Fraud Test 2

5 types of FS fraud

5 types of false statement fraud:

1. Fictitious revenues,

2. timing differences,

3. improper asset valuations,

4. concealed liabilities and expenses, and

5. improper disclosures

How would you commit a financial fraud:

FS fraud: deliberate misstatements or omissions of amounts or disclosures of financial statements to decieve fiancnail staement users, particularly investors and creditors

• Falsification, alteration or manipulation of financial records, supporting documents, or business transactions

• Material intentional omissions or misrepresentations of events, transactions, accounts, or other significant information from which FS are prepared

• Deliberate misapplication of accounting principles, policies, and procedures used to measure, recognize, report, and disclose economic events and business transactions 

  • EX: Steinmart not marking down inventory until sold

• Intentional omissions of disclosure or presentation of inadequate disclosures, (missed the end of this)

Subtypes of fictious revenue

• Recording of goods or services that did not occur(most egreiguos) 

  • Fake or phantom customers

  • Legitimate customers although goods haven’t been delivered

  • Beating the accounting system

• Sales with condition: appears like a real sale

  • A sale is booked even though some rights have not been passed to the purchaser

  • Playing the accounting system

Red Flags of Fictouis Revenue

“Paul Made Crazy Red Raspberry Cookies.” 🍪

• Rapid growth or unusual (p)rofitability, especially when compared with companies in the same industry

• An unusual surge in sales by a (m)inority of units within a company or of sales recorded by the corporate headquarters

• Recurring negative (c)ash flows from operating or an inability to generate cash flows from operations, while reporting earnings and earnings growth

• Unusual growth in the number of days' sales in (r)eceivables 

• Significant transactions with (r)elated parties or special purpose entities not in teh ordinary course of business or where those entities are not audied or audited by a different firm

• Significant, unusual or highly (c)omplex transactions that are close to the the period and end adn post a difficult substance over form

Subtypes of timing differences

Subtypes

• Long-term contracts - pretty difficult to account for in an audit and easy to manipulate

• Channell stuffing - changing terms at the end of the period to get revenue

  • Buyers are encouraged to overbuy in an attempt to inflate current-year earnings

  • There may be a greater risk of return

  • offering deep discounts and bulk

• Shifting revenues or expenses between one period and the next 

• Recording revenues and/or expenses in improper periods

  • this could be expensing certain costs in periods where they didn’t actually incur

  • if i am under budget this year, I may record extra expenses or vice versa

When is revenue recognized

This is discussed in relation to fictitious sales and heavily in relation to timing differences 

Revenue Recognition

• Persuasive evidence an arrangement exists

• Delivery has occurred or services have been rendered

  • bill and hold

• Teh seller’s price to teh buyer is fixed or determinable

• Collectibility is reasonably assured 

Red Flags of Timing Differnces

If you want something a little sillier to make it stick:
“Peter’s Clumsy Cousin Rachel Paints Giraffes.” 🎨🦒

• Same as fictitious revenue:

  • Rapid growth or unusual (p)rofitability, especially compared ot that of other companies in the same industry(same as RR)

  • Recurring negative (c)ash flows from operations or an inability to generate cash flows from operations while reporting earnings and earnings growth

  • Significant, unusual or highly (c)omplex transactions that are close to the period and end adn post a difficult substance over form

  • Unusual decline in teh number of days’ sales in (r)eceivables

• Different from fictitious revenue

  • Unusual decline in the number of days’ (p)urchases in AP

  • unusual increase in (G)M or margin in excess of industry peers

Concealed Liabilities subtypes

• Subtypes

  • Liability/expense omission

    • easy to just not record them 

    • throwing away incoives or unrecorded judgments

    • difficult to uncover, especially if things were just thrown away

  • Caplyuzed expenses

    • you could capitalize things that should be expensed and spread out the cost

    • you could also expense things that should be capitalized to lower net income and taxes

  • Failure to disclose warranty costs and liabilities or reserves

    • substantially omitting or understating sales returns, warrant returns, and allowances

Concealed Liabilities Red Flags

Redflags

“Ruby Usually Avoids Naughty Angry Raccoons.” 🦝

• Same as timing differences and fictous revenue

  • Recurring negative cash flows from operating or an inability to generate cash flows from operations, while reporting earnings and earnings growth

  • Unusual increase in gross margin or margin in excess of industry peers

• Different

  • Assets, liabilities, revenues or expenses are based on significant estimates that involve subjective judgments or uncertainties that are difficult to corroborate

  • Nonfinancial management’s excessive participation in or preoccupation with teh selection of accounting principles or the determination of significant estimates

  • Allowances for sales returns, warranty claims, are shrinking in percentage or are out of line with industry peers

  • Unusual recession in days purchases in AP

  • Reducing AP while competitors are stretching out payments

Improper Disclosure Subtypes

• Subtype

  • Liability omissions

    • contigent liability, loan covenant, etc. 

  • Subsequent Events

  • Management fraud: significant fraud committed by investors

  • Related Party Transactions - nothing wrong with related party transactions but they must be disclosed

  • Accounting Changes - this relates to teh disclosure adn teh treatment, failing to propery retroactively restate FS

Improper disclosure Red Flags

• Red Flags

“Pat’s Cat Ran Down Busy Elm Street Very Incredibly Rapidly.” 🐱💨

• Same as others

  • Rapid Growth or unusal profitability especially compared to that of other companies in teh same industury

  • Significant, unusaual 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 

• Different 

  • Domination of management by a single person or small group(in a non-owner-managed business) without compensating controls

  • Ineffective BoD or audit committee oversight over the financial reporting process and internal control

  • Ineffective communication, implementation, support, or enforcement of the entity’s ethical standards and values by management or teh communication of inappropriate values

  • Overly complex organization structure involving unusual legal entities or managerial lines of authority

  • Known history of violation 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 inappropriate accounting on teh basis of materiality

  • formal or informal restrictions on teh auditor that inappropriately limit access to people or information or teh ability to communicate effectively with the BoD or audit committee 

Improper Asset Valuations subtypes

• Subtypes

  • Inventory valuation

  • Accounts receivable - credit risks/collectibility

  • Business combination

  • Investments(this one wasn’t in the book)

  • Fixed assets(could also refer to improper capitalization - ie startup costs)

Improper Asset Valuation Red Flags

Red Flags

“Carlos’s Elephant Named Greg Always Runs Past A Dark River.” 🐘🌊

• Same

  • Recurring negative cf

  • Significant estimates that are subjective

  • Nonfinancial management's excessive participation with accounting principles

  • Unusual growth in gross margin or margin in excess of industry ppers

  • Unusual growth in days' sales in receivables

  • Unusual growth in teh number of days’ Purchases in inventory 

  • Allowance for bad debts, excess and obsolete invenotry and so on are shrinking in percentage terms or otherwise out of line with industry peers

• Different

  • Significant declines in customer demand and increasing business faluires in either industry or overall economy

  • Unusual change in the relationship between fixed assets adn depreciation

  • Adding to assets while the corporation's capital is tied up in assets

Audit Guidance fraud considerations

How do auditors knwo what to do?

• (SAS 99 AU 240) consideration of fraud in a financial statement audit

• How do auditors know what to do?

  • The company you work for will use this reference to form an audit guide

  • Step 1: Planning, Step 2: Performing, Step 3: Finalize 

    • Within these steps, random things will relate to AU 240

What are teh 10 things you must do in an audit with repect to fruad

1. Description and characteristics of fraud

2. Importance of exercising professional skepticism

3. Discussion among engagement personnel regarding the risk of material misstatement due to fraud

4. Obtaining information needed to identify risks of material misstatement due to fraud

5. Identifying risks that may result in a material misstatement due to fraud

6. Assessing the identified risks after taking into account an evaluation of the entity’s programs and controls

7. Responding to the results of the assessment

8. Evaluate audit evidence

9. Communicate about fraud to management, the audit committee and others

10. Document Auditor’s consideration of fraud

Steps 1-3 in audit report with respect to fraud

1. Description and characteristics of fraud

   1. Mistatements arising from fraudulent financial reporting

      1. Manipulation or alteration of accounting records

      2. Misrepresentation or intentional omissions

      3. Intentional misapplication of accounting principles

   2. Misstatements arising from the misappropriation of assets

   3. Capured within audit guide

2. Importance of exercising professional skepticism

   1. Captured within audit guide

3. Discussion among engagement personnel regarding the risk of material misstatement due to fraud

   1. Brainstorming

   2. Internal and external pressures

   3. Required steps during preparation process 

Steps 4 through 6 in audit report with repect to fraud

4. Obtaining information needed to identify risks of material misstatement due to fraud

   1. Make inquiries of management about the risks of fraud and how they are addressed

   2. Consider any unusual or unexpected relationships that have been identified in performing analytical procedures in planning the audit

   3. Consider whether one or more fraud risk factors exist

   4. Consider other information that may be helpful in teh identification of the risk of material misstatement due to fraud

   5. Required steps during preparation process 

5. Identifying risks that may result in a material misstatement due to fraud

   1. Type of risk

   2. Significance of the risk

   3. Likelihood of the risk

   4. Pervasiveness of the risk

   5. Reflected in procedures performed during audit, as determined/documents in preparation phase

6. Assessing the identified risks after taking into account an evaluation of the entity’s programs and controls

   1. Specific controls designed to mitigate the risks of fraud

   2. Broader programs designed to deter adn detect fraud

   3. Reflected in procedures performed during audit, as determined/documents in preparation phase

Step 7 in audit report with respect to fraud

7. Responding to the results of the assessment

   1. Responses involving the nature, timing, and extent of procedures to be performed to address the identified risks

   2. Responeses to adress further risk of management override of contols

   3. exmaining JE and other adjustments for evidence of possible material misstatement due to fraud

   4. Reviewing accounting estimates for biases that oculd resolt in material misstatemnet due to fraud

   5. evaluating the business rational for significant transactions

   6. Reflected in procedures performed during audit, as determined/documents in preparation phase

Step 8-10 in audit risk with respect to fraud

8. Evaluate audit evidence

   1. This step assesses and responds the risk of materail misstatment at or near the completion of field work

   2. Evaluate whether anylitcal procedures indicatea  previoly unrecognized risk of fraud

   3. Reflected in teh preparation and finalaizetion phases(maybe)

9. Communicate about fraud to management, the audit committee and others

   1. If fraud may exist, the matter should be brought to the attention of an appropriate level of management even matter is considered inconsequential

   2. Fraud involving senior management should have been reported directly to the audit committee

   3. Reflected in teh preparation and finalaizetion phases

10. Document Auditor’s consideration of fraud

    1. Reflected throughout relevant steps

Conflicts of interest, what is it, what is the difference between bribery and what is the types

• Purchase scemese

• Sales schemes 

• Other

there is an undisclosed personal or economic interest

the victim(employer) is unaware that is employee has divided loyalties

• if the employer knows it is not a conflict of intersr

• the fraudster may not always get ecoomic incentives

Bribery vs Conflicts of interst

• differnce is motive

• if an employee approves a vendor for a kickback this is bribery

• if an employee submits payments to her own undisclosed company this is conflict of interset

within conflics of interst what are purchasing schemes

• Purchasing schemes 

  • Overbilling

    • Tyson overcharges walmart for chicken so that the Walmart employee gets a bonus

    • Maybe two friends talk so that the Walmart employee can get a bonus

    • Bill ordinates froma  a real company in which the fraudster has an undisclosed economic or personal interest

    • Fraudster uses influence to ensure teh victim uses this vendor

    • Does not negoticate in good faith or try to get the best price for the employer

  • Turnaround sales

    • Fraudster known taht the company is seeking to purchase a particular asset and purchases it themselves

    • Utrns around and sellis it to the company at an inflated price(markup is dagamanes)

Within conflicts of itnerset what are sales schemes

• Sales scheme

  • Underbilling scheme: goods are sold below fair value to a customer in which the purchaser has a hidden interest

  • Writing off sales: purchases are made from teh victim company credit memos are later issued - writing off AR

WHat are other conflict of interst schemes

• Business divisions: siphonoing off clients of teh victim company to ones own interst

• Resource diversions: diverting funds and other respourses to teh devolpment of thier own business

• Financial disclosures: inadequate discliusre if cinflicts of interst and related-party transactions adn any criminal chrages

Preventing adn detecting conflicts of interst

hard

Prevent:

• ethics policy to define what constitutes a conflict

• ploicy requiring annual disclsure

Detect

• anonymous report

• comparing home affrssses adn phone numbers

What are the types of bribery

• invoice kickbacks

• bid-rigging schmes

Whar are invoice kickbacks within bribery, who can do it

• Invoice kickbacks

  • Involve submission of invoices for goods and services that are either overpriced or completely fictitious 

  • One company buys overpriced goods from another because there is some sort of personal interest

  • Involve collusion between employees and vendors

  • Almost always attack the purchasing function of the victim company 

  • Vendor pays the kickbacks to ensure a steady stream of business from teh purchasing company

  • No incentives to provide quality merchandise or a low price

  • Almost always leads to overpaying for goods or services

  • Employees with approval authority have it easy to get involved

    • Vendor submists inflated invoices to the victim company

    • Overstates the COGS or services or reflects fictitious sales

    • Ability to authroize purchases is ket to teh scheme

  • Employees without authritiy makes it harder

    • Cicrimvent purchasing controls

    • May prepare false vouchers

    • May forge an approval or have unaurthized access to system/password

how to prevent invoice kickbacks

Normal controls may not detect kickback schemes

• Prevention:

  • Policies adn written things 

    • Implement an ethics policy 

    • Establish written policies 

    • Excessivly forbid employees with personal interest

    • Expressibly forbid employee form engagin in any transaction in which he has an undeisclosed interest

  • Action Items

    • Ensure all contracts have a right to audit clause

    • Assign an employee independent of the purchasing department to routinely review buying patterns

how to detect invoice kickbacks

• Deterction

  • Moniter

    • Moniter for price inflation w market rates

      • create price thresholds

    • moniter excessive purchases from one suppler

    • moniter excess qunitity purchased

    • inventory shortages

    • monitor trends in COGS and services

  • Actions

    • maintain up to date venodr lists and purchases should only be made from apporve suppliers

  • Results

    • inferior quality of inventory

      • pay for high quality but deliver low quality

    • Price inflation

Whar are bid-rigging schemse

• All bidders for a project are expected to be on an even playing field unless the process is rigged

• Potential targets with influence/power

  • Buyers

  • Contracting official

  • Engineers

  • Quality assurance

  • Subcontractors

• This affects decision makers for a big project

• 3 phases: 

  • Pre-solicitation phase

    • Option 1: Specifications are manipulated by a fraudster

      • Specifications include a list of elements, materials, dimensions, and other relevant requirements

      • Set the specification to a particular vendor’s capabilities

      • Use prequalification procedures to eliminate certain vendors

      • Sole-source or non-competitive procurement justification

      • Bid splitting: splitting a project in half with two vendors

      • Give the vendor the right to see the specifications before their competitors get the specs

    • Option 2: Need recognition is identified by fraudsters: 

      • Employee of the purchasing company convinces the company that a particular project is necessary

      • Has the specification tailored to teh strengths of a particular supplier

      • Making up a need 

      • Red flgase

        • Higher requirements for inventory levels

        • Writing off large numbers

        • Defining a need that can only be met by a certain supplier

        • Faliure to devolp a list of satisfactory back up suppliers

  • Solicitation phase - goal: decrease the competition

    • Restricting teh pool of vendors from which to choose

    • Bid pooling

    • Fictitious suppliers

    • Restricting the time for submitting bids

    • Soliciting bids in obscure publications

    • Publicizing the bid during holiday periods 

  • The submission phase

    • Gets help on preparing bid

    • Fraud in sealted bid process

      • Last bid submitted is teh one that is awarded to contract

        • Winning bidder can see the other competitors bids before submitting their ow

how do you prevent and detect aganist bid rigging schmese

• Prevention: none

• Detection: 

  • Unusual bidding patterns

    • Low bids followed by change orders

    • A very large unexplained price difference among bidders

    • Predictable rotation of bidders

    • Fewer bidders than expected for the project

    • Losing bidders who become subcontractors

  • Vendors with teh same address and phone number

  • Projects are split into smaller ones

What are illegalgal gratitudes

Illegal gratutides: just like bribery but after the fact

• Given to reward a decision rather than influence

• Decision made to benefit a person or company but it is not influenced by any sort of payment

• May influence future decisions

what is economic extortion

Economic extortion: employee demands payment from a vendor to decise in teh vendor’s favor

• Pay up or else