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Common Financial Fraud Schemes

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DRAFT COMMON FINANCIAL STATEMENT FRAUD SCHEMES Jamal Ahmad, JD., C.P.A. David Jansen, C.A. Jonny J. Frank, J.D., LL.M. Contents 1 Introduction 2 Categories of Fraud 3 Fraudulent Financial Reporting 3.1 Earnings Management Methods Permissible by GAAP; The “Grey Zone” 3.2 Earnings Management Methods Not Permissible by GAAP 4 Overview of Largest Fraudulent Financial Reporting Cases (1997 – 2002) 5 Improper Revenue Recognition 5.1 Reviewing for and Investigating Allegations of Improper Revenue Recognition 5.1.1 Accounting Policies and Customer Contracts 5.1.2 Forensic Auditing Techniques 5.2 Side Agreements 5.3 Liberal Return, Refund Or Exchange Rights 5.4 Channel Stuffing 5.5 Early Delivery Of Products 5.5.1 Partial Shipments 5.5.2 Soft Sales 5.5.3 Contracts With Multiple Deliverables 5.5.4 Up-Front Fees 5.6 Bill and Hold Transactions 5.7 Fictitious Revenue Schemes 5.7.1 Fictitious Sales 5.7.2 Round Tripping
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Jamal Ahmad, JD., C.P.A.David Jansen, C.A.

Jonny J. Frank, J.D., LL.M.


1 Introduction

2 Categories of Fraud

3 Fraudulent Financial Reporting 3.1Earnings Management Methods Permissible by GAAP; The “Grey Zone”3.2Earnings Management Methods Not Permissible by GAAP

4 Overview of Largest Fraudulent Financial Reporting Cases (1997 – 2002)

5 Improper Revenue Recognition 5.1Reviewing for and Investigating Allegations of Improper Revenue

Recognition5.1.1 Accounting Policies and Customer Contracts5.1.2 Forensic Auditing Techniques

5.2 Side Agreements 5.3Liberal Return, Refund Or Exchange Rights5.4Channel Stuffing5.5Early Delivery Of Products

5.5.1 Partial Shipments5.5.2 Soft Sales5.5.3 Contracts With Multiple Deliverables5.5.4 Up-Front Fees

5.6Bill and Hold Transactions5.7Fictitious Revenue Schemes

5.7.1 Fictitious Sales 5.7.2 Round Tripping

5.8Other Improper Recognition Schemes 5.8.1 Recognizing Revenue On Disputed Claims Against Customers5.8.2 Holding The Books Open Past The End Of A Period5.8.3 Recognizing Income On Consignment Sales Or On Products

Shipped For Trial Or Evaluation Purposes5.8.4 Construction Accounting Schemes5.8.5 Sham Related Party Transactions

6 Asset Overstatement/Liability Understatement Schemes6.1Inventory Schemes

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6.1.1 Inflating Inventory Quantity (Fictitious Inventory)6.1.2 Inflating Inventory Value 6.1.3 Fraudulent Or Improper Inventory Capitalization

6.2 Accounts Receivable Schemes6.2.1 Creating Fictitious Receivables6.2.2 Artificially Inflating The Value Of Receivables

6.3 Investment Schemes 6.3.1 Fictitious Investments6.3.2 Manipulating The Value Of Investments

Misclassification of Investments Recording Unrealized Declines in Fair Market Value/Overvaluation

6.4 Improper Capitalization of Expenses 6.4.1 Software Development6.4.2 Research and Development6.4.3 Start Up Costs6.4.4 Interest Costs6.4.5 Advertising Costs

6.5 Recording Fictitious Fixed Assets6.6g Depreciation and Amortization Schemes

7 Understatement of Liabilities 7.1General 7.2Off Balance Sheet Entity Schemes

7.2.1 Off Balance Sheet Treatment versus Consolidation 7.2.2 The Old Rules 7.2.3 The “New” Rules

7.3Overstatement of Liability Reserves (“Cookie Jar Reserves”)

8. Improper or Inadequate Disclosures

9. Materiality

10 Misappropriation of Assets 10.1 Misappropriation of Cash

10.1.1 Skimming of Cash Unrecorded or Understated Sales or Receivables Lapping

10.1.2Fraudulent Disbursements Billing Schemes - Creation of Fictitious Vendors or Shell

Companies to Convert Monies Billing Schemes - False Credits, Rebates, Refunds and

Kickbacks Billing Schemes - Over billing Billing Schemes - Pay and Return Schemes Theft of Company Checks Payroll Fraud - Ghost Employees Payroll Fraud - Falsified Hours

10.2 Misappropriation of Inventory Conversion of Inventory


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10.2.1Conversion of Inventory 10.2.2False Write-Off’s and Other Debits to Inventory 10.2.3False Sales of Inventory

11. Other Fraudulent Revenue and Expenditures11.1 Revenue And Assets Obtained By Fraud11.2 Expenditures and Liabilities For An Improper Purpose


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1. Introduction

Statement on Auditing Standards No. 991 (“SAS 99”) requires auditors to focus

on two broad areas of fraud: (i) fraudulent financial reporting and (ii)

misappropriation of assets. Each of these has a multitude of fraud schemes.

This chapter provides an overview of the most common financial statement fraud

schemes, indicators of their occurrence, and methods of detection.

The focus is to familiarize the reader with certain fraud schemes, the various

indicators which evidence that these schemes may be or are being perpetrated

and how an auditor might detect those schemes. While this chapter discusses

numerous fraud schemes, it does not contain a comprehensive list of all possible

schemes. Similarly, with respect to the listed schemes, space constraints

prevent discussion of all possible detection procedures the auditor can perform to

determine whether the particular scheme exists.

2. Categories of Fraud

Fraud schemes can be grouped in various categories. For example, from a legal

perspective, frauds can be distinguished between: frauds by the corporation and

frauds against the corporation. Frauds committed by the corporation carry legal

risk, that is, potential civil, regulatory, and criminal liability. Frauds committed

against the corporation carry financial risk, that is, the loss of income or assets.

External and internal misappropriations of assets are by far the most common

fraud against the corporation.

This chapter groups, financial frauds into four broad categories:

Fraudulent Financial Reporting Schemes;

Misappropriation Of Assets;

Revenue And Assets Obtained By Fraud and

Expenditures and Liabilities For An Improper Purpose


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Most auditors would consider only to the first two categories (fraudulent financial

reporting and misappropriation of assets) to be financial statement frauds. The

final two categories although financial in nature, are not generally considered to

be financial statement frauds, as they do not impact upon the balances in the

financial statements.

3. Fraudulent Financial Reporting

Most fraudulent financial reporting schemes involve “earnings management”,

which the Securities and Exchange Commission (“SEC”) has defined as “the use

of various forms of gimmickry to distort a company’s true financial performance in

order to achieve a desired result.”2

Earnings management, however, does not always involve outright violations of

Generally Accepted Accounting Principles (“GAAP”) - - more often than not,

entities manage earnings by choosing accounting policies that bend GAAP to

attain earnings targets. Thus, it is important to distinguish between earnings

management techniques that are aggressive in nature but otherwise permitted by

GAAP, and those that clearly violate GAAP.

Accountants working with public companies, however, take note. The SEC takes

the position that compliance with GAAP will not necessarily protect an entity from

an SEC enforcement action, if financial performance is distorted.3

3.1 Earnings Management Techniques Permissible Under GAAP: The “Grey Zone”

GAAP frequently allows management alternative ways to record the operations

of an entity. For instance, GAAP allows any depreciation method, so long as it

systemically and rationally allocates the cost of the asset over its useful life.4

Similar instances in which management is provided wide latitude include:


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Changing depreciation methods from an accelerated method to the more conservative straight-line method or vice versa;

Changing the useful lives or the estimates of salvage values of assets; Determining the appropriate allowance required for uncollectible accounts

receivable; Determining whether/when assets have become impaired and are

required to be reserved against or written off; Choosing an appropriate method of inventory valuation (LIFO, FIFO,

specific identification etc.); Determining whether a decline in the market value of an investment is

temporary or permanent; and Estimating the write-downs required for investments.

Thus, in certain instances, GAAP “allows” a company to manage earnings by

simply altering its accounting policy to select those accounting principles that

benefit it most. The SEC itself has noted that accounting principles are not

meant to be a straightjacket and that flexibility of accounting is essential to

innovation.5 Abuses occur, however, when this flexibility is exploited to distort

the true picture of the corporation.6

Entities have a host of reasons for selecting those principles that will paint the

rosiest financial picture. Some would argue that the market demands it, as

reflected by the stock price punishment for companies that differ by as little as

one penny per share from prior estimates. External market pressures to “meet

the numbers” conflicts with market pressure for transparency in financial


Often, it is difficult to distinguish between “aggressive”, but allowable accounting

and that which is abusive and prohibited. How, for example, does one determine

whether management’s reserve for uncollectible accounts is or is not


The line between aggressive and fraudulent behavior hinges on management ‘s

intent. Fraud rarely occurs if management’s intent is transparent and clearly


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understandable. What, however, if management selects a GAAP permissive

policy to conceal a fraud or error? Does the selection of the otherwise allowed

policy demonstrate intent to commit fraud? Consider also whether management

selects a policy that it knows will have both a positive and negative effect on the

financial picture. If management selects the policy but refuses to recognize the

negative effect, does that demonstrate fraud in the selection of the policy?

Whether a fraud has been committed is fact-specific. For purposes of this

chapter, we have assumed that management has acted with malicious intent.

The case examples cited also involve instances where the company and/or its

management was charged and most often found guilty of wilfully engaging in the

alleged misconduct.

3.2 Earnings Management Methods Not Permissible by GAAP

Some financial frauds have no grey; that is, earnings management that are

clearly not within the parameters of GAAP. These techniques can inflate

earnings, create an improved financial picture, or conversely, mask a

deteriorating one.

Examples cited by the SEC include:

“Big Bath” charges; Creative acquisition accounting; “Cookie jar” liability reserves; Use of materiality to record small but intentional misstatements in the

financial statements; and Revenue recognition irregularities.7

4. Overview of Largest Fraudulent Financial Reporting Fraud Cases (1997 – 2002)

To demonstrate the breadth of recent fraud cases, the table below outlines some

of the larger and more publicized frauds and accounting scandals detected over

the period 1997 – 2002. The schemes involved an array of industries and


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included both frauds “by” and “against” the entity as well as corporate


Company Fraud Scheme Result

Adelphia Communications

Misappropriation of firm assets by executives for personal use.Concealment of $2.3 billion in loans to cover losses by founder and family members.

Declared bankruptcy in January 2002. CEO and family members charged with fraud.

Cendant Corp. As a result of its merger of HFC with CUC International, it was revealed that CUC overstated revenue by $500 million between 1995 and 1997 using assorted techniques such as recording fictitious revenues and understating liabilities.

Restated 1997 earnings decreased by more than $161 million. Former CFO, VP, and controller pled guilty to numerous other charges. Company settled $3.2 billion shareholder suitErnst & Young paid $335 million to settle shareholder lawsuit.

Enron Overstated income by intentionally understating liabilities and concealing debt through the creation of off balance sheet entities. Inadequately disclosed Co.’s off balance sheet transactions. Possible tax evasion.

Declared bankruptcy in December 2001.Lost more than $80 billion in market capitalization. Former CFO among others convicted of money laundering and securities, wire and mail fraud. Additional charges brought against others. Resulted in dissolution of company and accountants Arthur Anderson.

Global Crossing Charged with using "swap deals" with other telecom carriers to inflate sales.

Declared bankruptcy January 2002. SEC investigations pending.

K-Mart Inflated revenue by improperly recognizing entire $42.3 million in revenue from a multiyear contract in 2nd quarter of 2001.

Declared bankruptcy, January 2002. Two former VPs charged with earnings fraud.

MicroStrategy Improperly recognized revenue from sales of software as agreements were entered into rather than as services were

Restated earnings for fiscal years 1998 and 1999, which caused revenues to be reduced by almost $66


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Company Fraud Scheme Result

provided. million. Former CEO, COO, and CFO each fined $350,000.

Sunbeam Corp. Created $35 million in inappropriate restructuring reserves in 1996 that were reversed in 1997 to inflate income thus creating the illusion of a rapid turn around. In 1997, reported over $70 million of revenue from bill and hold sales, channel stuffing and other inappropriate accounting practices.

Restated 1997 income from $109 million to $38 million. CEO charged with violating federal securities laws by misrepresenting material information about the company. CEO settled by paying a piece of a $141 million fine.Former controller and chief accounting officer each agreed to pay $100,000 in fines. Former Arthur Anderson partner also settled for undisclosed amount.

Tyco International

Misappropriation of $600 million by CEO and CFO for personal use through theft and the false sale of securities. Company also separately sued former CEO seeking the return of more than $100 million. Suit alleges CEO gave himself unauthorized bonuses totalling $58 million and unauthorized loans of more than $43 million, and of taking personal credit for more than $43 million in charitable donations that actually were made by Tyco.

Three former executives including CEO and general counsel arrested for fraud. CEO also charged with avoiding payment of over $1 million in sales taxes on $13 million of artwork

WorldCom Intentionally improperly capitalized billions of dollars of expenses as capital expenditures. Former CEO facing possible charges for allegedly profiting improperly from IPOs offered by brokerages in return for investment banking business.

Declared bankruptcy, July 2002. Former finance chief and finance and accounting executives charged with securities fraud.

Xerox Overstated revenue for over 4 years by accelerating the

Co. agreed to pay $10 million in fines and restate its income


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Company Fraud Scheme Result

recognition of $3 billion in revenue and inflating earnings by about $1.5 billion. Alleged scheme included the recognition of revenue on its office copier leases too early in their cycles.

for the years 1997-2000.

SEC sued three current KPMG partners and one former partner of securities fraud in the claiming the firm fraudulently let the Co. manipulate its accounting practices to fill a $3 billion gap and make it appear to be meeting market expectations.

5. Improper Revenue Recognition

Improper recognition of revenue - either prematurely or of fictitious revenue – is

the most common form of fraudulent earnings management. Premature

recognition of revenue involves the recording of revenue generated through

legitimate means, at any time prior than would be allowed under GAAP.

Premature recognition should be distinguished from recognition of fictitious

revenue derived from false sales or to false customers.

The Report of the National Commission on Fraudulent Financial Reporting

(hereinafter, “ the COSO Report”)8 found that improper revenue recognition was

alleged in 47% of the cases reviewed by the Commission from 1981 to 1986. A

second COSO Report found that the number of revenue recognition alleged

matters accounted for 50% of all matters enforced by the SEC from 1987-1997.9

According to SEC figures, 32 of the 90 actions bought by the Commission in

1999 involved improper revenue recognition using such techniques as side

letters, rights of return, consignment sales, and the shipping of unfinished

products. Another 12 cases involved the booking of fictitious sales.10

A PricewaterhouseCoopers study revealed that in the year 2000, 66% of the

shareholder actions filed alleged revenue recognition violations.11 In 2001, the

number of revenue recognition actions jumped to 69% of all actions filed.12


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Finally, of the approximately 140 earnings management/accounting cases

brought by the SEC in 2002, more than half related to revenue recognition.13

With respect to premature recognition, SEC Staff Accounting Bulleting 101,

Revenue Recognition in Financial Statements, (“SAB 101”) 14 spells out four

basic criteria that must be met before a public company may recognize revenue.

Specifically, these criteria require:

Persuasive evidence that an arrangement exists; Evidence that delivery has occurred or that services have been rendered; A showing that the seller's price to the buyer is fixed or determinable; and Ability to collect payment must be reasonably assured.

SAB 101 echoes the recognition requirements originally listed in AICPA

Statement of Position (“SOP”) 97-2, Software Revenue Recognition15, which

governs the software industry. Accountants should also refer to industry specific

literature depending upon the client and circumstances.16 In fact, SAB 101

explains that where it exists, companies should apply industry specific authority

over SAB 101.

Many of the schemes described in this chapter violate more than one of the SAB

101 recognition criteria. The indicia for each listed scheme are not mutually

exclusive; that is; factors indicating the potential existence of one scheme can

often be used to detect others.

Companies can use numerous methods to engage in premature or fictitious

revenue recognition. Following are the most common techniques:

Agreements or policies which grant liberal return, refund or exchange rights;

Side agreements; Channel stuffing; Early delivery of product

Contracts with multiple deliverables; Soft sales; Partial shipments; and Up-front fees;

Bill and hold transactions;


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Recording false sales to existing customers and false sales to fictitious customers;

Round tripping Other forms of improper recognition:

Recognizing revenue on disputed claims against customers; Holding the books open past the end of a period; Recognizing income on consignment sales or on products

shipped for trial or evaluation purposes; and Improper accounting for construction contracts ; and

Sham related party transactions.

5.1 Reviewing For and Investigating Allegations of Improper Revenue Recognition

5.1.1 Accounting Polices and Customer Contracts

Inquiries into alleged improper revenue recognition usually begin with a review of

the entity’s revenue recognition policies and customer contracts. The auditor

considers the reasonableness of the company’s normal recognition practice and

whether the company has done everything necessary to comply. For example, if

the company customarily obtains a written sale agreement, the absence of a

written agreement becomes a red flag.

The review should begin with a detailed reading of the contract terms and

provisions. Particular attention should be focused upon terms governing (i)

payment and shipment, (ii) delivery and acceptance, (iii) risk of loss, (iv) terms

requiring future performance on the part of the seller before payment, (v)

payment of up-front fees, and (vi) other contingencies. The auditor must consider

timing – particularly as it relates to the company’s quarter and year-end periods.

In which periods were the sales agreements obtained? When was the product or

equipment delivered to the buyer’s site? When did the buyer become obligated

to pay? What additional service(s) was required of the seller?

In the absence of a written agreement, the auditor should consider other

evidence of the transaction, e.g. purchase orders, shipping documents, payment

records, etc. He or she should also consider SAB 101 as well pronouncements


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specific to the particular business, as accounting literature often contains relevant

examples and issues. For example, companies engaged in business over the

internet face unique revenue recognition issues. The Emerging Issues Task

Force Abstract (“EITF”) 99-19, Reporting Revenue Gross as a Principal versus

Net as an Agent, 17 attempts to solve this problem by listing factors which are

considered by the SEC in determining whether revenue should be reported on a

gross or net basis. Similarly EITF 01-9, Accounting for Consideration Given by a

Vendor to a Customer (Including a Reseller of the Vendor’s Products),18

addresses the issue of sales incentives, such as discounts, coupons, rebates,

and "free" products or services offered by manufacturers to customers of retailers

or other distributors. Being aware of the applicable authority governing the facts

and circumstances can assist the auditor in his determination of recognition


5.1.2 Forensic Auditing Techniques

The auditor should perform the following techniques when investigating revenue

recognition allegations:

Inquire of management and other relevant personnel as to the existence factors causing the auditor to believe the scheme exists19;

Perform substantive analytics designed to detect the fraud being investigated; and

Perform substantive testing to determine whether there is evidence to support the existence of a scheme or lack of evidence to support the validity of a transaction. Such substantive procedures include but are not limited to:

- Request and review documents such as contracts and support for invoices and deliveries;

- Confirmation with customers to the existence of accounts receivable and the amount of consigned goods;

- Possible public records/background research/site visits conducted on customers/third parties to verify existence of the entity being billed;

- Analyzing journal entry activity and supporting documentation in certain accounts, focusing on round dollar entries at the end of periods;


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- If entries are accruals, obtaining support for the reversal and confirming the proper timing of the entries.

The following general indicators can often alert the auditor or auditor as to the

potential existence of premature revenue recognition:

Unexplained change in recognition policies; Unexplained improvements in gross margin; Increasing sales with no corresponding increase in cash from operations; Reported sales, revenue or accounts receivable balances which appear to

be to high or are increasing too fast; Reported sales discount, sales returns or bad debts expenses which

appear to be too low; Large, numerous or unusual sales transactions occurring shortly before

the end of the period; Large amounts of returns or credits after the close of a period; or Inconsistent business activity –

- Increased revenues with no corresponding increase in distribution costs or

- Increased revenues with no offsetting increase in accounts receivable.

The use of analytics should also not be overlooked as a means of detecting

fraud. Analytical procedures and relationships the auditor can perform or review

to determine whether revenue is being recognized prematurely include:

Comparing current period financial statement line item amounts with amounts from prior periods and inquiring as to significant changes in accounts between periods (Horizontal Testing, See Chapter );

Reviewing balances in revenue related accounts for unusual changes; Calculating the percent of sales and receivables to the total balance sheet

in the current period, comparing it with prior periods and inquiring of any unusual changes (Vertical Testing, See Chapter ) ;

Reviewing the statement of cash flows to determine if cash collected is in proportion to reported revenues;

Reviewing sales activity for the period and note any unusual trends or increases such as increases towards the end of the period;

Significant or unusual or unexplained changes in the following particular ratios (See Chapter XX for a detailed explanation of ratios):

o Increases in Net Profit Margin (Net Income/Total Sales);o Increases in Gross Profit Margin (Gross Profit/Net Sales); o Increases in the Current Ratio (Current Assets/Current Liabilities); o Increases in the Quick ratio (Cash and Receivables and Marketable

Securities/Current Liabilities);o Increases in the Accounts Receivable Turnover (Net Sales/A/R);


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o Increases to Days Sales Outstanding (A/R Turnover/365); o Increases in Sales Return Percentages (Sales Returns/Total

Sales); o Increase in Asset Turnover (Total Sales/Average Total Assets); o Increases in Working Capital Turnover (Sales/Average Working

Capital); o Decrease in A/R Allowance as a % of A/R (Allowance/Total A/R);

ando Decreases in the bad debt expense or allowance accounts.

Of course, good interviewing and sound analytics will not substitute for having a

good understanding of the client’s business. Even seasoned auditors have been

misled and thought revenue to be appropriate because they did not fully

understand the business. Thus, after all the analytics and interviews, the auditor

must ask him or herself whether the information and results obtained make

sense in light of the client’s industry and business. The auditor should also to the

extent applicable, benchmark performance results against other companies in

the same industry.

5.2 Side Agreements

While SAB 101 requires a definitive sales or service agreement, agreements can

and often are legitimately amended. Problems arise however when a company

enters into such an arrangement and subsequently modifies, supplements,

revokes, or otherwise amends the original agreement with a written or oral side

agreement prepared and agreed to outside the normal reporting channels of the


Management often employ side arrangements or letters to boost sales figures.

Sales force members also use them to meet sales targets or to obtain

undeserved commissions. Side agreements created outside of the normal and

proper recording channels are often used to perpetrate many of the schemes

listed in this chapter.


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The existence of numerous side agreements should raise red flags to the auditor

and require further detailed inquiry as to the facts and circumstances surrounding

how, when and why the agreements were entered into. Additional investigation

is warranted if the inquiry points to preparation outside the normal reporting


Common side agreement fraud schemes involve:

Liberal or unconditional rights of return granted to customers; Rights to cancel orders at any time; Contingencies that nullify the sale, such as:

o Re-sale;o Receipt of funding;

Rights of continuing negotiations; and Extension of payment terms.

Case Illustration

The case of Informix Corp illustrates the improper use of side-agreements.20

Informix sold licensed software to companies, which, in turn, would resell the

licenses to third parties. Consistent with then current GAAP for revenue

recognition with respect to software21, the company’s written policy was to

recognize revenue from the sale of licenses only upon receipt of a signed and

dated license agreement. However, to meet the earnings expectations of the

company and financial analysts, management entered into numerous written and

oral side agreements containing different provisions, which caused them to

violate GAAP revenue recognition principles. These provisions included:

Allowing resellers to return and to receive a refund or credit for unsold licenses;

Committing the company to use its own sales force to find customers for resellers;

Offering to assign future end-user orders to resellers; Extending payment dates beyond twelve months; Committing the company to purchase computer hardware or services from

customers under terms that effectively refunded all, or a substantial portion, of the license fees paid by the customer;

Offering to pay for customer storage costs; Diverting the company's own future service revenues to customers as a

means of refunding their license fees; and


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Paying fictitious consulting or other fees to customers to be repaid to the company as license fees.

Auditors should perform inquiries of management, accounting and sales

personnel as to whether they are made aware of all side agreements entered into

by the other party that modify sales in any one of the methods mentioned or in

any other fashion. The auditor should also inquire of sales people whether they

are allowed or encouraged to use side letters or agreements to complete a sale

and whether these agreements are made using proper reporting channels.

In addition to inquires, the auditor should review the company’s right of return

policy and understand its rationale. The auditor should satisfy him or herself by

reviewing a sample of contracts for side agreements and confirm with a sample

of customers the major contract terms of their contracts, including the existence

or absence of any side agreements.

5.3 Liberal Return, Refund, Or Exchange Rights

Most industries allow customers to return products to sellers for any number of

reasons, and GAAP allows entities to recognize revenue in certain cases even

though the customer may have a right of return. Specifically, Statement of

Financial Accounting Standard (“SFAS”) No. 48, Revenue Recognition Where

Right of Return Exists22 provides that when customers are given a right of return,

revenue may be recognized at the time of sale if the:

Sales price is substantially fixed or determinable at the date of sale; Buyer has paid or is obligated to pay the seller; Obligation to pay is not contingent on resale of the product; Buyer's obligation to the seller does not change in the event of theft or

physical destruction or damage of the product; Buyer acquiring the product for resale is economically separate from the

seller; Seller does not have significant obligations for future performance or to

bring about resale of the product by the buyer; and Amount of future returns can be reasonably estimated.23


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Sales revenue not recognizable at the time of sale is recognized either when the

return privilege has substantially expired or if the above conditions are

subsequently met. Companies can and often do run astray of SFAS 48 by

establishing accounting policies or creating sales agreements which (i) grant

customers vague or liberal rights of returns, refunds or exchanges, (ii) fail to fix

the sales price, (iii) make payment contingent upon resale of the product or some

other future event such as the receipt of funding from a lender.

Payment terms that extend over a substantial portion of the period in which the

customer is expected to use or market the purchased products also create

problems. These terms effectively create consignment arrangements inasmuch

as no economic risk has been transferred to the purchaser. As will be discussed

in Section 5.9.3, sales under consignment arrangements cannot be recorded as


Case Illustration

In the case of Midisoft Corporation, 24 the SEC charged the company with

overstating revenue on in the amount of $458,000 on transactions for which

products were shipped, but for which, at the time of shipment, the company had

no reasonable expectation that the customer would accept and pay for the

products. The company eventually accepted back most of the product as sales

returns during the first quarter of the subsequent period.

The SEC noted that Midisoft’s written distribution agreements generally allowed

the distributor wide latitude to return product to Midisoft for credit whenever the

product was, in the distributor's opinion, damaged, obsolete, or otherwise unable

to be sold. In preparing Midisoft's financial statements for fiscal 1994, company

personnel submitted a proposed allowance for future product returns that was

unreasonably low in light of the large levels of returns Midisoft received in the first

several months of 1995. Furthermore, various officers and employees in the

company’s Accounting and Sales Departments knew the exact amount of returns


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the company had received prior to the end of March 1995, when the company’s

independent auditors finished their field work on the 1994 audit. Had Midisoft

revised the allowance for sales returns to reflect the returns information, it would

have had to reduce accordingly the amount of net revenue reported for fiscal

1994. Instead, several Midisoft officers and employees devised schemes to

prevent the auditors from discovering the true amount of the returns including

preventing the auditors from touring that portion of the Midisoft headquarters

where the returned goods were stored. In addition, Midisoft accounting

personnel altered records contained in the computer accounting system to

reduce falsely the level of returns.

Midisoft teaches that the auditor should carefully review the terms of the

contracts and any side or extension agreements to determine what rights are

afforded the customer with respect to returning and exchanging the delivered

product. Only in those cases where the customer has limited or no right to return

the product should revenue be recognized. The auditor should also inquire into

the company’s refund and exchange policy: how it was derived, whether it is

subject to override, by whom and how often it is overridden. Other relevant

inquiries include sales personnel as to whether the company has offered

customers price concessions, refunds, or new products.

Auditors should also inquire of accounting staff and financial personnel as to the

returns policy and confirm with warehouse personnel who process returns that

the policy is being followed. In addition to the inquiries, the auditor may also

choose to perform the following analytics:

Compare returns in current period to prior periods and inquire as to any

unusual increases; Determine whether returns are processed timely (this may require a visit

an inquiry with warehouse personnel, an inquiry can also be made of customers on confirmations)

o Companies may slow down the return processing process to avoid reducing sales in the current period.


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Perform sales return percentage (Sales Returns/Total Sales) and inquire as to any unusual increase; and

Compare returns subsequent to reporting period to both the return reserve and the monthly returns for reasonableness.

5.4 Channel Stuffing

Channel stuffing refers to the practice of offering deep discounts, extended

payment terms or other concessions to customers to induce the sale of products

in the current period, when they would not have not been otherwise sold until

later periods, if at all.

Case Illustration

The case against Sunbeam Corporation25 is illustrative. In December 1997,

Sunbeam established a program offering discounts, favourable payment terms,

guaranteed mark-ups and the right of return or exchange on unsold products to

any distributor willing to accept the company’s products before year-end. The

company failed to disclose this practice in its quarterly 10Q. As a result, the SEC

charged that the company’s 10Q statement was misleading and that the

company had eroded future sales and profit margins by pulling them into the

current period.

Channel stuffing often is indicated by an increase in shipments, which is usually

accompanied by an increase in shipping costs, at or near the end of period.

Where these circumstances occur, the auditor or auditor should (i) inquire

whether the goods were sold at steep discounts and (ii) review customer

contracts and side agreements for unusual discounts in exchange for sales and

rights of return provisions. The auditor should also inquire of sales personnel and

shipping personnel regarding management influence to alter normal sales

channel requirements.


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In addition, customers offered deep discounts often purchase inventory in excess

of required needs to take advantage of the reduced prices. This excess,

inventory is often returned by the customer after the close of the period as it

cannot be resold. The auditor thus should consider the amount of returns shortly

after the close of a period as compared to prior periods and margins on sales

recorded immediately before the end of a reporting period.

5.5 Early Delivery of Product

Companies can circumvent the SAB 101 delivery requirement in a variety of

ways including:

Shipping unfinished or incomplete products to customers, or at a time prior to when customers are ready to accept them;

Engaging in “soft sales” (shipping of products to customers who have not agreed to purchase);

Recognizing the full amount of revenue on contracts where services are still due to the client, and/or

Recognizing the full amount of revenue on fees collected up front.

Based on the provisions of SAB 101, income should not be recognized under

these circumstances because delivery has not actually occurred.

Customers on the other side of early delivery schemes often return the

unfinished product or demand more completion before payment is rendered.

Analytics that may reveal the existence of an early delivery scheme include:

Comparing returns in the current period and prior periods; Comparing shipping costs in current period and prior periods; and Comparing shipping costs as a percentage of revenue in the current

period and prior periods.

Careful scrutiny of the sales contract will also assist to detect these schemes.

When must payment be made in relation to delivery? Which party bears the risk

of loss on shipment? The audit or investigative team should then compare these

contract terms with the requirements of SAB 101 and other accounting literature.


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The auditor should also make broad inquiries of non-financial personnel such as:

Shipping department personnel:Were shipments earlier than normal for customers?Is inventory stored in the warehouse documented as shipped?Was there inventory shipped to addresses other than customer sites?Were there any adjustments to shipping dates?Whether there exists consigned goods and their location.

Sales force personnel:Are shipments of any products designed to arrive ahead of the customer’s required delivery date?Do sales personnel pick up product and deliver to customers?Are there sales personnel with excessive “samples”? Do sales personnel have free reign in access to the warehouse?

Warehouse personnel: - Are there any misstatements in the amount of merchandise the

company ships or receives? - Has there been destruction, concealment, predating, or postdating of

shipping and/or inventory documents?- Has there been an acceleration of shipments prior to month or year-

end?- Have there been shipments to a temporary or holding warehouses

prior to final shipment to the customers’ premises?- Are there any other unusual, questionable, or improper practices?

Additional audit procedures include:

Comparing the purchase order date with the shipment date; Determine whether sales personnel are paid commissions based on

the sale of product or upon collection; Inquiring of outside related business interests of key/sales personnel

that may be suspected in an improper revenue recognition scheme; Performing public records searches on certain entities and individuals; Determining whether shipments have been made to these outside

business interests; Reviewing amounts and trends of shipping costs at or near the end of

a period even to legitimate customers; Reviewing rate of returns; Inspecting shipping documents for missing, altered or incorrect

information; and Reviewing customer complaint logs or e-mail correspondence for

complaints of shipments of goods prior to the customer’s readiness to accept.

5.5.1 Partial Shipments


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Many companies will prematurely recognize 100% of revenue on partial or

incomplete shipments of customer orders. The delivery requirement is not met, if

the unshipped portion constitutes a substantial portion of the total deliverable.

Case Illustration

The SEC’s enforcement action against FastComm Communications Corp is

illustrative.26 In 1999, the SEC charged FastComm with recognizing revenue on

the sale of products that were not fully assembled or functional. The SEC

charged that it was improper because delivery had not yet occurred.

Auditing for partial shipments is similar to auditing for early product delivery. The

auditor must consider:

Numerous returns of incomplete products after the close of period by customers seeking the full product;

Large, numerous or unusual transactions occurring shortly before the end of the period;

Examining product details on the invoices; Is the invoice cut with all products ordered whether shipped or not?

Obtain understanding of drop shipments to customers; if a drop shipment is partial, is the invoice to the customer also partial?

How does the company ensure all drop shipped products are properly accounted for in the sales invoice process and also in paying for the goods to the supplier?

Reviewing customer complaints regarding lack of completeness in shipments.

In addition, the auditor will want to inquire of management and sales personnel

regarding the policy and process for billing partially filled orders. A review of the

shipping documents and comparison to the sales journal will also often reveal

what was booked as sales and what was actually shipped. The auditor may also

consider talking to customers or reviewing correspondence from customers to

see if there are numerous complaints from customers regarding partial



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5.5.2 Soft Sales

Case Illustration

In 1996, the SEC charged Advanced Medical Products employees with

recognizing revenues on “soft sales” or sales for which the customer had

expressed interest but not actually committed to purchasing. The company

shipped the products to its field representatives, who held them while the

customer decided whether to purchase the product.

The company however, recognized the revenue as of the date of the shipment to

the field representative. Employees withheld sending invoices and monthly

statements to prevent customer complaints resulting from being invoiced for

equipment that they had not agreed to purchase.

To detect this scheme, the auditor may wish to review customer complaint logs

and correspondence for complaints of goods shipped prior to the customer’s

readiness to accept or when the customer was merely making inquiry into the


5.5.3 Contracts With Multiple Deliverables

Another common scheme occurs when companies ship product or equipment to

customers who are not obligated to pay for such equipment until it is “accepted.”

Acceptance typically requires a seller to substantially complete or fulfil all the

terms of an arrangement before delivery is deemed to have occurred. Common

customer acceptance provisions included in contracts that, if not satisfied by the

seller, would preclude recognition include:

Seller’s obligation to perform additional services subsequent to the delivery, e.g., product installation and activation;

Product testing prior to payment; and Training of personnel with respect to produce use.


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If a contract requires the seller to provide “multiple deliverables” or elements, the

delivery is not deemed complete unless substantially all elements or deliverables

are delivered. The sales revenue should be recognized only if inconsequential

elements remain to be delivered.

When assessing whether revenue can be recognized prior to delivery of all

required elements or deliverables, the criteria under GAAP is whether the

undelivered portion is “essential to the functionality” of the total deliverable.27

SAB 101 enumerates several factors that should be considered in determining

whether remaining performance obligations are substantial or inconsequential.28

Case Illustration

The SEC action against Advanced Medical Products is a classic example of

improperly recognizing revenue on contracts with multiple deliverables.29 Rather

than shipping the product to the customer, Advanced Medical Products shipped

products to company’s field representatives, who were responsible for installing

the product and training the customer’s employees. The SEC charged that the

company incorrectly recognized revenue upon shipment to the field

representatives. This policy contravened GAAP as there was no economic

exchange and risk of loss had not passed to the customer because the products

were still in the control of the company.

In addition to the general indicators listed above, this scheme, which has been

prevalent in the software industry, can possibly be uncovered by confirming with

major customers whether all services have been performed with respect to the

products purchased and received. For companies that deal with distributors of

their product, auditors should obtain an understanding as to whether the

company “forces” a pre-determined listing of SKUs to its distributors, without an

order from the distributors. If this is the case, there may be a culture of forcing

product out to distributors to ‘meet the numbers.’ A rash of returns from the

distributors in subsequent months might also reveal this practice. Further


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manipulation of the books and records can occur by the entity when these

returns are not processed in a timely fashion.

5.5.4 Up-Front Fees

Some firms will collect up-front fees for services provided over an extended

period, e.g., maintenance contracts. SAB 101 provides that up-front fees should

generally be recognized over the life of the contract or the expected period of


5.6 Bill and Hold Transactions

“Bill and Hold” schemes are another common method of bypassing the delivery

requirement. As its name implies, a legitimate sales order is received,

processed, and ready for shipment. The customer however, for whatever

reason, may not be ready, willing, or able to accept delivery of the product at that

particular point in time. The seller holds the goods in its facility or ships them to a

different location, such as a third party warehouse for storage until the customer

is ready to accept shipment.

The seller however, recognizes revenue immediately upon shipment. The

auditor must consider whether the seller has met (or is seeking to circumvent)

enumerated specific criteria established by the SEC30, including whether:

Risk of ownership has passed to the buyer; Customer has made a fixed commitment to purchase the goods,

preferably in written documentation; Buyer must request that the transaction be on a bill and hold basis; Buyer must have a substantial business purpose for ordering the goods on

a bill and hold basis; Delivery must be fixed and on a schedule that is reasonable and

consistent with the buyer's business purpose; Seller must not retain any specific performance obligations under the

agreement such that the earning process is not complete; Ordered goods must be segregated from the seller's inventory and not be

subject to being used to fill other orders; and


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Product must be complete and ready for shipment.

In addition to the above factors, the SEC also recommends preparers of financial statements to consider:

The date by which the seller expects payment, and whether the seller has modified its normal billing and credit terms for this buyer;

The seller's past experiences with and pattern of bill and hold transactions; Whether the buyer has the expected risk of loss in the event of a decline

in the market value of goods; Whether the seller's custodial risks are insurable and insured; and Whether extended procedures are necessary in order to assure that there

are no exceptions to the buyer's commitment to accept and pay for the goods sold (i.e., that the business reasons for the bill and hold have not introduced a contingency to the buyer's commitment).31

Auditors coming across agreements that do not meet the above criteria should

be wary of potential bill and hold schemes. Auditors should consider whether:

Bills of lading are signed by a company employee rather than shipping company;

Review of shipping documents indicates excessive shipments made to warehouses rather than to a customer's regular address (which could mean that shipments are made to the seller’s warehouses rather than customer locations);

Shipping information is missing on invoices; High shipping costs incurred near the end of the accounting period; Large, numerous or unusual sales transactions occurring shortly before

the end of the period; or Decrease in current year monthly sales from the prior year that may

indicate the reversal of fraudulent bill and hold transactions in a subsequent period.

When confronted with the above indicators, the auditor should first inquire of

management regarding any bill and hold policies and any customers with bill and

hold arrangements. The auditor should also make inquiry of warehouse

personnel regarding “customer” inventory being held on the premises in a third

party warehouse, or shipped to another company facility. Finally, the auditor

should inquire of shipping department or finance personnel if they have ever

been asked to falsify or alter shipping documents.


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If additional investigation is warranted, the auditor should review the customer

contracts to determine whether they meet the requirements of SAB 101

enumerated above. The auditor should also:

Review underlying shipping documents for accuracy and verify existence of transactions;

Compare shipping costs to prior periods for reasonableness. Review warehouse costs and understand the business purpose of all

warehouses owned/used by the company; Confirm special bill and hold terms with customers directly including

transfer of risk of loss and liability to pay for the bill and hold goods; Test reconciliation of goods shipped to goods billed for accuracy; Select a sample of sales transactions from the sales journal, obtain the

supporting documentation and - Inspect the sales order for approved credit terms;- Compare the details among the sales orders, shipping documents and

sales invoices for inconsistencies; - Compare the prices on sales invoices against published prices; and - Re-compute any extensions on sales invoices; and

In conjunction with the physical inventory, tour the facility or warehouse and inquire of warehouse personnel about any held customer products.

Case Illustration

In 2003, the SEC charged Anika Therapeutics with improperly recognizing

approximately $1.5 million in revenue form a bill and hold transaction. A

distributor placed orders with Anika for a total of approximately 15,000 units of a

particular product in April and July 1998. As part of the agreement with the

distributor, Anika invoiced the distributor for the total 15,000 units for over

$500,000 in September 1998 but held the product at Anika’s refrigerated facility

until the distributor requested the product, which did not occur until March 1999.

However, Anika recorded the revenue for this sale in the quarter ended

September 30, 1998. 32

5.7 Fictitious Revenue Schemes


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Schemes to create fictitious revenues, as opposed to prematurely recognize

revenue, cross the line between the potentially defensible and the completely


5.7.1 Fictitious Sales to Existing or Non Existent Customers

A common technique to overstate revenues is to create fictitious orders either for

existing or fictitious customers. These schemes involve the preparation of false

supporting documentation to provide “backup” to non-existing sales or services

never rendered.

Fictitious revenue schemes can and often will be detected by the same methods

used to detect premature revenue recognition schemes. Auditors should


Discovery of significant revenue adjustments to revenue at the end of the reporting period;

Unexpected increases in sales by month at period end; Customers with unknown names or addresses or which have no apparent

business relation to the business; Increased sales accompanied by stagnant or decreasing cost of sales and

corresponding improvement in gross margins; Improvement in bad debts as a percentage of sales; and/or Decrease of shipping costs compared with sales.

Fictitious revenue schemes are relatively easy to investigate, once detected.

The audit or investigative team should focus on accounting personnel and inquire


Revenues are recorded outside of the normal invoicing process, or standard monthly journal entries;

Journal entries have adequate, proper and bona fide supporting documentation;

Accounting personnel have been pressured to make or adjust journal entries; and

Accounting or sales personnel have been pressured to create false invoices for existing or fictitious customers.


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The auditor should also inquire whether sales or shipping personnel have noted

any unusually high sales or shipments to customers with no reasonable

explanation or noted any significant sales or shipments to unfamiliar new


Auditors should also consider the following detection procedures:

Send confirmations to customers who may be associated with suspicious transactions;

Perform alternative procedures for confirmations not returned or returned with material exceptions such as:

- Including other matters on the confirmations such as any consigned inventories held at the customer location or held for the customer; and

- Including amount of pending returns on the confirmation as a blank line for the customer to complete.

Review journal entries and supporting documentation, and verify their accuracy;

Identify amount of returns in subsequent period; Look for sales which reverse in the subsequent period; and Conduct research of publicly available information (e.g., on-line database,

manual record and Internet) to verify existence and legitimacy of customers. Follow up physical visits may also be prudent.

Case Illustration

Consider the case of medical device supplier, Boston Japan33, which during fiscal

years 1997-1998 recognized over $75 million dollars of revenue from fraudulent

sales. Company sales managers leased commercial warehouses, recorded false

sales to distributors, and shipped the goods to the leased warehouses. The

company masked the fact that the distributors never paid for the goods by issuing

credits to the distributors and then recording false sales of the same goods to

other distributors, without ever moving the goods out of the leased warehouses.

Company employees even recorded sales to distributors that were not involved

in the medical device business, but that had agreed with company sales

managers to collude in the fraud. Some of the false sales were made to

distributors that never resold any of the goods and never paid Boston Japan for

any purported sales. The sales managers and cooperating independent


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distributors further colluded to cover up false sales by falsely confirming the

legitimacy of the sales to the company’s auditors.

5.7.2 Round Tripping

Round tripping consists of recording transactions that occur between companies

for which there is no economic benefit to either company. For example, a

company that provides a loan to a customer so that the customer can purchase

the product engages in round tripping if the loan was issued with no real prospect

that the customer will ever repay the loan. These transactions are deemed

completed for the sole purpose of inflating revenue and creating the appearance

of strong sales.

Round tripping recently has occurred extensively in the telecommunications and

oil and gas industries. For example, numerous telecommunication companies

boosted their sales volume by exchanging the indefeasible rights of use on their

fiber-optic networks to other telecommunications companies (this practice was

known in the industry as “capacity swaps.”) These transactions were sometimes

booked as income even though the swaps generated no net cash for either


Case Illustration

In 2002, the SEC began investigating the way telecom giant Qwest

Communications International Inc. and some of its competitors, such as Global

Crossing accounted for sales of fiber-optic capacity and whether it was proper for

the company to recognize the revenue right away immediately.

Qwest sold capacity on their fiber-optic network to carriers and also purchased

capacity from them. Both companies recognized revenue from capacity swaps

and indefeasible rights of use (“IRU”) that allowed another carrier or company the

unfettered use of the capacity over a long period of time. In some cases, the


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amount of the sale and purchase were almost identical. Qwest booked the

revenue from these sales all at one time instead of deferring part of it over many

years. GAAP however, requires companies to record the revenue generated by

an IRU over the time of the contract.

The effect was to boost Qwest's revenue by $1 billion in 2001 and $465 million in


Since most roundtrip transactions involve counterparties in the same line of

business, an auditor should review a list of the company’s significant customers.

If there is a customer in the same line of business, the auditor should scrutinize

the transactions for evidence of any round tripping. The auditor should also

review the vendor list and compare it to the customer list. The same company

appearing on both lists might indicate round tripping. There is always the

possibility of an intermediary being involved in the transaction, so an auditor

should be aware of companies that appear on the two lists but would not be valid

customers or vendors. Round tripping often takes place with related parties so

the auditor should be aware of related party transactions and follow the steps

outlined in Section 5.9.5

5.8 Other Improper Recognition Schemes

5.8.1 Recognizing Revenue On Disputed Claims Against Customers

Reasonable assurance of payment is basic to revenue recognition. Companies

sometimes circumvent this requirement by recognizing the full amount of revenue

even though the customer has for some reason disputed payment. Auditors

should inquire as to all receivables that are in dispute and, if necessary, confer

with legal counsel for the company to assess whether collection of the revenue is

sufficiently certain to be able to be properly recognized.


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5.8.2 Holding The Books Open Past the End of a Period

Improperly holding open the books beyond the end of an accounting period can

enable companies to record additional end of period sales that are invoiced and

shipped after the end of a reporting period. While standard cut-off testing will

often discloses these schemes, auditors should be cognizant and skilled in

detecting manipulation of information systems to achieve this result. Direct

inquiry of accounting personnel, billing clerks and warehouse personnel may

assist in determining whether the books are held open past the end of the period.

Computer forensics can also be used to ferret out these schemes.

Case Illustration

In 1993, the management of Platinum Software Corp., was concerned about the

company’s "days sales outstanding" ("DSO") – the measure of the time a

company takes to collect its receivables. The company’s DSO had increased

throughout 1993, in part because it had improperly recognized revenue on

contingent or cancelled license agreements. One of the company’s responses to

the increasing DSO was to hold open the company’s open for cash received after

period-end. Management recorded checks received by the company in July

1993, on the company’s balance sheet as an increase in cash and a reduction in

receivables as of June 30. Holding the books open resulted in a cash

overstatement and associated receivable understatement. Similarly, for the

quarter ending September 1993, management included cash that the company

received for about a week into October, resulting in a cash overstatement and

accounts receivable understatement of $724,000. The same pattern continued

through December 1993, resulting in a cash overstatement and accounts

receivable understatement of $3,463,000. The company was ultimately ordered

to cease and desist in this practice by the SEC.

5.8.3 Recognizing Income on Consignment Sales or Products Shipped for Trial/Evaluation Purposes


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SAB 101 prohibits revenue recognition from consignment arrangements until

completion of actual sale. The same criteria apply to products delivered for

demonstration purposes. 34 The reason for this is that in a typical consignment

arrangement, neither title nor the risks and rewards of ownership pass from the

seller to the buyer. Consignment sales and sales shipped under trial or

evaluation purposes are thus merely specific examples of contingent events

which must be satisfied before revenue can be recognized. Particular attention

must be paid to the terms, facts and circumstances of any agreement in which:

The buyer has the right to return the product and

- Buyer does not pay the seller at the time of sale, and the buyer is not obligated to pay the seller at a specified date or dates;

- Buyer does not pay the seller at the time of sale but rather is obligated to pay at a specified date or dates, and the buyer’s obligation to pay is contractually or implicitly excused until the buyer resells the product or subsequently consumes or uses the product;

- Buyer’s obligation to the seller would be changed (e.g., the seller would forgive the obligation or grant a refund) in the event of theft or physical destruction or damage of the product;

- Buyer acquiring the product for resale does not have economic substance apart from that provided by the seller; or

- Seller has significant obligations for future performance to directly bring about resale of the product by the buyer; and

- The product is delivered for demonstration purposes.35

Case Illustration

In the second quarter of 1998, FLIR Systems inappropriately recognized

$225,000 in revenue relating to a consignment sale. The purchase order

submitted by the FLIR’s customers stated “…payment for each system to be

made when a system is sold by [the customer] to an outside customer.” Despite

these words, FLIR recognized revenue from this sale, even though no end-user

was ever identified at the time of the purchase order.36

5.8.4 Contract Accounting Schemes

GAAP provides for contract revenue to be recognized using either the

percentage of completion or completed contract method. The percentage of


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completion method applies only if management can reliably estimate progress

toward the completion of a contract; that is; management must be able to

estimate reliably the total costs required to complete the contract.37 Conversely,

GAAP requires the "completed contract" method when management cannot

reliably estimate progress toward completion. The completed contract method

requires the company to postpone recognizing revenue until the contractual

obligations have been met.38

The percentage of completion is the method that is most often subject to abuse.

Some companies will use the percentage of completion method notwithstanding

that they do not qualify for that method. Companies can artificially inflate

revenue by increasing the costs incurred toward completion, underestimating the

costs of completion, or overestimating the percentage completed.

The auditor should perform the following procedures when performing an audit or

investigation of contracts:

Select a sample of contracts and confirm:o Original contract price; o Total approved change orders;o Total billings and payments;o Details of claims; o Back charges or disputes; ando Estimated completion date.

Ensure that all incurred costs are supported with adequate documentation detailing the nature and amount of expense;

Audit estimated costs to complete by reviewing estimates and comparing with actual costs incurred after the balance sheet date;

Ensure that all estimated costs to complete the contract should be supported by reasonable assumptions;

Ensure that all contracts are approved by appropriate personnel; Review unapproved change orders; Identify unique contracts and retest the estimates of cost and progress on

the contract; Test contract costs to ensure costs are matched with appropriate

contracts and costs are not shifted from unprofitable contracts to profitable ones;

Ensure that losses are recorded as incurred; Review all disputes and claims;


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Visit the construction contract site to view the progress of a contract; and/or

Interview project managers, subcontractors, engineering and technical personnel to get additional information on the progress of an engagement and the assumptions behind the contract.

Case Illustration

In 1996, the SEC charged 3Net Systems with improperly recognizing over $1

million of revenue in both 1991 and 1992, by misrepresenting to its outside

auditors the degree to which certain work had been completed under certain

contracts with existing customers. In fact, 3Net had not completed any of the

contracts, and in addition, had not even determined the costs to complete.

Further, 3Net had no other means of reliably estimating progress toward

completion for these contracts, as it lacked the systems necessary to estimate

and track progress on their development. Because 3Net could not reliably

estimate progress toward completion, the contracts in question did not qualify for

the percentage of completion method. The SEC charged 3Net should have used

the completed contract method for the contracts. Had it done so, 3Net would not

have reported revenue in fiscal 1991 because it completed none of these

contracts by the end of fiscal 1991.39

5.8.5 Sham Related Party Transactions

Sham related party transactions are transactions between related parties where

either little or no consideration is given for the product or service. The existence

of related party transactions cuts to the very first criteria of SAB 101 that there be

persuasive evidence of an arms length arrangement. Sales transactions should

stem from express or implied contracts and represent exchanges between

independent parties at arm’s-length prices and terms. Accordingly, arms-length

transactions cannot be achieved in those situations where the parties are related

or where one party can exercise substantial control over the other.


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Related party transactions carry the presumption that one or both parties have

received a benefit that they would not have otherwise received had the

transactions been truly arms length. Related party schemes can take place in

the context of any of the schemes listed in this chapter.

Transactions between related parties are often difficult to audit as these

transactions are not always accounted for in a manner that communicates their

substance and effect with transparency. The possibility of collusion always exists

given that the parties are, by definition, related. Internal controls, moreover,

might not identify the transactions as involving related parties.

An auditor may encounter related parties that are known by some members of

the company; however, the relationships are not properly disclosed in the books

and records. The auditor should inquire as to outside business interests and

then try to determine whether they are properly disclosed, and the volume of

transactions, if any, that are occurring between the entities.

Auditors should also focus on the relationship and identity of the other party to

the transaction and whether the transaction emphasizes form over substance.

Common indicators of such related party, sham transactions include but are not

limited to:

Borrowing or lending on an interest-free basis or at a rate of interest significantly above or below market rates;

Selling real estate at prices that differ significantly from appraised value; Exchanging property for similar property in a non-monetary transaction; Loans with no scheduled terms for when or how the funds will be repaid.40

Loans with accruing interest differing significantly from market rates; Loans to parties lacking the capacity to repay; Loans advanced for valid business purpose and later written off as

uncollectible;41 Non-recourse loans to shareholders; Agreements requiring one party to pay the expenses on the other’s behalf; Round tripping sales arrangements (seller has concurrent obligation to

purchase from the buyer); Business arrangements where the entity pays or receives payments of

amounts at other than market values;


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Failure to adequately disclose the nature and amounts of related party relationships and transactions as required by GAAP42;

Consulting arrangements with directors, officers or other members of management;

Land sales and other transactions with buyers of marginal credit risk; Monies transferred to or from the company from a related party for goods

or services that were never rendered; Goods purchased or sent to another party at less than cost; Material receivables or payables from to or from related parties such as

officers, directors and other employees;43 Discovery of a previously undisclosed related party; Large, unusual transactions with one or a few other parties on or at period

end; and Sales to high-risk jurisdictions or jurisdictions where the entity would not

be expected to conduct business. .

If related party transactions are detected or suspected, the auditor should

consider further inquiry, including:

Conducting public records searches/background investigations on customers, suppliers and other individuals to identify related parties and confirm legitimacy of business;

Performing data mining to determine whether transactions appear on computerized files;

Performing document review of identified transactions to obtain additional information for further inquiry;

Searching for unusual or complex transactions occurring close to the end of a reporting period;

Searching for significant bank accounting or operations for which there is no apparent business purpose;

Reviewing the nature and extent of business transacted with major suppliers, customers, borrowers and lenders to look for previously undisclosed relationships;

Reviewing confirmations of loans receivable and payable for indications of guarantees;

Performing alternative procedures if confirmations are not returned or returned with material exceptions;

Reviewing material cash disbursements, advances and investments to determine if the company is funding a related entity;

Testing related party sales to supporting documentation (i.e., contract and sales order) to ensure appropriately recorded;

Discussing with counsel, prior auditors and other service providers the extent of their knowledge of parties to material transactions; and

Inquiring about side agreements with related parties for right of return or contract cancellation without recourse


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6. Asset Overstatement/Liability Understatement Schemes

Improper reporting of assets is another way for companies to overstate earnings.

A direct relationship exists between overstatement of assets/understatement of

liabilities on the balance sheet and the inflation of earnings. The WorldCom

scandal for example, exemplifies how expenses improperly capitalized as assets

on the balance sheet can serve to inflate income. In many cases, perpetrators

are looking for a place on the balance sheet to place the debit. Overstating an

asset or understating a liability usually occurs with this scheme. Accounts such

as inter-company and foreign currency exchange gain/loss should not be

overlooked as potential places to hide the debit.

Common asset overstatement fraud schemes include:

Creating fictitious assets; Manipulating balances of legitimate assets with the intent to overstate

value; Understating liabilities or expenses, including failing to record (or

deliberately under estimating) accrued expenses, environmental litigation liabilities and other business problems;

Misstating inter-company expenses; and Manipulating foreign currency exchanges.

An auditor can often become alert to the possibility of fictitious or over inflated

assets by inquiring as to whether the entity intends to secure financing. If the

answer is yes and if that financing is contingent on the value of particular assets

such as receivables or inventory, that should lead the auditor to ask more

questions and perform additional procedures to verify the existence, and location

and value of these assets. As with certain other schemes, the auditor can most

often detect these schemes by observing the company’s operations and inquiring

as to unusual items.

6.1 Inventory Schemes


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The original COSO Report found that fraudulent asset valuations comprised

nearly half of the cases of financial fraud statements. Misstatements of

inventory, in turn, comprised the majority of asset valuation frauds.

Generally, when inventory is sold, the amounts are transferred to cost of goods

sold and included in the income statement as a direct reduction of sales. An

overvaluation of ending inventory will understate cost of goods sold and in turn,

overstate net income.

Inventory schemes can generally fall into three categories:

Artificially inflating the quantity of inventory on hand; Inflating the value of inventory by

- Postponing write-downs for obsolescence); - Manipulating unit of measurement to inflate value;- Under-reporting reserves for obsolete inventory, especially in

industries where products are being updated or have a short shelf life; and

- Changing between inventory reporting methods (average costing, last invoice price, LIFO, FIFO, etc.);

Fraudulent or improper inventory capitalization.

Following are indicators an auditor can look for to detect possible inventory


A gross profit margin which is higher than expected; Inventory that increases faster than sales; Inventory turnover that decreases from one period to the next; Shipping costs that decrease as a percentage of inventory; Inventory as a percentage of total assets that rise faster than expected; Decreasing cost of sales as a percentage of sales; Cost of goods sold per the books that do not agree with the company's tax

return; Falling shipping costs while total inventory or cost of sales have increased;

and Monthly trend analyses that indicate spikes in inventory balances near


6.1.1 Inflating Inventory Quantity (Fictitious Inventory)


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The simplest way to overstate inventory is to add fictitious items to inventory.

Companies can accomplish this by creating fake or fictitious:

Journal entries; Shipping and receiving reports; Purchase orders; and Quantities on cycle counts or physical counts.

Some companies even go as far as maintaining empty boxes in a warehouse.

The most effective way for the auditor or auditor to confirm the inventory balance

is physically to observe the client’s inventory, particularly at times when an

inventory count is being performed. In fact, Generally Accepted Auditing

Standards (“GAAS”) require auditors to physically observe, test, and inquire as to

the amount of inventory on hand and to satisfy themselves with respect to the

methods of inventory taking and the measure of reliance placed upon the client’s

representations about the quantities and physical condition of inventories.44

When the auditor cannot be satisfied as to the inventories he or she must

physically count the inventory and test transactions in that account.45 Where

inventory is stored outside the company site, such as public warehouses,

auditors should conduct additional procedures to confirm balance.

Case Illustration

Fraud history is filled with names of companies made famous or infamous by

fictitious inventory schemes including McKesson and Robbins, ZZZ Best and

Crazy Eddie. The most famous bogus inventory fraud perhaps is the “Salad Oil

Swindle” of the 1960s. In that case, management of the company rented

petroleum tanks and filled them with seawater. The company was able to

convince the auditors that the tanks contained over $100 million in vegetable oil

because the oil rose to the top of banks. In fact, the little oil that was present was

pumped from one tank to the next depending on the company’s advance

knowledge of the auditor’s inventory observation plan.46


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The auditor should look for the following operational factors may arouse

suspicions of fictitious inventory:

Inventory that cannot be easily physically inspected; Unsupported inventory, cost of sales or accounts payable journal entries; Unusual or suspicious shipping and receiving reports; Unusual or suspicious purchase orders; Large test count differences; Inventory that does not appear to have been used for some time or that is

stored in unusual locations; Large quantities of high cost items in summarized inventory; Unclear or ineffective cut-off procedures or inclusions in inventory of

merchandise already sold or for which purchases are not recorded; Adjusting entries which have increased inventory over time; Material reversing entries to the inventory account after the close of the

accounting period; Inventory that is not subject to a physical count at year end; Improper or “accidental” sales that are reversed and included in inventory

but not counted in physical observation (for example a company “accidentally” delivers a specifics product to a customer, tells the customer it was a mistake and requests the customer to send the product back); and

Excessive inter-company and interplant movement of inventory with little or no related controls or documentation.

Even physical observation however, is not fail-proof. Even when an auditor can

observe inventory, a company can still perpetrate fraud by:

Following the auditor during the course of the count and adding fictitious inventory to the items not tested;

Obtaining advance notice of the timing and location of the inventory counts thereby permitting the company to conceal shortages at locations not visited;

Stacking empty containers at the warehouse which are not checked during the count;

Entering additional quantities on count sheets, cards, scanners, etc. that do not exist or adding a digit in front of the actual count;

Falsifying shipping documents to show that inventory is in transit from one company location to another;

Falsifying documents to show that inventory is located at a public warehouse or other location not controlled by the company;

Including consigned items as part of the inventory count; and Including items being held for customers as part of the inventory count.

To deter management from inflating inventory during physical counts, the auditor

should consider:


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Reviewing company policy for inventory counts (frequency and procedures);

Inquiring of management and internal audit as to the dollar adjustment of the book to physical counts and the reasons for the significant differences;

Inquiring as to whether all inventory shrinkages have been reported; Inquiring and observe inventory at third-party locations/off-site storage

locations; Observing a physical inventory unannounced; and Conducting physical inventories for multi –locations all on the same date.

6.1.2 Inflating Inventory Value

GAAP requires that inventory be reported at the lower of replacement cost or

market value (i.e., current replacement cost.)47 Companies inflate inventory value

for a variety of reasons other than to boost earnings. For instance, a common

reason to inflate the value of inventory is to obtain some form of financing using

the inventory as collateral. The higher the value of the inventory, the more the

company will be able to obtain in the form of financing.

Inflating inventory value achieves the same impact on earnings as manipulating

the physical count. Management can accomplish this simply by creating false

journal entries designed to increase the balance in the inventory account.

Another common way to inflate inventory value is to delay the write-down of

obsolete or slow moving inventory, since a write down would require a charge

against earnings.

Auditors thus should be fully aware of the items comprising inventory and their

life cycles, particularly as it relates to that industry. In addition, during the

physical observation of the inventory, the auditor must look for and inquire about

older items that appear to be obsolete. Few or no write-downs to market or no

provisions for obsolescence in industries where there have been changes in

product lines or technology or rapid declines in sales or markets warrant further

investigation as to why the company has not accounted for such declines even

when the inventory in question may be relatively new.


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When a potential inventory valuation problem is detected or suspected, the

auditor should consider:

Inquiring of accounting personnel as to the company’s inventory pricing policy and how they identify net realizable value mark-downs;

Inquiring of management, accounting and finance personnel as to whether the company has shown historical patterns in the past of over valuation (i.e., prior year write down which became value impaired);

Inquiring of accounting personnel as to whether they have ever been requested to delay inventory write downs due to obsolescence etc.;

Touring the warehouse looking for items which appear to be old or obsolete and asking warehouse personnel if stock is slow moving, damaged or obsolete;

Inquiring of accounting personnel if they are aware of any items being sold below cost; and

Inquiring of industry experts whether the products are saleable and at what cost.

6.1.3 Fraudulent Or Improper Inventory Capitalization

Improper capitalization of expenses is discussed in detail in Section 6.4. With

respect to inventory fraud however, companies will sometimes seek to inflate

inventory by capitalizing certain expenditures associated with inventory, such as

selling expenses and general and administrative overhead. Amounts that are

actually expenses instead are improperly reported as additions to the asset

balance, thereby artificially increasing inventory value.

Auditors and investigators need to be cognizant of the company’s capitalization

policies, as well industry practice with respect to the expenses in question.

Moreover, the auditor should consider whether past accounting policies have

been aggressive with respect to capitalization, which would tend to indicate the

need for further investigation. Finally, the auditor should look for changes to

standardized cost amounts that increase the amounts capitalized to inventory.


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6.2 Accounts Receivable Schemes

Companies can manipulate accounts receivable with the same techniques that

they can manipulate inventory; that is, by creating:

Fictitious receivables; and Inflating the value of receivables.

Analytics that may assist in detecting overstated receivables include:

A decrease in the company’s quick or current ratio; Unexplained decrease in accounts receivable turnover Unexplained increase in days sales outstanding; and An increase of the ratio of credit sales to cash sales.

6.2.1 Creating Fictitious Receivables

The indicia of fictitious receivables are generally similar to those in our discussion

of fictitious earnings:

Unexpected increases in sales and corresponding receivables by month at period end;

Large discounts, allowances, credits or returns after the close of the accounting period;

Large receivable balances from related parties or conversely from customers with unknown names or addresses or which have no apparent business relation to the business;

Receivable balances increasing faster than sales; Organizations that pay commissions based on sales rather than the

collection of the receivable; Increased receivable balances accompanied by stable or decreasing cost

of sales and corresponding improvement in gross margins; Lengthening of aging of receivables or granting of extended credit terms; Excessive write offs of customer receivable balances after period end; Re-aging of receivables; Excessive use of account called “miscellaneous/unidentified customer” Large unapplied cash balance; Increased trend of past due receivables; and Lack of adequate controls in the sales and billing functions.

As part of the inquiry process, the auditor should:

Inquire of finance personnel and management as to whether the company is trying to obtain financing secured by its receivables;


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Inquire of sales personnel as to whether they have been pressured to create fictitious or fraudulent sales invoices;

Inquire of accounting or sales personnel as to whether they have been pressured to:

- Overstate the value of receivables;- Create fictitious journal entries or invoices for the sales of inventory

or assets; and Inquire whether customers have been pressured to accept large volume

orders close to the end of period.

Fictitious receivables schemes can also often involve related parties, as related

parties are more likely to assist in collusion and providing of false information to

the auditor. Auditors should inquire into the legitimacy of receivables if they

appear to involve a related party.

Case Illustration

One of the most famous financial frauds occurred in the 1980’s by “Crazy” Eddie

Antar, who operated a chain of consumer electronic stores. Among other

techniques used by Antar to overstate income was the creation of fictitious

receivables by having employees create phoney sales invoices showing

merchandise sales. Antar even had the cooperation of major suppliers, who lied

when auditors sought confirmations of receivable balances.48

6.2.2 Inflating The Value Of Receivables

Inflating the value of legitimate receivables has the same impact as creating

fictitious ones. GAAP requires accounts receivable to be reported at net

realizable value. Net realizable value is the gross value of the receivable less an

estimated allowance for uncollectible accounts.49 GAAP requires companies to

estimate the uncollectible portion of a receivable to determine the net realizable

value of receivables. The GAAP preferred method to determine uncollectible

receivables is to periodically record the estimate of uncollectible receivables as a

percentage of sales, outstanding receivables, or based on an aging of

outstanding receivables.


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Under the allowance method bad debt provisions are recorded as a debit to bad

debt expense, (an income statement account) and a credit to allowance for

doubtful accounts, (a balance sheet contra receivable account.) When all or a

portion of the receivable becomes uncollectible, the uncollectible amount is

charged against the allowance account. When receivables are recorded at their

true net realizable value, the recording of a bad debt provision decreases

accounts receivable, current assets, working capital and most importantly, net


Companies circumvent these rules by underestimating the uncollectible portion of

a receivable. Underestimating the value of the provision (i.e., the amount

deemed uncollectible) artificially inflates the value of the receivable and records it

at an amount higher than net realizable value.

Overvaluing receivables also serve to understate the allowance account, such

that the provision is insufficient to accommodate receivables that in fact become


A related scheme is not writing off (or delaying the write-off) of receivables that

have in fact become uncollectible. These schemes are relatively easy to execute

given the subjectivity involved in estimating bad debt provisions.

Potential auditing procedures include:

Spending adequate time to review and understand the provision; Inquiring of management and accounting personnel as to the reasoning

behind the amount of the provision; and Determining the reasonableness of the provision in relation to the true

facts surrounding the receivables.

Indicia of the potential overvaluation of receivables include:

Minimum bad debt provisions or reserves that appear to be inadequate in relation to prior periods;


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A history of extending payment terms to customers with limited ability to repay;

A history of inadequate reserves for uncollectible receivables; Deteriorating economic conditions, e.g., declining sales; Deteriorating accounts receivable days outstanding; Untimely reconciliations and/or reconciliations that are “back of the

envelope”; History of inadequate reserves for uncollectible receivables; Net receivables (i.e., net of the allowance for doubtful account) which are

increasing faster than revenues; Uncollectible accounts which have been on the books for extended

periods of time but have not been written off; and Recorded disputes with a customer that may potentially threaten ability to


Follow up procedures include inquiring of:

Company changes to its credit policy and the reason for such changes; Management as to the reason for any change in the reserve rates or

policy for reserves in accounts receivable; The sales force and Credit Department about whether they have been

pressured or requested to grant credit to customers who are not credit worthy;

The Credit Department if they have been requested to extend payment terms for certain customers;

The Credit Department to determine whether certain sales people have instructed them to approve a customer and to avoid/circumvent the normal approval process; and

The nature and details surrounding any disputes with customers.

Case Illustration

In 2002, pharmaceutical company Andrx Corp. announced the company would

have to restate its results going back to 1999 due to the discovery that an

employee of one of its subsidiaries altered certain accounting records pertaining

to accounts receivable balances and their associated aging relating to its

pharmaceutical and distribution operations.50

6.3 Investment Schemes


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Fraudulent investment schemes provide another method for a company to

overstate assets. Similar to schemes relating to inventory and receivables,

management can create fictitious investments or deliberately over-value existing


As discussed below, the auditor must first be familiar with all of the entity’s

investments and understand their classifications. This knowledge is necessary to

spot the red flags of potential fraudulent accounting practices. The auditor must

also be aware of the current market status of all investments and must confirm

that the entity’s books and records reflect all increase or decreases in such

status. In addition, the auditor should question all classifications of securities to

ensure that they are indeed classified in a manner that is consistent with the

company’s intentions and not just done to recognize gain or forgo recognizing

loss. The auditor should be also wary of losses on securities held as available

for sale that are accumulating in the other comprehensive income account. The

company must eventually take a charge for these losses either through a sale or

through a permanent write down. Evidence of accumulating losses may lead the

auditor to conclude that management is intentionally delaying the recognition of

such a loss.

6.3.1 Fictitious Investments

Fictitious investments are similar to the creation of other fictitious assets. Indicia


Missing supporting documentation; Missing brokerage statements; and Unusual investments (i.e., gold bullion) or ones held in remote locations or

with obscure third parties.

Follow up procedures an auditor can conduct include:

Confirming the existence of the investment by physical inspection or by confirmation with the issuer or custodian;

Confirming unsettled transactions with the broker-dealer;


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Reviewing the minutes of board of directors meetings and the company’s Treasury policies to ensure that all investments were authorized by the Board and that company policy was followed in the trading of and investment in securities; and

Reviewing internal controls to ensure that the duties of purchasing, recording, and custody are adequately segregated.

6.3.2 Manipulating the Value of Investments

Companies can also manipulate their financial statements by inflating the value

of investments by misclassifying them or failing to record unrealized declines in

market value for those investments. We begin our discussion with a brief

overview of the applicable GAAP requirements.

GAAP requires investments of debt securities (i.e., bonds and other corporate

paper) to be classified as either trading, held to maturity or available for sale. 51

Investments may be classified as held to maturity only if the holder has the

positive intent and ability to hold those securities to maturity. Held to maturity

securities are reported at amortized cost with no adjustment made for unrealized

holdings gains or losses unless the value has declined below cost and is not

expected to recover. In the latter instance, the security is written down to fair

value and a loss recorded in earnings.52

GAAP requires investments to be classified as trading if they are bought and held

principally for sale in the near term. Investments not classified as trading or as

held-to-maturity are classified as available-for-sale securities.53

Trading and available for sale securities are reported at fair market value and

must be periodically adjusted for unrealized gains and losses to bring them to fair

market value. Unrealized gains or losses from trading securities are included in

income for the period. Unrealized gains or losses from changes held as

available for sale are reported as a component of other comprehensive income.54

Equity securities (i.e., common or preferred stock) on the other hand, can be

classified only as trading or available for sale. Unrealized gains or losses from


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changes in fair market value are reported in earnings for trading securities and as

a component of other comprehensive income for securities held as available for


The transfer of a security between categories of investments is required to be

accounted for at fair value. Securities transferred from the trading category will

already have had any unrealized holding gain or loss reflected in earnings. For

securities transferred into the trading category, the unrealized holding gain or

loss at the date of the transfer are to be recognized in earnings immediately. For

a debt security transferred into the available-for-sale category from the held-to-

maturity category, the unrealized holding gain or loss at the date of the transfer

must be reported in other comprehensive income. Securities transferred from

available for sale to held to maturity report unrealized holding gain or loss at the

date of the transfer as a separate component of other comprehensive income

and amortized to interest income over the remaining life of the security.55

Generally, with respect to investments, auditors should consider inquiring of:

Management as to company policies regarding the recording of unrealised gains or losses on trading and available for sale securities; and

Accounting personnel as to they have been asked to:

- Record held to maturity securities at anything but amortized cost;

- Not record all unrealised gains and losses in available for sale and trading securities have been recorded and if not the reason; and

- Postpone a write down of a debt security.

Misclassification of Investments

Companies can manipulate financial statements by intentionally misclassifying

securities or transferring securities to a class that would trigger the recognition of

gain or conversely postpone the recognition of a loss. For example, a company

might misclassify a debt security as held to maturity to avoid recognizing a

decline of value in the current period. Similarly, transferring a security from held


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to maturity to either trading or available for sale would permit the recognition of

gains that had not been previously recognized.

The Treasury function most commonly decides the classification at the time that

the security is acquired. Auditors should review any changes in classification for

possible abuse.

Recording Unrealized Declines in Fair Market Value

Deciding whether to write down a security due to a permanent decline in value is

highly subjective and ordinarily left to the discretion of management. Accepting a

write down results in a charge against net income. The auditor thus should

consider whether management has inappropriately failed to or delayed a write

down an impaired security to inflate income.

6.4 Improper Capitalization Of Expenses

Capitalization of company expenditures is another fertile area for abuse. The

most common way is to record expenditures as capital items rather than ordinary

expenses. This technique allows the company to capitalize and amortize the

expense over many periods rather than recognize it in its entirety in the current


The start of any audit with respect to questionable capitalization policies should

be the company’s accounting policy with respect to this area in addition to the

policies of other entities in the industry. Is the company being overly aggressive

with its policies as compared to other companies? Due consideration must also

be given to management’s reasons for selecting the policy. The auditor will also

want to consider whether the costs in question are providing future benefit

thereby warranting capitalization. Detecting capitalization policies can often be

achieved by considering or reviewing the following items:


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Is there a heavy capitalization of fixed assets? Are capitalized costs that are increasing faster than revenue over lengthy

periods? Are repair and maintenance expenses (or other operating expense)

dropping out of line with operations (indicating these are possibly being capitalized instead of expensed?

With respect to construction contracts, does interest expense properly increase when construction and capitalization of expenditures has ceased?

Have prior accounting policies have been aggressive with respect to capitalization?

Case Illustration

The WorldCom case is perhaps the most infamous example of how a company

can inflate earnings through improper capitalization of expenses. The company’s

internal audit department discovered that management had categorized billions

of dollars as capital expenditures in 2001 that, in fact, were ordinary expenses

paid to local telephone companies to complete calls. The scheme allowed

WorldCom to turn a $662 million loss into a $2.4 billion profit.

6.4.1 Software Development

GAAP requires companies to treat costs associated with developing new

software as expenses until the point of technological feasibility. Technological

feasibility is established upon completion of a detail program design or, in its

absence, completion of a working model. Upon technological feasibility, all

software production costs must be capitalized and subsequently reported at the

lower of unamortized cost or net realizable value.56

Whether technological feasibility has been reached is a subjective decision and

thus subject to abuse. By arbitrarily determining technological feasibility,

management can manipulate income by increasing or decreasing the amount

capitalized or expensed. Auditors should consult with the company’s technical

personnel (i.e. engineers, programmers) in reviewing management’s assertions

that technological feasibility has been achieved.


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6.4.2 Research and Development (“R&D”)

GAAP generally requires R&D costs to be expensed due to the uncertainty of the

amount and timing of economic benefits to be gained from R&D. A company,

however, may capitalize materials, equipment, intangibles, or facilities that have

1 Issued October, 20022 Securities and Exchange Commission, Annual Report, (Securities and Exchange Commission 1999.)3 The SEC’s enforcement action against Edison Schools (“Edison”) is illustrative; SEA Rel. No. 45925, AAE Rel. No. 1555 (May, 2002.) Edison operates public schools on behalf of local governments, which paid directly certain school expenses. Edison Schools recognized these payments as revenue, even though they did not flow through their accounts. The SEC launched an enforcement action notwithstanding that the accounting technically complied with GAAP. 4 See, Accounting Research Bulletin (“ARB”), No. 43, Chap. 9; Also see, Accounting Technology Bulletin No. 15 Arthur Levitt, “The “Numbers Game” speech at the New York University Center for Law and Business (Sep. 28, 1998.)6 Id. at p.3. 7 Id. 8 October 1987. Available at www.coso.org9 The Committee of Sponsoring Organizations of the Treadway Commission ‘s Report on Fraudulent Financial Reporting 1987 to 1997, (March 1999.) 10 Richard H. Walker, “Behind the Numbers of the SEC's Recent Financial Fraud Cases”, Speech at 27th Annual National AICPA Conference on Current SEC Developments, (Dec. 7, 1999.) 11 PricewaterhouseCoopers LLP 2000 Securities Litigation Study. 12 PricewaterhouseCoopers LLP 2001 Securities Litigation Study. 13 Revenue Recognition Update, Christian R Bartholomew, Morgan Lewis & Bockius LLP (2002.) 14 17 CFR Part 211, Dec. 3, 1999. 15 Issued Oct. 27, 1997. 16 See e.g., Statement of Position 81-1 Accounting for Performance of Construction-Type and Certain Production-Type Contracts, (July 15, 1981.); Also see, Statement of Financial Accounting Standards No. 51, Financial Reporting by Cable Television Companies (Nov. 1981.)17 Issued 1999. 18 Issued Feb. 2, 2002. 19 Effective interviewing techniques are considered in another chapter. 20 SEC SA Rel. No. 42326, AAE Rel No. 1215, (Jan. 11, 2000.)21 Statement of Position 91-1, Software Revenue Recognition, Issued 1991. SOP 91-1 has since been superseded by SOP 97-2, Software Revenue Recognition, Issued 1997, which retains the basic recognition criteria of SOP 91-1. 22 Issued June 1981.23 Id. at ¶6. 24 SEA Rel. No. 37847;AAE Rel No. No. 846 (Oct. 22, 1996.)25 SA Rel No. 44305; AAE Rel No. 1393, (May 15, 2001.)26 AAE Rel. No. 1187 (Sept. 28, 1999.) 27 SAB 101 FAQ Question No. 3. 28 Id.


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alternate future uses.57 The SEC has also been particularly concerned about

mergers and the acquirers who classify a large part of the acquisition price as in

process research and development (“R&D”), thereby allowing the entity to

immediately expense the costs.58 This practice allows the entity to write off the

R&D in a single chunk in the year of acquisition and not burdening future

earnings with amortized R&D charges. This type of practice also involves the

creation of liabilities for future operating expenses.

29 SEA Rel. No. 37649, AAE Rel. No. 812 (Sept. 5, 1996). 30 See In the Matter of Stewart Parness, Accounting and Auditing Enforcement (AAE) Rel. No. 108 (August 5, 1986); Also see SFAC No. 5, ¶84(a) and SOP 97-2, ¶22. 31 Id. 32 SEA. Rel No. 47167; AAE Rel No. 1699 ( Jan. 13, 2003.) 33 SEA. Rel No. 43183, AAE Rel. No. 1295, (Aug. 21, 2000.) 34 SAB 101, Topic 13A, Question 2. 35 SAB 101, Topic 13A, Question 2. 36 SEA Rel. No. 8135; AAE Rel. No. 1637 (Sept. 30, 2002.) 37 See, AICPA SOP 81-1, ¶.23. 38 Id., ¶.3039 SEC Rel. No. 37746; AAE Rel. No. 833 (Sept. 30, 1996.) 40 SAS No. 45, Related Parties, AU §334. 41 Practice Alert, Auditing Related Parties and Related Party Transactions42 See, FASB no. 57, Related Party Disclosures, Issued 43 See, Accounting and Auditing for Related Parties and Related Party Transactions, A Toolkit for Accountants and Auditors, AICPA (Dec. 2001.) 44 Statement on Auditing Standards (“SAS”) No. 1 § 331 (Amer. Inst. of Certified Pub. Accountants 1972); AU §331.11. 45 Id. 46 Norman C. Miller, The Great Salad Oil Swindle, New York; Howard McCann, 1965. 47 ARB No. 43, Inventory Pricing, Chap. 4, Statement 5. 48 Joseph T. Wells, So That’s Why It’s Called a Pyramid Scheme, Journal of Accountancy, October 2000. 49 SFAS No. 5, Accounting for Contingencies, (Mar. 1975.)50 CITE CASE51 See, SFAS 115, Accounting for Certain Investments in Debt and Equity Securities, (May 1993), at ¶6. 52 Id. at ¶7. 53 Id at ¶12 (a) and (b). 54 Other comprehensive income is generally defined as the change in equity of a business enterprise during a period from all transactions and events except those resulting from investments by owners and distributions to owners. 55 SFAS 115, ¶15. 56 See, SFAS No. 86, Accounting for the Costs of Computer Software to Be Sold, Leased, or Otherwise Marketed, (Aug. 1985) 57 See, Financial Concepts No. 2, Accounting for Research and Development Costs, (Oct. 1974.) 58 Arthur Levitt, “The “Numbers Game” speech.


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Case Illustration

The SEC action against Pinnacle Holdings, Inc. arising from its acquisition of

certain assets from Motorola is illustrative. The SEC found that that Pinnacle

improperly established more than $24 million of liabilities that did not represent

liabilities at the time of the acquisition.59

6.4.3 Start Up Costs

Similar to R&D, GAAP requires all start-up costs to be expensed in the year

incurred.60 However, many entities will label start up activities as other costs

thereby attempting to capitalize them.

6.4.4 Interest Costs

SFAS 34, Capitalization of Interest Costs61, requires the capitalization of interest

costs incurred during the acquisition and construction of an asset. The interest

cost capitalized is added to the cost of acquiring the asset and then amortized

over the useful life of the asset. The total interest cost capitalized in a period

may not exceed the interest cost incurred during that period. Capitalization is no

longer allowed when the cost of the asset exceeds its net realizable value. One

potential scheme in this area is for the company to continue capitalizing interest

after construction has been completed.

6.4.5 Advertising Costs

SOP 93-7, Reporting on Advertising Costs62, provides that all advertising

expenses must be expensed as incurred unless there exists persuasive historic

59 See, In the Matter of Pinnacle Holdings, Inc., SEA Rel. No. 45135, AAE Rel No. 1476 (Dec. 6, 2001) 60 SOP 98-5, Reporting on the Costs of Start-Up Activities, (Apr. 1998)61 Issued October, 197962 Issued Dec. 29, 1993.


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evidence that allow the entity to make a reliable estimate of future revenue to be

obtained as a result of the advertising in which case the expenditures are allowed

to be capitalized.

Case Illustration

In 2000, the SEC charged America Online, (“AOL”), with incorrectly amortizing

for the fiscal years 1995 and 1996, the subscriber acquisition costs associated

with the manufacturing and distributing of computer disks containing its program

to prospective customers. The SEC claimed that because of the volatile and

unstable nature of the internet industry during the period in question, AOL could

not with any reliability make a prediction of future net revenues. Thus, the

subscriber costs were more like advertising costs and required expensing in

accordance with SOP 93-7. AOL had reported profits for six of the eight quarters

in 1995-1996 instead of the losses it would have reported had these costs been

expensed. The costs improperly capitalized amounted to approximately $385

million by September 30, 1996 when AOL decided to write them off.

6.5 Recording Fictitious Fixed Assets

Similar to the concept of recording fictitious sales or receivables, entities will

record fictitious assets to improve the balance sheet which, as previously

discussed, inflates earnings as well.

Indicia of fictitious assets include:

Fixed assets on books and records which do not have an apparent relation to the business;

Lack of a subsidiary ledger to record additions and retirements; Lack of adequate policies and procedures to determine whether property

and equipment are received and properly recorded; Lack of procedures to account for fixed assets that may have been moved

from one facility to another; Existence of a second-hand storage facility for fixed assets that may still

have useful life but for some reason are not being used;


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Lack of adequate written policies and procedures concerning the recording, retirement and disposition of fixed assets; and

Sub-ledgers that do not reconcile to the general ledger.

Follow up procedures to consider if any of these indicia are present include:

Tour of the client’s facility to review fixed assets: select certain fixed assets from the fixed asset listing (especially new, significant additions), physically confirming that the fixed asset exists and physically inspecting the asset’s serial number if applicable;

Determine that retired assets are no longer included in financial statements; and

Review internal controls to ensure that there are written policies covering retirement procedures which include serially [sequentially] numbered retirement work orders, reasons for retirement and all necessary approvals.

6.6 Depreciation & Amortization Schemes

An easy way to inflate the value of an asset is to extend its

depreciable/amortizable life so that it is carried on the books for a longer period.

Depreciation is another area in which management is given leeway to choose

any method so long is that method allocates the costs in a “rational and

systematic manner.”

Detection of these schemes begins with a review of the company’s depreciation

policy. Most companies have written policies for depreciating assets. Lack of a

written policy heightens the potential for abuse as it enables management

potentially to record depreciation on an ad hoc basis with no particular rational.

Similarly, recent changes to the entity’s depreciation policy should be scrutinized

for both their purpose and effect on the entity’s assets.

Auditors who have suspicions should consider:

Reviewing the records of depreciable assets for unusually slow depreciation or lengthy amortization periods;

Comparing prior years depreciation charges with current year for reasonableness;

Identifying changes in policy which may affect the rate of depreciation that appears to boost earnings;


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Inquire into historical depreciation policies to determine the extent of their aggressiveness; and

Reviewing a detailed list of fixed assets as well as the assigned lives of the assets and then randomly selecting certain fixed assets and recalculating the net book value at reporting date based upon the recorded life of the asset.

7. Understatement Liabilities and Expenses

7.1 General

Understating liabilities and expenses mirrors overstating income and assets - -

both serve to inflate artificially earnings and/or the company’s financial condition.

Auditors can use various analytical indicators to search for indicia of these

schemes, including:

An increasing current ratio (current assets/current liabilities) or quick ratio (cash + marketable securities + net receivables/current liabilities) from one period to the next;

Unexpected improvements in gross margins from one period to the next;

Change in inventory with no simultaneous increase in accounts payable or accrued expenses between periods; and

A comparison of the percent change in the accrued expense account with revenues reveals that revenue is increasing faster than accrued expense payable.

In addition to the above analytical procedures, an auditor should also inquire of

accounting personnel as to whether they have ever been asked to postpone

expenses until a subsequent period. Finally, the auditor should also:

Review expense ledger and perform cut-off test to ensure that expenses are recorded in proper period and not postponed until a subsequent period;

Review prior years expenses and liabilities and look for unusual trends; Perform current or quick ratio analysis which may indicate the

concealment of liabilities; Examine account detail looking for unusual debits to liabilities which

would have the affect of reclassifying an expense to the balance sheet and also improving the current ratio (certain levels of current ratio may be required for debt covenant compliance);


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Consider performing data mining procedures to identify significant payments for further review to determine whether the payment should have been capitalized;

Review internal controls to ensure expenses are record in proper period and not postponed until a subsequent period; and

Review expenditures to determine whether they are more appropriately classified as expenses.

7.2 Establishing Off-Balance Sheet Entities The Enron scandal highlighted the practice of fraud by using “off-balance sheet”

vehicles to transfer and conceal debt.63 It must be noted however, that off-

balance sheet vehicles, despite a recent significant tightening in accounting

rules, are in fact permissible under GAAP. The fraud occurs when companies

use them to, for example, conceal debt thereby misleading investors about the

risks and rewards of a transaction, particularly when inadequate or misleading

disclosure is provided. Off-balance sheet transactions also have an income

statement impact as well. With an off-balance sheet transaction, a company’s

“investment” account on the income statement will reflect the relevant proportion

of net profit or loss that results from operation of the underlying net assets. In

other words, the effect of non-consolidation should leave income the same as if

the off-balance sheet investment had been consolidated. However, the individual

line items composing that net income or loss are not explicitly shown. A

consolidation treatment conversely, would show individual revenue and expense

line items.

7.2.1 Off-Balance Sheet Treatment Versus Consolidation

Off-balance sheet transactions are transactions wherein a company retains the

benefits of assets in a corporate vehicle not consolidated for financial accounting

purposes. These investments can typically appear in the asset section of the

balance sheet as a single net line item, titled variously as an “investment in

affiliate”, “retained interest in securitization”, etc.

63 Up until the issuance of new guidance by FASB, off-balance sheet vehicles were commonly referred to as “SPE’s” or special purpose entities. Under the new accounting rules, they are known as variable interest entities. It must be noted that the types of entities that are likely to be deemed VIEs are broader than those that most practitioners would have thought were SPEs.


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Off-balance sheet transactions enable the company to avoid showing the

individual asset of the off-balance sheet vehicle in the balance sheet, and more

importantly, the associated debt used to acquire the off-balance sheet vehicle’s

assets. Stated differently, the company executing the transaction reports only its

proportion of the net assets of the off balance sheet vehicle as an asset, rather

than reporting the gross assets of the vehicle, including the vehicle’s total debt

and outside interests held by other parties. While this form of reporting

technically would not change the net equity of the company executing the

transaction, the consolidated balance sheet would show greater total assets and

greater total debt. Thus, in executing an off-balance sheet transaction, the

company looks more financially attractive. In addition, there is an impact upon

balance-sheet dependent financial ratios; for instance, it is likely that debt to

equity ratios will be higher, and therefore less favorable, under consolidation

treatment as compared to non-consolidation.

Off-balance sheet treatment has historically been used for among other things:

Securitization transactions - financial assets such as receivables are sold to an off-balance sheet vehicle while the seller retains a subordinated interest in that entity;

Leasing transactions – long-lived assets are acquired by an off-balance sheet entity. The use of the assets is conveyed to a third party via an operating lease; and

Non-controlling investments: assets or businesses are held by an entity that does not convey control back to the investors. One simple example is a jointly controlled joint venture. The assets and debt of that venture remains off-balance sheet for at least one of the partner/investors involved.

7.2.2 The Old Rules

Enron has resulted in substantial changes to the accounting rules for off-balance

sheet transactions. Until recently, accounting rules relied on two basic “models”

to determine whether consolidation treatment was proper. The first model

focused upon voting control, and required consolidation if one entity controlled

another. This “voting-control” model was heavily relied upon in situations where


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the subject of the analysis was a business, rather than just a pool of assets and


The second model, the “SPE model,” applied primarily to entities seen as

“special purpose entities.” Factors which would typically tend to indicate that a

vehicle is an SPE are (i) limited powers in the vehicle’s powers/charter or (ii) the

housing of assets, rather than a business, for which there were a limited purpose

and with respect to which few decisions need be made.

The potential for abuse under the old rules generally occurred in the following


Intentional manipulation in the determination of whether to apply the voting control or the SPE model - - the result being that the wrong conclusion had been reached;

Intentional manipulation in the application of the correct accounting model; and

Intentional and overaggressive use of the wrong accounting model.

7.2.3 The “New Rules”

In light of the Enron scandal, the Financial Accounting Standards Board (“FASB”)

expanded upon the accounting guidance that governs when a company should

include the assets and liabilities of another entity in its own financial statements.

Financial Interpretation No. (“FIN”) 46, Consolidation of Variable Interest Entities,

applies consolidation requirements to applicable entities created after January

31, 2003. While the technical rules of the new rule are beyond the scope of this

chapter, it is worth providing a brief synopsis of the major provisions. The

underlying principle behind the new Interpretation is that if a business enterprise

has the majority financial interest in an entity, which is defined in the guidance as

a variable interest entity (“VIE”), the assets, liabilities and results of the activities

of the VIE should be included in consolidated financial statements with those of

the business enterprise. Prior to FIN 46, one company generally has included

another entity in its consolidated financial statements only if it controlled the

entity through voting interests. FIN 46 changes that by requiring a variable


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interest entity to be consolidated by a company if that company is subject to a

majority of the risk of loss from the VIE’s activities or entitled to receive a majority

of the entity's residual returns or both. A company that consolidates a VIE is

called the primary beneficiary of that entity.

In general, a variable interest entity is a corporation, partnership, trust, or any

other legal structure used for business purposes that does not have sufficient

equity investment at risk to permit it to finance its activities without additional

subordinated financial support. The Interpretation is also applicable to an entity

whose equity holders do not have (i) the direct or indirect right to make decisions

about the entity's activities through voting rights or similar rights, (ii) the obligation

to absorb the expected losses of the entity if they occur or (iii) the right to receive

the expected residual returns of the entity. A variable interest entity often holds

financial assets, including loans or receivables, real estate or other property.

FIN 46 places much emphasis on a risk and reward model of consolidation and

contains a new scope test that serves to direct whether an off-balance sheet

entity is a VIE, and thus whether the provisions of FIN 46 govern and require

consolidation of the off-balance sheet entity.

The scope test itself is composed of two key questions. The first question is

whether there is sufficient equity in the entity. The second question is whether

the equity has the proper characteristics. A “no” answer to either question

means the entity is a variable interest entity that must apply the new model and

consolidate. To demonstrate whether an entity has enough residual equity

between the equity holders to absorb expected losses, as defined by FIN 46, in

most cases requires a demonstration that equity exceeds the expected losses, if

any. If they do not, the entity is a VIE requiring consolidation under FIN 46. The

second question asks whether the equity of the entity does have has certain

characteristics that make it act like true e residual common equity.


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One of the issues involved with the scope test is the high degree of subjectivity

involved. What is sufficient equity as required by the rule? The rule creates a

rebuttable presumption that an equity investment of less than 10 percent of an

entity's total assets is not sufficient to permit an entity to finance its activities

without additional subordinated financial support. One can rebut the presumption

by demonstrating that the entity:

Is currently or intends to finance its activities without additional subordinated financial support;

Has at least as much equity invested as other entities holding only assets similar in quantity and quality that operate without additional subordinated financial support; or

The amount of equity invested in the entity is greater than a reasonably reliable estimate of the entity's expected losses.64

Assuming an entity is a variable interest entity, and thus within the scope of FIN

46, the rule then focuses upon which party to the transaction has a majority of

the risks and/or rewards. However, in order to determine who bears a majority of

the risk or reward, a projection of cash flows may be required. These projections

are an opening for a great degree of subjectivity and therefore manipulation.

The above rules are too new to have resulted any fraud cases. Obviously, hiding

or disguising information from the auditor or investing public is the easiest way

for a company to keep assets and liabilities off its books or inflate income.

Another possibility as mentioned above, is manipulation of the amount of equity

reported in the entity to avoid coming under the provisions of FIN 46.

Management might also manipulate the estimate of expected losses in their cash

flow projections in order to obtain off-balance sheet treatment. Manipulation can

take many forms such as failing to recognize impairments that would decrease

expected cash flows.

Auditors will need to consider the potential of these new schemes on a case-by-

case basis.

64 Fin 46 ¶9.


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7.3 Overstatement of Liability Reserves (“Cookie Jar Reserves”)

While most fraud schemes are geared toward inflating the current financial

position, companies sometimes overstate the amount of provisions to cover the

expected costs of liabilities such as taxes, litigation, bad debts, job cuts and

acquisitions. In doing so, management will establish inflated accruals in those

years where the company is extremely profitable and doing well and can afford to

incur larger expense amounts. These “cookie jar reserves” are then tucked away

for management to reach into and reverse in future years where the company is

unprofitable or marginally profitable when a boost to earnings would be


Company managers estimate reserves. The outside auditor judges whether the

reserves are reasonable. Generally, it is difficult for auditors to challenge

company estimates because there are no clear accounting guidelines. This

creates a ripe environment for abuse.

Be mindful of account descriptions. A title such as “Miscellaneous Provision”

may be an indicator of a Cookie Jar reserve account. Fro example, in a recent

investigation conducted by PwC, inquiry was made of the internal auditor as to

which account the company used when it needed to ‘make the numbers’?

Without hesitation, the internal auditor cited an account number, which was

associated with an account named “Miscellaneous Provision.” Through account

analysis and collaboration with company employees, it was determined that over

$7 million was in this account to use for a rainy day. The explanation provided

was that the company had already met the goals to pay bonuses for the end of

the period, so this account had some reserve left if need be for future periods.

Case Illustration

In 2002, Microsoft Corp. settled SEC allegations that it had misstated earnings by

maintaining unsupported reserves regarding accruals, allowances, and liability

accounts relating to marketing expenses, sales to original equipment


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manufacturers, accelerated depreciation, inventory obsolescence, valuation of

financial assets, interest income, and impairment of manufacturing facilities.

These reserves totalled between $200 million to $900 million during the fiscal

years ended June 30, 1995 through June 30, 1998. These corporate reserves

did not have properly substantiated bases but were based, in part, on judgment

regarding the likelihood of future business events. The SEC further charged the

company with failing to maintain sufficient documentation of the bases for these

reserve accounts and to apply its own accounting policy relating to the

reconciliation of entries in its accounting system. Microsoft failed to maintain

sufficient documentation of the bases for these reserve accounts and to apply its

own accounting policy relating to the reconciliation of entries in its accounting


8. Improper and Inadequate Disclosures

Financial statement fraud is not limited to numbers. A company can also

misrepresent the financial condition of the company through misstatements and

omissions of the facts and circumstances behind the numbers. Improper

disclosures can take various forms notably, misrepresentations, intentional

inaccuracies, or deliberate omissions in:

Descriptions of the company or its products, in news reports, interviews, annual reports, websites, etc.;

Management discussions and other non-financial statement sections of annual reports, 10-Ks, 10-Qs, and other reports; and

Footnotes to the financial statements.

In all these instances, management has perpetrated a fraud on the readers of the

financial statements by not providing sufficient information required to make an

informed decision regarding the financial position of the company.

Case Illustration

65 SEA Rel No. 46017; AAE Rel. No. 1563 (Jun. 3, 2002.)


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Enron has become famous for its misleading disclosures. Consider for example,

the following disclosure provided by Enron Corp. in its 2000 Proxy Statement:

“During 2000, certain Enron subsidiaries…entered into a number of transactions with LJM2 Co-Investment…Andrew S. Fastow, Executive Vice President and Chief Financial Officer of Enron, is the managing member of LJM2’s general partner.”

The paragraph describing the “transactions” read as follows:

“These transactions occurred in the ordinary course of Enron’s business and were negotiated on an arm’s length basis with senior officers of Enron other than Mr. Fastow. Management believes that the terms of the transactions were reasonable and no less favourable than the terms of similar arrangements with unrelated third parties.”

These disclosures misled average investors, as well as seasoned analysts, to

assume that Enron was engaged in legitimate transactions that were providing

the company with enormous amounts of revenue. We all now know however that

these transactions were anything but arms length and reasonable and certainly

not less favourable than other transactions entered into by the company.

Consider another example of an improper Enron disclosure. In the company’s

financial statements in Forms 10-Q and 10-K beginning with the second quarter

of 1999 and through the second quarter of 2001, the company made the

following footnote disclosure with respect to its related party transactions:

““A senior officer of Enron is managing member of LJM’s general partner.”

This clearly inadequate disclosure was made despite the fact that SEC

Regulations expressly requires a description of any transactions involving a

registrant that exceed $60,000 and in which an executive of the company has a

material interest.66

The Sarbanes-Oxley Act of 200267 ,(“Sarbanes”), attempts to correct many of the

shortcomings of non-financial disclosures. Sarbanes requires CEOs and CFOs 66 See, SEC Regulation S-K §229.404, Certain Relationships and Related Transactions (1996.)


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to acknowledge their duty to establish and maintain “disclosure controls and

procedures” (“DC&P”) and to confirm the effectiveness of the company’s such

disclosure controls & procedures. The term DC&P is a new term that expands

beyond traditional notions of internal controls, as it includes both financial and

non-financial information. DC&P includes all information in the company’s public

filings including such items as market share, information on competitive

environment, regulatory environment, business goals, objectives and strategy,

governance matters, planned acquisitions, customers, supply chain, and

contracts. Sarbanes also requires prompt disclosure (in plain English) of all

material changes in the company’s financial condition and other significant

company news. The statute also requires disclosure of off-balance sheet

transactions, as defined under the statute.68

Sarbanes likely will create a new array of fraud schemes as unscrupulous

companies and individuals seek to circumvent the disclosure requirements and

other reforms in the statute. Whether auditors will be required to audit the

accuracy of non-financial statement disclosure has not been settled as of the

writing of this chapter. Nonetheless, auditors should scrutinize all disclosures

carefully and, where appropriate, inquire into the source and truthfulness of non-

financial statements, such as description of business plans, claims of market

share, etc. The auditor should consider seeking access to normally restricted

files such as internal memos, minutes of board meetings, business plans, and

other information not normally looked at during the course of a financial

statement audit. If the company denies access, it may tip off the auditor that

there is something the company does not want you to see.

9. Materiality

67 17 CFR Parts 228, 229, 232, 240, 249, 270 and 274 (Aug. 29, 2002.) §302. 68 The statute requires companies to “disclose all material off-balance sheet transactions, arrangements, obligations (including contingent obligations), and other relationships of the issuer with unconsolidated entities or other persons that may have a material current or future effect on the issuer's financial condition, results of operations, liquidity, capital expenditures, capital resources or significant components of revenues or expenses.”


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No discussion of financial statement fraud is complete without a discussion of

materiality. Companies (and sometimes auditors) dismiss improprieties because

they are not “material” to the financial statements.

Materiality is a mixed question of legal and accounting principles. Guidance can

be found from the Supreme Court, SEC, FASB, and academia. The Supreme

Court has defined something as material if “…there is substantial likelihood that

the disclosure of the omitted fact would have been viewed by the reasonable

investor as having significantly altered the ‘total mix’ of information made

available.”69 The SEC echoes this in Regulation S-X where in it defines material

items to be limited to “…those matters to which an average prudent investor

ought to be reasonably informed before purchasing the registered security.”70

The FASB has defined materiality to be “…the magnitude of an omission or

misstatement of accounting information that, in the light of surrounding

circumstances, makes it probable that the judgement of a reasonable person

relying on the information would have been changed or influenced by the

omission or misstatement.”71

Over time, companies and their auditors have also developed certain “rules of

thumb” to assist them in determining when a matter might be deemed material.

One frequently used rule of thumb is that a misstatement or omission that is less

than 5% of some factor (i.e., net income or net assets, etc.) is not material.

The SEC sought to settle the issue of materiality and remedy the potential for

earnings management abuse with the release of SAB No. 99, Materiality.72 SAB

No. 99 provides guidance for preparers and auditors on evaluating the materiality

of misstatements in the financial reporting and auditing process by summarizing

and analysing GAAP and federal securities laws as they relate to materiality in

addition to offering examples of what is and is not acceptable with regard to

materiality. While the SEC does not object to the use of the 5% threshold as a 69 TSC Industries, Inc. v. Northway, Inc., 426 U.S. 438, 449 (1976.) 70 Rule 1-02. 71 Statement of Financial Accounting Concepts (“SFAC”) No. 2, (1980.)72 Issued August, 1999.


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preliminary assessment of materiality, it emphasizes that exclusive reliance on

quantitative benchmarks, such as the 5% rule can only be the beginning of a

materiality analysis and not a substitute for a full analysis of one. SAB 99 goes

on to note that when considering materiality, certain qualitative factors can cause

even quantitatively small misstatements to become material. Examples of

qualitative factors to be considered include whether the misstatements

Arise from imprecise estimates; Mask changes in earnings trends;

Cause financial statements to meet analysts’ expectations;

Would change a loss to income or vice versa;

Affect compliance with regulations or contracts;

Affect management compensation; or

Arise from illegal acts.

Thus, it is clear that numerical tests also will no longer satisfy a materiality

analysis and that the auditor must question the facts and circumstances

surrounding all suspicious transactions and cannot simply pass on them if they

are deemed financially immaterial.

10. Misappropriation of Assets

The chapter has so far focused on reporting fraudulent financial reporting by the

corporation. However, financial fraud can and often is committed against the

corporation - - the most common being external or internal misappropriation of

assets. The Association of Certified Fraud Examiners estimates that up to 6% of

organizational revenues are lost to fraud.73 While most misappropriations are

often quantitatively immaterial when looked at in isolation, often times they occur

enough so that they rapidly become material to an organization.

73 Association of Certified Fraud Examiners, Report to the Nation, (2002.)


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The chapter does not detail each and every way employees and third parties

steal from companies. Many schemes are interrelated and share similar

characteristics. For instance, register disbursement schemes can often be

detected by and prevented with the same techniques used to stop billing

schemes. The discussion of one satisfies the other. One common theme

however, is the importance of having and applying strong internal controls, which

cannot be circumvented or overridden.

In addition, this section does not detail every asset a company may have that is

subject to misappropriation but seeks only to list those assets that appear on the

balance sheet of most entities. Companies in different industries have various

types of assets on their balance sheet. Thus there will be certain assets not

listed here. For instance, intellectual property is an asset which can be subject to

theft. However due to the complexities of issues surrounding that asset, it is not

listed in this chapter.

Case Illustration

After Robert Maxwell, founder of the Mirror Newspaper Group drowned

mysteriously while cruising off the Canary Islands, investigators discovered that

he had misappropriated approximately 440 million pounds from his companies

and their pension plans to finance his corporate expansion. Maxwell’s companies

were forced to file for bankruptcy protection in Great Britain and the United

States in 1992.

10.1 Misappropriation of Cash

Cash schemes are the most common form of misappropriation of assets. The

major categories include: (i) skimming and larceny of cash and (ii) fraudulent

disbursements. Fraudulent disbursements include: (i) billing schemes, (ii) payroll

schemes, (iii) expense reimbursement schemes, (iv) check theft and tampering

of checks and (v) register disbursement schemes.74



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10.1.1 Skimming of Cash

Unrecorded or Understated Sales or Receivables - (Failure to record the full amount of sales or other items of income.)

Many asset misappropriation schemes start at the entry point of the sale. An

employee can embezzle monies by not recording the sale or full amount of the

monies received. Deterrence of skimming activities requires adequate

segregation of duties among the individuals recording the sales, receiving the

monies, and recording the sales in the books. In addition, particular attention

must be paid to those individuals, such as consultants and sales people, who

handle cash in offsite locations. These individuals often operate without

sufficient controls governing their conduct that can lead to the perpetration of this


Case Illustration

In 2003, at least eight Southwest Airlines employees were accused of

misappropriating more than $1.1 million from the airline company using a variety

of skimming techniques. In one method, a ticket counter worker saved an old

ticket that should have been voided. The unmarked ticket then was sold to a

cash-paying customer, who used the ticket. The employee pocketed the money.

Special attention should also be given to payments made on the account.

Perpetrators can convert the cash and then either wait for an alternative source

of funds to make up for the replace the funds converted (This practice, more

commonly known as lapping, will be discussed in detail below.) The perpetrator

may simply not record the payment against the customer’s account at all. The

customer’s receivable balance will remain unchanged or slightly changed despite

the fact that they have been making payments. After the receivable has aged

significantly, the perpetrator writes off the receivable balance as unpaid.

Adequate segregation of duties again is key. The same individual should not be

in charge of recording and monitoring receivables in addition to being given the

responsibility of authorizing and recording write offs.


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The auditor should review the customer complaint log for complaints regarding

the misapplication or lack of payment to their receivable account balance and

follow-up on any recorded complaints with both management and the customer

to see what the nature of the problem was, how it was resolved, by whom within

the organization and finally whether the problem occurred subsequently.

The auditor should also consider performing certain analytics and noting

particular trends such as:

Cash that is decreasing in relation to total current assets; Cash that is decreasing in relation to credit sales; Decrease in sales accompanied by an increase in cost of sales; Current ratio which has decreased significantly from prior periods; Decreasing gross margins from the prior to the current period; Cash collections which are significantly less than reported revenues; Significant amount of write offs in the current period as compared to the

previous period; and Decreasing trend of payments on accounts receivable.

Other indicia of the existence of this scheme include:

Lack of segregation of duties between the sales, receipts and recording functions;

Poor controls over the completeness of recording sales; Sharp increase in the average length of time that customer cash receipts

are maintained in an account before being applied to customer’s outstanding balance;

Periodic or large or numerous debits or other write offs to aged accounts; Recorded customer complaints regarding misapplication of payments to

their account; Forced account balances such as overstatements of cash balances that

are made to match the accounts receivable balance; Numerous or significant reversing entries or other adjustments been made

which have caused the books or register to reconcile to the amount if cash on hand; and

Large or numerous suspicious debit adjustments to aged receivable accounts.

Finally, an auditor confronted with these high risk factors should consider:


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Inquiring of management or internal audit group whether there ever been previous problems with employee theft of incoming cash receipts;

Inquiring as to the company’s policy for monitoring off site sales people (if applicable) or rental properties that generate cash flows for the company;

Inquiring on how reconciling items or discrepancies are treated and reviewed by management;

Inquiring of management and sales personnel regarding customer complaints about billing and/or payments not being applied to their accounts;

Following up with customers regarding any recorded complaints; and Inquiring of management and others whether they are aware of any

employees having financial difficulties. Lapping

Lapping generally involves converting one customer’s payment and then using a

subsequent payment, usually from another customer, to cover the payment

converted from the previous customer's account. For example, the perpetrator

will steals the payment intended for customer A’s account. When a payment is

received from customer B, the thief credits it to A’s account. And when customer

C pays, that money is credited to B.

Lapping tends to increase at exponential rates and lapping schemes often tend

to reveal themselves because the employee is unable to keep track or obtain

additional payments to cover up the prior skimming.75

Case Illustration

In 1998, Canadian police arrested a bank manager of the Canadian Imperial

Bank of Commerce and charged her with forging her client’s signatures and

using the lapping scheme to misappropriate more than USD $500,000 of client

funds. Approximately USD $158,000 of this money was used for her own

purposes. According to police, the manager began the scheme by forging a

client's signature to prematurely cash an investment certificate.

She redeemed that first set of investments and when she redeemed the second

set, it would cover the shortage in the first set, with a little bit left over for her own

use. Before that second set of investments came due, the manager would cash

75 Joseph T. Wells, Lapping It Up, Journal of Accountancy (Feb. 2002)


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another set to pay that second set off, and so on. In each case, the amount taken

increased and eventually totalled USD $500,000 worth of her clients'

The controls, analytical and other indicators that apply to skimming also apply to

lapping. However, one of the most effective ways to control a potential lapping

scheme is to require a daily bank deposit in addition to an independent

confirmation that the deposit was properly made. Additionally, the auditor be

aware, pay attention and inquire into any delays in the processing of payments to

customer’s accounts and inquire as to the reason for those delays.

10.1.2 Fraudulent Disbursements

Cash schemes involve the theft of revenues before they have been recorded in

the books and records of the company. Fraudulent disbursement schemes, on

the other hand, involve theft of funds already entered into the books and records.

Fraudulent disbursement schemes generally fall into five main categories:

Billing schemes; Theft of company checks;

Payroll schemes;

Expense reimbursement schemes; and

Register disbursement schemes.

These five categories in turn can be broken down further to include a host of

other individual schemes many which, like the cash skimming schemes

discussed above are similar in their nature and means of detection.

Billing Schemes - Creation of Fictitious Vendors or the Use of Shell Companies to Convert Monies

A common billing scheme is the creation of fictitious vendors or shell companies.

The perpetrator will create a fictitious vendor, usually a company owned by him

or her self, and then have the fictitious bill the entity for goods or services it does

not receive. Alternatively, the perpetrator can create a shell company to


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purchase goods or services, which are then marked up and sold to the employer

through the shell. This scheme is most easily accomplished when one or few

individuals maintain control over multiple functions and duties such as

purchasing, selecting vendors, and receiving, and approving payments. Lack of

adequate written cash disbursement procedures, such as requiring independent

approval for disbursements over a particular amount, also heightens the risk of

this scheme.

Third party vendor diligence is a useful prevention and detection technique.

Such diligence should include:

Verification of the name and address of the new vendor by obtaining and maintaining on file copies of corporate records and other relevant documents evidencing its existence (and not simply a shell);

Obtaining credit references from Dun and Bradstreet or other similar reports;

Requesting the vendor to furnish credit and other references establishing its identity; and

Checking the vendor address against the employee database to ensure that it does not match the known addresses of any employees or to determine whether any other relations exist between employees and the vendor. In addition, the auditor should be alert for addresses that are PO boxes. These should be instant red flags of the existence of a fictitious vendor.

Once the new vendor has been approved, he or she should be entered into a

master vendor database to which only a select few individuals have authority to

enter into and change. These changes should be made in accordance with

written procedures requiring proper authorization. An independent third party

should periodically audit the database to ensure that the listed vendors are

indeed still active and not being used to process fictitious invoices.

Once the company commences business with the vendor, an appropriate

independent person should approve all purchase orders prior to being

processed. In addition, adequate supporting documentation including an original


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invoice from the supplier, and a receipt to indicate that the product was delivered,

should be requested and reviewed to support all cash disbursements.

The same person should not be able to both request and approve purchase

orders. Likewise, only designated check signers should be able to disburse


New accounts should also be monitored for some time for:

Increases in the amount or frequency of billings; Variances from budgets or projections;

Discrepancies between the vendor’s prices and those charged by other sources; and

Frequent or sizeable price increases by certain vendors with no explanation.

Auditors should follow up fraud indicators by looking for:

Transactions lacking all required supporting documentation; Numerous disbursements approved by one particular employee to a

particular vendor which are just below the employee’s spending authority or which are for large even amounts or which are made on unusual dates such as weekends and holidays;

Invoices which do not match with the original purchase order and if applicable the original sales contract;

Multiple payments to the same vendors in the same period by the same employee usually under the employee’s spending limit;

Excessive “soft expenses” such as consulting fees, sales commissions, and advertising where there are no tangible products attached to the payable, paid to the same vendor by the same or few employees;

Checks made to “cash” or “bearer” for alleged services or products received;

Suspect endorsements on checks; and Checks with more than one endorsement, checks payable to businesses

or individuals that were cashed and not deposited and checks endorsed by individuals.

Computer assisted auditing programs are available for many of these indicators.

The auditor should compare the master vendor database against the prior year’s

database. The auditor should inquire into the selection and approval process of


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new vendors. Further, the auditor should match the checks issued against the

master vendor database, and investigate any payments to vendors who are not

in the master database.

Case Illustration

A former controller of a well-known hotel misappropriated over $15 million in

cash by setting up a dummy corporation and issuing phoney invoices for services

never rendered to the hotel. The controller was able to get away with this

scheme for over 6 years because he maintained sole control over the hotel bank

account and was able to submit phoney invoices and issue checks or wire funds

to the dummy corporation controlled by him.

Billing Schemes - False Credits, Refunds, Rebates and Kickbacks

These fraudulent disbursement schemes require collusion between an internal

employee and a third party to issue false rebates, discounts or credits. These

schemes can occur with suppliers, as well as customers.

Deterrence and detection begin with the company’s process for issuing and

reviewing refunds, credits, rebates and discounts. Does the credit/refund/rebate

process contain sufficient levels of review by independent supervisory authority?

Do cash register employees possess authority to void their own transactions?

Are only selected individuals authorized to offer rebates/discounts to vendors and

customers? Do the appropriate people verify the rebate/credit transactions or

are they merely “rubber stamped”? Is there adequate segregation of

incompatible functions such as approval of vendors, maintaining the vendor

master file, purchasing, processing of payments, and issuing and authorizing

disbursements? Is there an adequate segregation of duties between individuals

authorized to process checks and those in supervisory role? Is access to cash,

checks, or purchase orders, shared by many employees?

Potential red flags for this scheme include:


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Duplicate or multiple large amounts of refunds, credits or rebates, issued just under the review limit or in round numbers to the same vendor;

Excessive number of “voided” purchase or sales transactions for which no supporting documentation is found;

Unusual reconciling items or lack of timely resolution of reconciling items; Large or numerous payments to particular vendors for which there is little

or no supporting documentation or where the documentation contains discrepancies between the payment information and the back up documentation;

Supporting documentation that contains anomalies such as invoices from several suppliers with different names but with the same address or which are signed by the same person or which return to a post office number; and

Sales contract specifications, purchase orders and invoices that are vague in nature;

The auditor can employ many of the procedures outlined in the fictitious vendor

discussion above. In addition, the auditor should consider whether to:

Review outgoing credits and rebates to ensure that such payments are made in accordance with company rules and that any discount terms are accurately recorded;

Review and question supporting documentation for voided or refunded sales transactions;

Determine whether certain vendors are receiving preferential treatment with respect to credits and rebates; and

Inquire of personnel in the purchasing and cash departments whether they are aware of any vendors who maintain any sort of relationship with other personnel in the company.

Finally, as a note, whether searching for red flags or trying to actually detect the

existence of this scheme, the auditor must always be cognizant of the existence

of related parties whom the perpetrator may be using to commit this scheme.

Billing Schemes - Over Billing

An over billing scheme also involves collusion between an employee and third

party. These generally involve extra illegitimate charges to a legitimate business

expense or trade payable. This scheme is similar to false credits schemes and

shares the same indicators. The auditor should be particularly wary of invoices


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carrying “extra” or “special” charges as well as discrepancies between the

purchase order and invoice amount.

Billing Schemes - Pay and Return Scheme

Pay and return schemes involve employee perpetrators, who improperly pay a

vendor or pay an invoice twice. The employee calls the vendor and requests

return of the improperly issued or duplicate check. The employee then intercepts

and converts the incoming check to his own use. This scheme is similar to

unrecorded sales schemes and can be deterred and detected by techniques

discussed in that section above.

Fraudulent Disbursements – Theft of Company Checks

Cash larceny occurs when the perpetrator steals currency from the company.

The theft can be of cash or its equivalent including checks, CDs etc. Theft of

company checks is a common and easy way to accomplish cash larceny

particularly when there is a clear lack of controls and segregation of duties in

incompatible functions. Another basic but effective control is the maintenance of

pre-numbered checks. Thus, any check out of sequence will be easy to identify

and investigated immediately.

Case Illustration

In 2001, a South Dakota accountant was arrested, charged and pleaded guilty to

stealing more than $100,000 from his former employer by stealing company

checks. The evidence showed that the accountant had stolen approximately 15

checks that had been improperly entered into corporate check registers. Nine of

the checks showed the accountant as the payee, and he had endorsed 11 of



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In addition to the risks identified throughout this section, the auditor should be

aware of the following factors that may facilitate the perpetration of this scheme:

Lack of adequate physical safeguarding of cash or incoming checks; Excessive amounts of voided checks; Numerous checks payable to employees other than regular payroll

checks; Excessive soft expenses (advertising, legal consulting etc.) or unexpected

trends in expenses; and Checks payable to “cash” or “bearer.”

Once the auditor has detected the possible existence of this scheme, there are

various procedures he or she can perform to confirm this possibility. The starting

point should be to review bank accounts established by company to ensure that

they have been properly authorized and that only authorized personnel are

drawing on them. Concurrent with such review, the auditor should also ensure

that the company is maintaining policies and procedures which ensure that

access to cash and bank accounts is maintained by select authorized employees

and further that all assets including company checks are adequately safeguarded

and that access is restricted to a few select employees. The next step should be

to perform reconciliations of various accounts looking for shortages or overages

and reviewing bank reconciliations for old outstanding checks that have not been

followed up on. Other potentially helpful procedures include selecting sample

checks for review of various potential indicators including:

Evidence of alterations or other tampering; Reviewing the endorsements to ensure that endorsements have been

made by proper parties and checks are deposited into authorized bank accounts; and

Reviewing endorsements for evidence of forgery, altered terms or other forms of tampering

Finally, if a perpetrator is going to steal checks he will likely write them to either

himself or to entities or individuals related to him or herself. Thus, the auditor

should look for checks with payments to “cash”, “bearer”, or unknown vendors.

Similarly, the auditor should review the list of vendors for shell companies or for

companies with no apparent business purpose to determine if the vendor is

linked to employees in any manner. (See, Section 10.1.2 for indicators and


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procedures to confirm the existence of shell companies.) In this regard, any

payments of excessive “soft” expenses to such vendors might be made with

stolen checks. The auditor should also review bank deposits to ensure that that

the control total of checks received matches the checks withdrawn.

Payroll Fraud

Fewer and fewer companies pay employees in cash and many hire third parties

to process payroll. Ironically, while these changes have simplified the processing

of payroll, they also have increased the risk of payroll fraud.

Payroll fraud schemes generally occur in two major forms: the creation of

fictitious employees and the padding of hours to cheat on time cards. Other

payroll frauds include inflated overtime claims, the use of incorrect hourly rates,

and overpayment of expenses or underpayment of deductions.

These schemes have different indicators and different means by which they are

perpetrated. The intent of both is essentially the same; to defraud the

corporation and steal from it.

Payroll Fraud - Ghost Employees

Ghost employee schemes involve payments to fictitious employees.

Computerized payrolls, absent adequate controls are highly vulnerable to these

schemes, as the computer does not know whether the employee is real or

fictitious. A related scheme is to simply not remove former employees from the


Segregation of the duties of hiring, payroll processing and disbursement is

essential to mitigating this risk. This helps to ensure that those in charge of

processing employees into the payroll system do not get involved in disbursing

checks to fictitious employees they have created. Other significant controls


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include adequate procedures governing the hiring and firing process, and

controls to ensure that new hires are adequately screened and that rigorous

background checks are performed on them. Once entered into the payroll

system, there must be checks and audits to ensure that the payroll, or individual

records on it, cannot generate more than one payment for each period.

Additionally, there should be checks to ensure that all payroll data is entered

promptly, accurately and only once and in the proper accounting period. Finally,

all employees who have been terminated or have otherwise left the firm should

be promptly removed from the payroll system.

Procedures the auditor can perform to try to detect this scheme include:

Comparing a list of current and former employees to the current payroll list to search for and verify additions to payroll;

Matching master information from the payroll file with the organization’s personnel file to determine whether there are "ghost" employees on the payroll;

Comparing suspected employee’s social security numbers against list of valid numbers and test for duplicate employees on the entire payroll file (appending or joining payroll files if necessary.);

Reviewing direct deposit account numbers to look for duplicate deposits; Obtaining a payroll check run to ensure that all checks are numerical; Randomly selecting employees and trace hours worked to time sheet (to

ensure that all hours are approved by supervisor for hourly employees) and obtain employee file to ensure all proper documentation validating hiring of the employee is in place;

Ensuring that changes to payroll are adequately documented and supported;

Comparing the payroll file at two dates (i.e. beginning and end of a month) to determine whether recorded starters and leavers (hires and terminations) are as expected and if any employees have received unusually large salary increases;

Ensuring each employee's salary is between the minimum and maximum for his/her position or grade; and

Comparing holidays and sick leave taken to the limits for a particular grade or position and if there is a high rate of absenteeism for sickness analysing by department to identify problem areas

Payroll Fraud - Falsified Hours


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Cheating on hours worked is a very easy way to steal from an employer, as it is

very difficult to validate the hours an employee spends on a given assignment.

To guard against this practice an employer must establish strong internal controls

that encompass some or all of the following procedures:

Maintain checks to ensure that all payroll data is entered promptly, accurately and only once and in the proper accounting period;

Require that all sales commission claims be made in writing; Ensure that all claims are checked to vouchers and any other supporting

documentation prior to authorisation; Establish procedures to check claims to ensure that the correct

reimbursement rates have been used; Establish procedures to ensure that all alterations to claim forms are

countersigned; and Establish procedures to ensure that signatures of authorised counter-

signatories are checked before payment is made.

The auditor in turn can attempt to detect this by:

Reconciling time cards/sheets (with approved supervisor signature and employee signature) to pay check or check run; and

Recalculating commissions by testing sales invoices, back to sales orders, shipper, and customer receipt.

10.2 Misappropriation of Inventory

Inventory fraud in its most basic definition is the misappropriation of inventory

from a business. There are three basic ways that inventory is stolen:

Physical removal of the inventory from the company location either after it has been purchased and delivered and without manipulation of the books and records or after it has been purchased but before delivery to the client;

False write offs or other credits to inventory; Recording false sales of inventory.

Anyone with access to inventory can engage in misappropriation - - the

difference between the schemes lies in how the theft is concealed. A purchasing

officer, for example, will usually not be able to adjust inventory records, so those

types of frauds will not be available to him. A sales person has access to sales

records and this will cover his theft differently than the purchasing officer.


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10.2.1 Conversion of Inventory

The most basic form of inventory theft is the physical conversion of existing

stock. Adequate physical security, which is beyond the scope of this chapter, is

the obvious solution.

Conversion of inventory before it has reached the company is more

sophisticated. This form of conversion occurs by the perpetrator who has

authority to order inventory without supervision and authorization. Once the

inventory is ordered, the perpetrator can direct the location to which it is

delivered. Prevention of this scheme requires stringent controls regarding the

ordering and approval functions. All orders should also require adequate

documentation including shipping records to verify that the inventory was actually

delivered to the company location.

10.2.2 False Write-offs and Other Debits to Inventory

Employees with the authority to write off inventory as damaged or scrap (or lack

adequate supervision) often perpetrate false write-off schemes. The company

will not detect that the inventory is missing once it is written off in the books and


Companies can institute controls to deter inventory manipulation. In addition to

adequate physical security, controls include independent verification of records

and separation of incompatible functions such as purchasing as writing off of

inventory. Inventory counts should be performed by people independent to the

inventory records department, or by independent third parties. A supervisor

should verify all write offs and monitor disposal. All entries on the perpetual

system should be referenced to a purchase, sale, or other record. Periodic

checks should be performed on those records.


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10.2.3 False Sales of Inventory

False sale frauds are very similar to recording a fictitious sale in the inventory

records of the business. The false sale is never recorded as a sale in the sales

records, which are usually kept independently from the inventory records. As

there is no sale and no amount to collect or bank, the “sale” is never recorded

and thus never missed. Alternatively, the false credit sale may be recorded

(probably under a false name) but the amount never collected and eventually

written off. A variation of the scheme is for the perpetrator to skim the proceeds

of a valid sale to a real purchaser and not record the sale and the payment for

the sale that is misappropriated.

Sales frauds, like other misappropriation frauds, occur due to a lack of controls or

a breakdown of the controls in the sales process. Sales department employees

should be monitored. All sales should require appropriate authorization in

addition to sufficient documentation to support the sale. Furthermore, the

individuals in the sales department should not be in charge of monitoring or

writing off receivables and should have no influence over that department.

The auditor should perform observations of physical inventory and compare the

inventory account for discrepancies between physical inventory and books. The

auditor should determine whether inventory purchases are properly authorized,

reconciled, and in possession of the company. Independent departments should

authorize sales, write offs and, other debits. Inventory data should be entered

completely, accurately, and only once. Finally, the auditor should ensure that

spot checks verifying the existence of inventory are per formed on a regular basis

by departments independent of the purchasing and sales departments or by

independent third parties.

11. Other Fraudulent Income and Expenses


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This final category of financial fraud arguably is a subset of either fraudulent

financial reporting or misappropriation of assets. We however treat these frauds

separately as accountants and auditors generally do not consider them as a part

of the financial statements.

11.1 Revenue and Assets Obtained By Fraud

Revenue obtained by fraud refers generally to the reverse side of a transaction

involving a misappropriation of assets. Assume, for example, that Company A

misappropriates cash from Company B by overcharging or by charging for non-

existent goods or services. From Company A’s perspective, the monies stolen

from Company B represents revenue, albeit revenue obtained by fraud. Tax laws

require Company A to pay tax and declare as income the illegal proceeds

received from Company B.

Some would contend that, for financial statement purposes, Company A should

not recognize the fraudulently obtained proceeds as revenue. This argument

finds support in both legal and accounting principles.

The legal argument would be Company A holds the revenue as a “constructive

trust” for Company B, since the revenue was obtained by fraud. Stated

differently, the legal argument would be that Company A, while it has use and

possession of the revenue received from the fraud, does not actually have title.

The accounting argument would be that the transaction fails to satisfy two of the

four recognition criteria required by SAB 101, namely:

Persuasive evidence that an arrangement exists; and Evidence that delivery has occurred or that services have been rendered

From the perspective of victim, neither of these conditions is met. If fraud has

occurred, the victim would argue that no arrangement exists to support the


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transaction. Likewise, the victim would most certainly argue that the counter-

party has failed to deliver product or services in support of the revenue.

SAS 99 does not require auditors to consider these frauds, even though it

presumably would be highly relevant for an investor to know whether the

revenues were earned legitimately or illegitimately. Financial statement auditors

consider these types of frauds to be beyond their scope because the financial

audit does not inquire to quality of the operations. Financial statement auditors

rather would contend that these types of issues are the province of internal audit

and operational audits. It remains to be seen whether the Sarbanes-Oxley Act

regulations eventually require financial statement auditors to consider thse type

of issues.

11.2 Expenditures And Liabilities For An Improper Purpose

Bribery of a government official exemplifies an expenditure made for an improper

purpose. Committing to pay some future expense of the same government

official is assuming a liability for an improper purpose. Should either transaction

be treated as a misappropriation of an asset? Does either transaction result in a

financial misstatement?

Both transactions involve business expenditures, legitimate or not. But, an

unwitting shareholder probably would argue that such expenditures are nothing

more than a misappropriation of corporate assets.

Most auditors would conclude that illegal payments do not constitute a

misappropriation of asset. Differences of opinion likely will arise over whether

the payments result in a financial misstatement and over the duty of the financial

statement auditor to detect improper payments.


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Assume, for discussion purposes, that the company’s financial statements do not

disclose that improper payments have been made. If the company were a public

company, the omission would give rise to a “books and records” violation of the

Foreign Corrupt Practices Act.76 Moreover, it would be material for an investor to

know this information.

From a financial statement perspective, however, the numbers are generally

correct, barring issues unrelated to the illegality of the payment. A misstatement

occurs only as result of management’s failure to disclose the nature of the


Financial statement auditors would contend that they are not responsible for

determining whether management has failed to disclose non-financial

information. SAS 99 generally supports this position, as it refers only to

misstatements resulting from fraudulent financial reporting and misappropriation

of assets.

Financial statement auditors would argue, moreover, they are not police and not

required to investigate their clients. They would contend that these types of

frauds, like revenue and assets obtained by fraud, are the province of a

compliance or operational audit and therefore beyond their scope. It remains to

be seen whether Sarbanes regulations eventually require financial statement

auditors to consider these types of frauds.

76 15 U.S.C. §§ 78dd-1, et seq (1977.)


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Chapter Endnotes