared himself “totally innocent of any wrongdoing,” but later decided to plead guilty to the racketeering and conspiracy charges against him. Kagan confessed to helping dupe company auditors and described trying to entice them into ignoring the facts of their ledgers. He also admitted that he had once accepted $115,000 in legal fees from Coated Sales without reporting the money to the SEC as required. Kagan was sentenced to eighteen months in prison. Jail terms for other low-level players ranged from a year to twenty-four months.

Coated President Ernest Glanz was given a year’s sentence—part of a deal he made to cooperate with the government. Richard Bober, Weinstein’s longtime friend, drew twenty months in prison and a $3 million fine, besides the $55.9 million civil judgment he shared with Weinstein. Creem remembers that when Bober testified in bankruptcy court, “The judge appeared shocked. He started asking Bober questions himself. I don’t believe he had ever heard anything quite like this in his courtroom before.”

Michael Weinstein struck a plea bargain, which nevertheless carried a pretty stout penalty. He forfeited virtually all of the properties, cars, and boats he had amassed, along with several businesses and numerous bank accounts worth several hundred thousand dollars each. He was given fifty-seven months in federal prison and charged to make restitution for any outstanding stockholder losses.

U.S. Attorney Michael Chertoff saw this as a decisive case, part of what he called “a new genre of corporate boardroom prosecutions.” Fed up with the mega-scams of megalomaniac executives, legal agencies are using the tough Securities Law Enforcement Remedies Act to go after the big players. “Major financial fraud,” Chertoff told a press conference after Weinstein’s guilty plea, “not only harms banking institutions but also infects the securities market, victimizing the thousands of persons who invest in stock. When dishonesty roams the boardroom, it is the creditors and investors who suffer.”

We have eight types of assignments for instructors to choose from:

Critical Thinking
Review Questions
Multiple Choice Questions
Fraud Casebook
Brief Cases
Major Case Investigation (MCI)
IDEA Exercises
Tableau Exercises

CRITICAL THINKING

CT-1 Dead or Alive? A woman shoots her husband. Then she holds him underwater for over five minutes. Finally, she hangs him. But five minutes later, they both go out together and enjoy a wonderful dinner. How can this be?
CT-2 A Night at the Movies… A married couple goes to a movie. During the movie the husband strangles the wife. He is able to get her body home without attracting attention. How?

REVIEW QUESTIONS

Why might senior management overstate or understate business performance?
What are some of the ways in which financial statement fraud is committed?
What is the conceptual framework for financial reporting?
What are the five classifications of financial statement fraud?
How are fictitious revenue schemes committed?
What are the four criteria necessary for a sale to be complete?
How can understating liabilities and expenses make a company appear more profitable?
What issues are generally involved in improper disclosures?
How may improper asset valuation inflate the current ratio?
How can financial statement fraud be deterred?

MULTIPLE CHOICE QUESTIONS

Which of the following is not a common reason why senior management might overstate or understate business performance?
1. Pressures to boost revenues or expenses
2. Improperly designed incentive (e.g., bonus) packages
3. High levels of personal debt leading to a need for the executive to generate cash
4. Desire to manage earnings until conditions improve
Which of the following is not a methodology by which financial statement fraud is committed?
1. Manipulation of revenue
2. Manipulation of asset valuations
3. Manipulation of disclosures
4. Manipulation of accounting regulations
From the conceptual framework for financial reporting, which concept permits management to account for transactions in any manner they please?
1. Materiality
2. Consistency
3. Historical cost
4. None of the above
Which of the following is not one of the five major classifications of financial statement fraud?
1. Fictitious revenues
2. Improper disclosures
3. Concealed liabilities
4. Channel stuffing
Which of the following is not a fictitious revenue scheme?
1. Matching expenses to revenues
2. Premature revenue recognition
3. Conditional sales
4. Channel stuffing
Given the four criteria necessary for a sale to be complete, which of the following is not one of those conditions?
1. Delivery has occurred or services rendered.
2. Cash has been collected.
3. The sales price is fixed or determinable.
4. Documentation exists that can serve as evidence of a sale.
Of the following, choose the one that depicts a situation where liabilities and expenses are manipulated to make a company appear more profitable?
1. Liabilities are capitalized to increase revenues
2. Adelphia Communications fraud
3. Failure to record employee payroll earned but not paid as of period end
4. Failure to record warranty costs when the facts suggest that disclosure is more appropriate accounting treatment
Related to financial reporting disclosures, even when reported, which of the following still requires careful examination by the antifraud professional?
1. Omitted liability disclosures
2. Related party transactions
3. Accounting changes
4. Management fraud
Which improper asset valuation may inflate the current ratio?
1. Valuing inventory at current retail prices
2. Accounting for declines in fair market value of inventory
3. Failing to record valuation impairment to property, plant, and equipment
4. Capitalizing expenses as property, plant, and equipment
Which of the following is not likely to deter financial statement fraud?
1. Reducing the amount of inventory on hand
2. Establishing Board of Directors and Audit Committee oversight in line with antifraud best practices
3. Segregation of duties for acquisition, payment, recordation, stewardship, and reporting of assets
4. Establishing a whistleblower hotline and protections for whistleblowers

FRAUD CASEBOOK

Phar-Mor

Read the following articles or other related articles regarding the Phar-Mor case and then answer the questions below:

Sources:

Markowitz, Arthur, “There’s Phar-Mor to ‘Drug’ Chain than Meets the Eye,” Discount Store News, September 2, 1991.
Freudenheim, Milt, “Phar-Mor and Its Ex-Auditor Clash on Fraud Case,” Drug Store News, August 6, 1992.
Frederick, James, “Scandal Rocks Phar-Mor,” Drug Store News, August 17, 1992.
Gilpin, Kenneth N., “Coopers & Lybrand Sues Phar-Mor Executives,” The New York Times, August 21, 1992.
Bloomberg Business News, “Accountants Sue Phar-Mor,” The New York Times, September 12, 1992.
Murray, Matt, “Phar-Mor, Inc. Reaches a Settlement of Claim Against Coopers & Lybrand,” The Wall Street Journal, October 4, 1995.
Associate Press, “Phar-Mor Founder Gets Long Sentence,” The New York Times, December 2, 1995.

Short Answer Questions

In June of 1990, how large was the capital infusion to facilitate Phar-Mor growth?
Who was Phar-Mor’s flamboyant Chief Executive Officer?
Who was Phar-Mor’s Chief Financial Officer?
On what date did Phar-Mor announce that David Shapiro would assume the duties of President and Mickey Monus Vice-Chairman?
How long was Mickey Monus’s prison sentence?
Is Mickey Monus now out of jail?

Discussion Questions

In a fraud case, why does each party (e.g., management, board, audit committee, auditors, lawyers, etc.) usually blame another party for the fraud?
Discuss the reasons for this phenomenon and explain the probable reasons why no one who knew about the fraud came forward to stop it?
Consider your role as a junior accountant within a company or new staff member within an audit/tax professional services firm. How should you protect yourself from becoming an unwitting participant in a fraud?

BRIEF CASES

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%

Using the financial statement data provided, complete the following assignments:
1. Describe any symptoms of fraud
2. Draw a conclusion about fraud predication and recommend next steps.

Assume that industry ratios were derived from a reputable source. Compute the year 1 and year 2 ratios for Alpha and Omega:

	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%

Using your calculated ratios from assignment 2 in concert with the metrics calculated in assignment 1, complete the following assignments:
1. Describe any symptoms of fraud
2. Combine the findings in the ratio analysis with the metrics calculated in assignment 1 and draw a conclusion about fraud predication and recommend next steps.

Assume that nonfinancial metrics were derived from reliable public and internal sources. Complete the analysis of NFMs for Alpha and Omega:

	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%

Using your calculated metrics from assignments 1 an 2 in concert with the metrics calculated in assignment 4, complete the following assignments:
1. Describe any symptoms of fraud
2. Combine the findings in the NFMs with the ratio analysis computed in assignment 2 and percentages calculated in assignment 1 and draw a conclusion about fraud predication and recommend next steps.

MAJOR CASE INVESTIGATION

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:

Memo—Additional facts, circumstances, and evidence
Private Investigator Invoice
Joan Rogers e-Mail (5 documents)

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).

IDEA EXERCISES: ASSIGNMENT 7

idea 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.

TABLEAU EXERCISES: ASSIGNMENT 7

tableau 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.

Endnotes

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Table of Contents for 7 Financial Statement Fraud

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Module 1: Financial Reporting Fraud: Who, Why, and How

Financial Statement Fraud

Who Commits Financial Statement Fraud?

Why Do People Commit Financial Statement Fraud?

How Do People Commit Financial Statement Fraud?

Public versus Private Company Financial Reporting Fraud

Module 2: Accounting Principles and Fraud

Conceptual Framework for Financial Reporting

Economic Entity

Going Concern

Monetary Unit

Periodicity

Historical Cost

Revenue Recognition

Matching

Transparent Disclosure

Cost−Benefit

Materiality

Industry Practice

Conservatism

Relevance and Reliability

Comparability and Consistency

Responsibility for Financial Statements

Users of Financial Statements

Types of Financial Statements

Types of Fraudulent Financial Statement Schemes

Module 3: Fraudulent Financial Statement Schemes

Defining Financial Statement Fraud

Costs of Financial Statement Fraud

Fictitious Revenues

Sales with Conditions

Pressures to Boost Revenues

Red Flags Associated with Fictitious Revenues

Timing Differences

Matching Revenues with Expenses

Revenue Recognition

Persuasive Evidence of an Arrangement Does Not Exist

Delivery Has Not Occurred or Services Have Not Been Rendered

The Seller’s Price to the Buyer Is Not Fixed or Determinable

Collectibility Is Not Reasonably Assured

Long-Term Contracts

Channel Stuffing

The Capital Forum

Snap-on: Declining Deferred Subscription Revenue Raises Questions About End-Customer Demand for Diagnostic Products

Company Update

A Closer Look at Subscription Pricing and Revenue Recognition

Recording Expenses in the Wrong Period

Red Flags Associated with Timing Differences

Concealed Liabilities and Expenses

Liability/Expense Omissions

Capitalized Expenses

Expensing Capital Expenditures

Returns and Allowances and Warranties

Red Flags Associated with Concealed Liabilities and Expenses

Improper Disclosures

Liability Omissions

Subsequent Events

Management Fraud

Related-Party Transactions

Accounting Changes

Red Flags Associated with Improper Disclosures

Improper Asset Valuation

Inventory Valuation

Accounts Receivable

Fictitious Accounts Receivable

Failure to Write Down

Business Combinations

Long-Term Assets

Booking Fictitious Assets

Misrepresenting Asset Value

Understating Assets

Capitalizing Nonasset Cost

Misclassifying Assets

Red Flags Associated with Improper Asset Valuation

Module 4: Detection of Fraudulent Financial Statement Schemes

Financial Statement Analysis

Table of Contents for
7 Financial Statement Fraud