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

• Rapid growth or unusual profitability, especially when compared with companies in the same industry

• An unusual surge in sales by a minority of units within a company or of sales recorded by the corporate headquarters

• Recurring negative cash 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 receivables 

• Significant transactions with related 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 complex transactions that are close to the the period and end adn post a difficult substance over form

Subtypes of timing differences and revenue recognition

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

Red flags: 

• Same as fictitious revenue:

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

  • 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 that are close to the period and end adn post a difficult substance over form

  • Unusual decline in teh number of days’ sales in receivables

• Different from fictitious revenue

  • Unusual decline in the number of days’ purchases in AP

  • unusual increase in GM 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

• 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 data 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

• 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/collectiability

  • Business combination

  • Investments

  • Fixed assets

Improper Asset Valuation Red Flags

• Red Flags

  • Recurring negative cf

  • Significant declines in customer demand

  • Significant estimates that are subjective

  • Nonfinancial management's excessive participation with accounting principles

  • Unusual growth in days' sales in receivables

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

  • Allowances for bad debts, excess, and obsolete compared with their historical or peers

  • Unusual change in the relationship between fixed assets adn depreciation

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