FRAUD EXAMINATION ALBRECHT, ALBRECHT, &

ALBRECHT

Financial Statement Fraud

CHAPTER 11

Learning Objectives

1. Understand the role that financial statements play in U.S. businesses.

2. Describe the nature of financial statement fraud.

3. Become familiar with financial statement fraud statistics

4. See how financial statement frauds occur and are concealed.

Learning Objectives

5. Understand the framework for detecting financial statement fraud.

6. Identify financial statement fraud exposures.

7. Explain how information regarding a company’s management and directors, nature of organization, characteristics, relationship with others, and financial results can help assess the likelihood of financial statement fraud.

What Are Some Problems with Financial Statements?

Misstated “Cooked” Inappropriate executive loans

and corporate looting IPO favoritism, spinning &

laddering Excessive retirement perks Exorbitant compensation Loans for trading fees Massive employee fraud

Review the Fraud Triangle.

Perceived OpportunityPerceived OpportunityPerceived OpportunityPerceived OpportunityPerceived Opportunity

What Are the Elements of the Perfect Fraud Storm?

1. Management lacked understanding of the causes for success of their companies

2. Moral decay occurring in the United States and around the world

3. Misplaced executive incentives

4. Wall Street’s unachievable expectations that targeted only short-term performance

5. The large amount of debt and leverage each of the fraudulent companies had placing tremendous pressure on executives

What Are the Elements of the Perfect Fraud Storm?

6. The nature of U.S. accounting rules

7. The opportunistic behavior of some CPA firms

8. The greed by executives, investment banks, commercial banks, and investors

9. Three types of failure by educators1. Failure to provide sufficient ethical training

2. Failure to teach students about fraud

3. Failure to teach less about content as an end in itself and to focus more content in the context of helping them develop analytical skills

Financial Statement Fraud Statistics.

Infrequent 300 over 10 years Costly Last 23.7 months Mean $25 million CEO in 72%, CFO, COO Computer hardware/software 78% of firms on NASDAQ

Most had no audit committee Most directors were insiders Family relationships between directors 56% audited by Big Eight or Big Six 25% changed auditors during fraud Significant number of class action suits Many resignations-few served jail time

Financial Statement Fraud Statistics.

What Are the Motives for Financial Statement Fraud?

High Stock Prices

Bond or Stock

Offerings

Increase Personal Wealth

To Meet Expectation

s

Competition

Discuss Detecting Financial Statement Fraud.

Complete the Fraud Exposure Rectangle.

1 2

3 4

Fraud Exposure Rectangle

Management &

Directors

The Organization &

Its Industry

Company’s Relationship with Other

Entities

Financial Results & Operating

Characteristics

Discuss Management & Directors.

Backgrounds

Motivations

Influence on Decision Making

Financial Statements Requires Management’s Participation

Work “ON” Behalf of the Organization

Comment On & Explain Relationships with Others.

Related Party Transactions With Financial Institutions & Bond

Holders Improper or Unrealistic Transactions Auditors Attorneys Investors Regulators

Describe Questionable Organizations & Industries.

Structures designed to hide fraud Unduly complex organizations Legitimate purpose for each business

segment Active or passive board of directors Active or passive independent audit

committee Active, independent internal audit Board of directors with few outsiders Offshore activities without an apparent

business purposes

Is it a new business without a proven business history?

Have recent significant changes occurred in the nature of the organization?

Is monitoring of significant controls adequate?

Are accounting and IT staff organized and effective?

Is it a declining industry with increasing business failures and declining demand?

List What to Ask About Organization & Industry.

What Approach is Taken to Examine Financial Statements?

Non-Traditional

Examine Footnotes

Comparisons of FinancialStatement Balances with

Similar Organizations

Large Volumes Of Inventory Requires Large

Volumes of Space

See if Activities Match Between Organization &

Standard Operations

Comparisons of FinancialStatement Balances with

Similar Organizations

What Approach is Taken to Examine Financial Statements?

Define the Acronyms.

1. COSO is

2. SEC is

3. GAAP is

Committee ofSponsoring Organizations

Securities andExchange Commission

Generally AcceptedAccounting Principles

Match Terms & Definitions.

10-K

10-Q

AAER

SEC

Document released by SEC when a company commits financial statement fraud

Annual report publicly traded companies file with SEC

Government Agency responsible for regulating stock trading & financial Statements of Public companies

Quarterly report publicly traded companies file with SEC

Match Terms & Definitions.

Financial Statement Fraud

Financial Statements

Treadway Commission

Reports summarizing cash & profits of an organization

Intentionally misstating financial statements

It recommended changes in financial statements