avoiding fraudulent dealings cooking the books cooking the books 10% of all frauds are financial...

Avoiding Fraudulent DealingsCooking the books

Cooking the Books

10% of all frauds are financial statement frauds

Average cost of about 2 million per scheme

Collusion and Power are the main contributors

Frequency of Fraud

2000

2005

2010

0% 20% 40% 60% 80% 100%

Fraudulent StatementsCorruptionAsset Misap-propriation

Cost in Value

$80,000 $93,000

$530,000

$250,000 $4,250,000

$1,000,000

$- $500,000 $1,000,000 $1,500,000 $2,000,000 $2,500,000 $3,000,000 $3,500,000 $4,000,000 $4,500,000

AssetMisappropriation

Corruption

FraudulentStatements

2002 2004

Who Commits Financial Statement Fraud?

Senior management

Mid- and lower-level employees

Organized criminals

Why Do People Commit Financial Statement Fraud

To conceal true business performance

To preserve personal status/control

To maintain personal income/wealth

Why Senior Management Will Overstate Business Performance

To meet or exceed the earnings or revenue growth expectations of stock market analysts

To comply with loan covenants

To increase the amount of financing available from asset-based loans

To meet a lender’s criteria for granting/extending loan facilities

To meet corporate performance criteria set by the parent company

Why Senior Management Will Overstate Business Performance

To meet personal performance criteria

To trigger performance-related compensation or earn-out payments

To support the stock price in anticipation of a merger, acquisition, or sale of personal stockholding

To show a pattern of growth to support a planned securities offering or sale of the business

Why Senior Management Will Understate Business Performance

To defer “surplus” earnings to the next accounting period.

To take all possible write-offs in one “big bath” now so future earnings will be consistently higher.

To reduce expectations now so future growth will be better perceived and rewarded.

To preserve a trend of consistent growth, avoiding volatile results.

To reduce the value of an owner-managed business for purposes of a divorce settlement.

To reduce the value of a corporate unit whose management is planning a buyout

Types of Fraud

Overstatement of Income Understatement of Income Improper Use of Resources Mischaracterization of one-time

expenses Misapplication of the accounting

rules Omission or misrepresented

information

Anti-Fraud Methods

Financial Statement Audits

Code of Conduct

Internal Audit

Independent Audit

Bottom of the List

Fraud Training

Anti-Fraud Policy

Most Effective

Surprise Audit

Mandatory Vacation - Job Rotation

Hotline

Employee Support

Executive Training

Why is it Easy to Commit Fraud? Companies trust employees Employees with authority Autonomy with lack of over-

sight Poor controls Mergers, acquisitions, spinoffs Discontinued services Relationship between auditing

firm and clients

Users of Financial Statements

TransactionActivity

TransactionActivity

InformationUsers

InformationUsers

FinancialStatementsFinancial

StatementsAccounting

SystemAccounting

System

BankersInvestorsVendorsGovernmentManagement

BankersInvestorsVendorsGovernmentManagement

Balance SheetIncome StatementStatement of Owner EquityStatement of Cash Flows

Balance SheetIncome StatementStatement of Owner EquityStatement of Cash Flows

DecisionsDecisions

Loan ApprovalFinancial InvestmentCredit ApprovalOperational & Financial Decisions

Loan ApprovalFinancial InvestmentCredit ApprovalOperational & Financial Decisions

Audit Design Flaws

Not designed to prevent fraud

Primarily check math and accounting rules

Look only for material misstatements

Relies on internal controls

Tests only a percentage

How They Do It!

Hide Fraud in Key Accounts High volume accounts – write-

offs, bad debt, supplies

Accounts auditors don’t understand

Predictable accounts that will be tested, inventory, accounts receivable

Use Account that Require Judgment and Estimates

Warranty Reserve

Allowance of Bad Debt

Sales Allowances and Returns

Restructuring / Discontinued Services

Grey Area

Abuse Reserve

Cookie Jar Accounting

Large Companies Require Large Reserve

Easy to Manipulate

Audit looks at Risk of Understating Reserve

Plan around Auditors Scope and Announced Procedures Exploit Scope and Materiality

Move Inventory locations

Falsify Documents

Force Auditors to choose alternate items to test

Follow the Basic Accounting Principals

Pretend to be Conservative Give auditors the answers they

want to hear Make numbers fall within

acceptable historic lines Make sure there are adjustments

for auditors to book Being stupid is not a crime Simple mistake

Cooking the Books

Income Statement Recording sales before all

conditions are met Order has been received Product has been shipped Little risk the shipment will not be

accepted No other reactions are required Title ownership has changed

payments due

Puff Up the Income Statement Improperly increased revenue

Sales recorded before completed Goods are shipped before sale is

final Revenue recorded while future

services are still due Bogus Revenue Supplier refunds recorded as

income Revenue recorded from self

dealings Revenue recorded from asset

exchanges

Puff Up the Income Statement Improper lowered costs or

expenses Current expenses shifted into

later period Expenses capitalized on Balance

Sheet Assets depreciated slower than

normal Liabilities not accrued Operating losses masked in

discontinued services

Sweeten the Balance Sheet Improperly increased income

Expenses shifted to different periods

Capitalize costs as inventory Assets depreciate or amortized

too slowly Worthless asset not written off

immediately Shift revenue and income into

later periods with reserves

Sweeten the Balance Sheet Improperly increased assets

and equity Increased equity through one

time gains Report gains on exchange of

similar assets Report gains by selling

undervalued assets Retire debt Report revenue rather than

liability on receipt of cash