FRAUD EXAMINATION

Revenue- and Inventory-Related

Financial Statement Frauds

List Common Ways to Commit Revenue Fraud.

1. Manipulate Revenue Accounts

2. Record Revenues Prematurely

Factoid

Revenue fraud is

the most common

fraud committed

.

Why Are Revenue Frauds so Common?

1. GAAP (Generally Accepted Accounting Principles) allows too many alternative ways to recognize & record revenue.

2. It is an easy fraud to commit.How is it done?1. Report Early2. Create Fictitious Revenues3. Hold Books Open 1 Year +

Typical Revenue – Related TransactionsComplete the Chart

Collect cash within discount period6

Estimate uncollectible A/R2Sell goods & services to customers1

Receivable PaidYES

Goods ReturnedNO

YESAcceptFrom

Customer

3Write Off

Receivablesas

Uncollectible

4NO

Discount TakenYES

NO Collect Cash After

Discount Period

5

What to Look For?1. Analyze the balances & relationships

within the statements.

2. Look for unusual changes in revenue-related accounts balances from period to period (looking for trends)

What Kind of Changes Should You Look For?

3. Compare the statement amounts & relationships with other data.

4. Compare the company’s financial results & trends with those of similar firms in the same industry, and

5. Compare financial statement amounts with the assets they are supposed to represent.

Discuss Revenue-Related Fraud Symptoms.

Analytical symptomsAccounting or

documentary symptoms

Lifestyle symptomsControl symptoms*Behavioral or verbal

symptomsTips and complaints

Lack of accountability for invoice numbers issued. Lack of segregation of duties between the - Processing of accounts receivable invoices and posting to sub

ledger - Posting to accounts receivable sub ledger and cash receipts Lack of policies and procedures regarding write-offs to satisfy

industry standards. Frequent undocumented and/or unapproved adjustments,

credits, and write- offs to accounts receivable sub ledger. Low turnover or slow collection cycle for accounts receivable. Dramatic increase in allowance for doubtful accounts in view

of positive economic events and stringent credit policies. No reconciliation of accounts receivable sub ledger to general

ledger control account. Insufficient supervisory review of accounts receivable activity

as well as customer account aging schedule. Unrestricted access to sub ledgers and general ledger.

Control Systems – Red Flags

Analyzing Financial Balances and Relationships within Financial Statements

Look for unusual changes in revenues and accounts receivable balances from period to period (trends).

Look for unusual changes in revenue-cycle-account relationships from period to period.

Comparing Financial Statement Accounts or Relationships with Nonfinancial Statement Information

Compare financial results and trends of the company with those of similar firms in the same industry.

Compare recorded amounts in the financial statements with nonfinancial statement amounts

Do Ratio, Vertical or Horizontal Analysis Tell if Fraud Has Been Committed?

List Other Investigative Procedures You Could Perform.

Compare to companies in same industry

Compare F/S to actual assets

Search for internal control weaknesses

Leads to Opportunit

y

Material Weaknesses Account-specific or transaction-level material weaknesses(1) Inadequate internal controls for accounting for loss

contingencies, including bad debts(2) Deficiencies in the documentation of a receivables

securitization program(3) No adequate internal controls over the application of new

accounting principles or the application of existing accounting principles to new transactions

Company-level material weaknesses(1) Override by senior management(2) Ineffective control environment

It is shown* that “material weaknesses in internal control are more likely for firms that are smaller, less profitable, more complex, growing rapidly, or undergoing restructuring”* http://faculty.washington.edu/geweili/DGM1JAE.pdf

Discuss TIPS.Ombudsman or HotlinePeople don’t know who to talk toPeople don’t want to wrongfully accuse

someone elseWhistleblower repercussionsPeople feel they have suspicions, not

knowledge

Explain How Inventory & Cost of Goods Sold Are Manipulated to Commit Fraud.

Overstating Inventory

Increases Net Income

Because Cost of Goods Sold

Decreases

Review Effect of Overstating Inventory on a Simplified Income Statement.

Gross Revenues (Sales)-Sales Returns-Sales DiscountsNet Revenues (Sales)-Cost of Goods SoldGross Margin-ExpensesNet Income

Understated

Overstated

Overstated

Review Effect of Overstating Inventory & Understating Purchases on Cost of Goods Sold.

Overstated Ending Inventory

Understated Purchases

No Effect No EffectNo Effect UnderstatedNo Effect No Effect

No Effect No EffectNo Effect Understated

Overstated No EffectUnderstated Understated

Beginning Inventory+Purchases-Returns to Vendor-Purchase Discounts on

InventoryGoods Available for Sale-Ending InventoryCost of Goods sold

Complete Inventory Cycle.

Purchase Inventory

Return Goods?

Take Discount?

Pay Vendor

Sell Inventory?Obsolete?

Inventory Counted?

Count Inventory

Determine Inventory Costs

Identify Some Inventory Fraud Symptoms.

Inventory Relationships1.Examine Changes in

Relevant Ratios2.Use Vertical Analysis

Inventory Account Balances

1.Focus on Changes in Statement Numbers

2.Study Statement of Cash Flow

3.Use Horizontal AnalysisWith Real-World Numbers1.Compare Statement

Amounts with the Assets They Are Supposed to Represent

With Industry Competitors

1.Compare Statement Results with Similar Companies

2.Compare Company’s trends with those of similar companies

Analysis of Period-to-Period

Changes

Analysis of Period-to-Period

Changes