Financial%20Statement%20Fraud

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Financial Statement Fraud

• Dr. Donald K. McConnell Jr.

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Note Most of the following information is
adapted from How to Detect and Prevent Financial
Statement Fraud, Association of Certified Fraud
Examiners, and is used with written permission of
the ACFE
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What Is Financial Statement Fraud?

• Misstatements arising from fraudulent financial
  reporting (AU 316.04)
• Deliberate misrepresentation of entity financial
  condition through intentional misstatements or
  omission of amounts or disclosures to deceive
  financial statement users
• Objectives
• Overstate profits, assets, and revenues
• Understate losses, expenses and liabilities

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Fraud Characteristics

• Pressure or incentive to commit fraud
• Perceived opportunity
• Rationalization to justify the act

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Examples of Situational Pressure

• Sudden decline in revenue or market share
• Unrealistic performance expectations or financial
  pressures from bonus plans
• the pressure to hit analysts estimates is
  enormous.
• Desire to live beyond ones means
• Emotional investment in the entity
• Egotism management started the company
• Cannot admit financial demise of the company

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Perceived Opportunity Can Arise from

• Management override of controls
• Absent or inadequate board of directors or audit
  committee
• Weak or nonexistent controls
• Unusual or highly complex transactions
• Accounting estimates requiring significant
  subjective judgment by management
• Ineffective internal audit function

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Rationalization

• An ability to justify dishonesty makes fraud
  possible
• Fraud committed solely for the betterment of the
  future of the Company
• However temporary often becomes permanent
• All large frauds started as small frauds

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Personal Motivations Which May Lead to Management
Fraud

• Desire for personal gain
• Living beyond means
• High personal debt
• Pay not commensurate with responsibilities
• Wheeler-dealer attitude
• Pride, ego
• Unrealistic job performance expectations

• Challenge to beat the system
• Family or peer pressure
• Excessive gambling habits
• Emotional investment in company
• Meet company budgets
• Compensation tied to entity performance

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Why Is Management Able to Perpetrate and Conceal
Fraud?

• Management knows where the holes are in
  accounting system
• Management can defeat most internal controls
• Upon questioning, management can play dumb,
  claiming a particular transaction was an honest
  mistake

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Management Fraud Warning Signs

• Weak controls
• Domination by an individual or small group
• Regularly assuming subordinate duties
• Aggressive attitudes
• Emphasis on earnings projections
• Consistently late reports
• Frequent disputes with auditors

• Profitability lags industry
• Decentralization without adequate monitoring
• Going concern issues
• Difficult accounting issues
• Difficult to audit transactions or balances
• Significant unusual related party dealings

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Companies Most Likely to Engage in Financial
Statement Fraud

• Start-up enterprises
• Growth companies beginning to show signs of
  slowing revenues and profits
• Companies facing going concern issues

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Treadway Commission (1987)

• Funded in 1985 by
• AICPA
• AAA
• FEI
• I I A
• IMA
• Charge identify causal factors of fraudulent
  financial reporting
• Recommend deterrence measures

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Treadway Commission Findings

• Most important proper tone at the top or
  corporate culture
• High level management rarely embezzles assets
• Most management fraud in the area of Accounting
  estimates
• Complete audit trails
• But estimates are subjective and manipulatable

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Treadway Analysis of SEC Cases against Public
Companies (7/81 through 8/86)

• 44 companies in industries experiencing
  economic decline
• 87 manipulation of financial statement
  disclosures evident
• 47 improper revenue recognition
• 38 intentional overstatement of assets
• 16 improper capitalization of expenses

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Treadway Analysis of SEC Cases against Public
Companies (7/81 through 8/86) con.

• 45 breakdown of controls usually due to
  management override
• 17 misrepresentations made to external auditors
• 66 highest level management involved
• 67 auditor failed to obtain sufficient
  competent evidential matter
• 36 auditor failed to recognize or pursue fraud
  warning signs inadequate skepticism

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Treadway Recommendations for Deterring Management
Fraud

• Improving tone at the top
• Adequate internal audit function
• Substantive audit committee activities
• Management or audit committee report
• Disclosures where second auditor opinions sought
• Involvement in quarterly reporting

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Improving the Tone at the Top

• Establish a tone committed to detecting
  fraudulent financial reporting
• Identify, understand, and assess risk of
  fraudulent financial reporting
• Design and implement effective internal controls
• Enforce written codes of corporate conduct

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Adequate Internal Audit Function

• To provide an objective, analytical review of
  operations
• Internal auditor should
• Appraise adequacy of design and operation of
  controls
• Isolate and identify problems
• Offer controls solutions
• Report directly to board or audit committee
  thereof

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Audit Committee Should

• Be informed, vigilant, effective overseers of
  financial reporting process and controls
• Have adequate resources and authority to
  discharge responsibility
• Review managements evaluation of external
  auditor independence, e.g.
• Nature of consulting services performed
• Consulting fees in relation to audit fees

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Management/Audit Committee Report

• Typically accompanies auditors report
• Informs readers about management and audit
  committee role in financial reporting process
• Represents that financial statements are
  managements responsibility
• Represents managements responsibility for
  establishing proper internal controls

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Second Opinions and Quarterly Reports

• When management seeks second opinions on
  significant accounting issues (Opinion
  Shopping)
• Advise audit committee thereof
• Explain accounting treatment chosen
• Auditor responsibilities AU 625
• Actively oversee the quarterly (interim)
  reporting process

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Why Dont Audits Detect Management Fraud?

• Inadequate performance of standards of field work
• Lack of professional skepticism
• Acceptance of glib explanations
• Inadequate understanding of client business and
  industry
• Inadequate assessment of controls, especially
  tone at the top issues

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Why Dont Audits Detect Management Fraud? (con.)

• Placing too much reliance on management
  representations
• Lack of knowledge regarding client products,
  processes and facilities
• Improper performance of audit procedures, or
  inappropriate audit procedures

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Ten Commandments for Fraud Auditors

• Assume anyone can commit fraud
• Think dirty (think like a crook, not like a book)
• Good documentation does not mean something
  happened, only that somebody says something
  happened
• Follow-up on rumors of wrongdoing
• Check out hunches
• Be nosy, especially if something does not seem
  clear

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Ten Commandments for Fraud Auditors(con)

• Pay attention to reasonableness of Accounting
  entries, especially corrections and adjustments
• Look for patterns in an unusual transaction
• Use statistical sampling (e.g. Benthams Law) to
  select items that would not otherwise be examined
• Pay attention to document details
• Source F. Pomeranz,The Successful Audit,
  Richard D. Irwin, 1992

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What Kinds of Document Details?

• Do numbers, dates, amounts make sense?
• Alterations, erasures
• Inconsistent typefaces
• Addresses
• Endorsements
• Do quantities, items make sense?

• Differing thickness of marks on paper
• Missing documentation
• Breaks in numerical sequence
• Copies rather than originals
• Evidence of raised amounts, forgery