Effect of Fraud on Financial Statements01

7/29/2019 Effect of Fraud on Financial Statements01

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EFFECT OF FRAUD ON FINANCIAL

STATEMENTS(1)

Fraud in financial statements typically takesthe form of:

Overstated ASSETS / REVENUE

Understated LIABILITIES /EXPENSES


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Overstating assets and revenues falselyreflects a financially stronger company byinclusion of fictitious asset costs or artificialrevenues. Understated liabilities andexpenses are shown through exclusion of

costs or financial obligations. Both methodsresult in increased and net worth for thecompany. This overstatement and/orunderstatement results in increased

earnings per share or partnership profitinterests or a more stable picture of thecompany's true situation.


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The schemes typically used have been divided into fiveclasses. Because the maintenance of financial recordsinvolves a double-entry system, fraudulent accounting

entries always affect at least two accounts and, therefore,at least two categories on the financial statements. Whilethe areas described below reflect their financial statementclassifications, keep in mind that the other side of thefraudulent transaction exists elsewhere. It is common for

schemes to involve a combination of several methods.The five classifications of financial statementschemes are:

A. Fictitious Revenues / Aggressive RevenuesRecognition

B. Timing DifferencesC. Improper Asset ValuationsD. Concealed Liabilities and ExpensesE. Improper Disclosures


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A- Fictitious Revenues / Aggressive

Revenues Recognition

Fictitious or fabricated revenues involve therecording of goods or services sales that didnot occur. It involves fake or phantomcustomers, but can also involve legitimatecustomers. For example, a fictitious invoicecan be prepared (but not mailed) for alegitimate customer although the goods arenot delivered. At the beginning of the nextaccounting period, the sale might be reversed

to help conceal the fraud, Another method isto use legitimate customers and artificiallyinflate or alter invoices reflecting higheramounts or quantities than actually sold.


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REAL LIFE EXAMPLE (1)

I n one recent case, a, foreign subsidiary of a U.S.

company recorded several large ficti tious sales to a

ser ies of companies.

They invoiced the sales but did not collect any of the

accounts receivable. which became severely past due.

The manager of the foreign subsidiary arranged false

conf irmations of the accounts receivable for audit

purposes and even hired actors to pretend to be the

customers dur ing a visit f rom US management.


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REAL LIFE EXAMPLE (1)

Background checks on the customers would have

revealed that some of the companies were ficti tious

while others were either undisclosed related parties

or operated in industr ies that would have no need of

the goods supposedly supplied.

An investigation revealed that the manager of theforeign subsidiary directed the scheme to record

f ictitious revenues in order to meet unrealistic

revenue goals set by U.S. management.


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SALES WITH CONDITIONS Sales with conditions are those that have terms that have

not been completed and the rights and risks of ownershiphave not passed to the purchaser. For example

o The price is contingent upon some future events.

o A service or membership fee is subject to unpredictablecancellation dur ing the contract per iod.

o The transaction includes an option to exchange the product

for others.

o Payment terms are extended for a substantial per iod andadditional discounts or upgrades may be requi red to induce

continued use and payment instead of switching to alternative

products.


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PREMATURE /EARLY REVENUES

RECOGNITION

The following four conditions must be present torecognize revenues (See Accounting principles re:

Revenue Recognition).1. Convincing evidence of an arrangement exists.

2. Delivery has occurred or services have been rendered.

3. The seller's price to the buyer is fixed or determinable4. Collectibility is reasonably assured.


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RECOGNITION OF REVENUE FROM LONG-TERM CONTRACTS [i]

Long-term contracts pose special problems forrevenue recognition. Long-term constructioncontracts, for example, use either the completedcontract method or thepercentage of completion method, dependingpartly on the circumstances.

The Completed Contractmethod does not recordrevenue until the project is 100% complete. Construction

costs are held in an inventory account until completion ofthe project.


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RECOGNITION OF REVENUE FROM LONG-TERM CONTRACTS [ii]

The Percentage of Completionmethod recognizesrevenues and expenses as measurable progress on a

project is made, but this method is particularlyvulnerable to manipulation. By the percentage ofcompletion and the estimated costs to complete aconstruction project in order to recognize revenuesprematurely and conceal contract overruns.


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CHANNEL STUFFING / TRADE LOADING[1]

This involves refers to the sale of an unusually largequantity of a product to distributors, who areencouraged to overbuy through the use of deep

discounts and/or extended payment terms.

This practice is especially attractive in industries withhigh gross margins (cigarettes, pharmaceuticals,perfume, soda concentrate, and branded consumer

goods) because it can increase short-term earnings.The downside is that by stealing from the next period'ssales, it makes it harder to achieve sales goals in thenext period, sometimes leading to increasinglydisruptive levels of channel stuffing and ultimately arestatement.


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CHANNEL STUFFING / TRADE LOADING [2]

Although orders are received, the terms of the ordermight raise some question about the collectibility ofaccounts receivable and there maybe side agreementsthat grant a right of return, effectively making the salesinto consignment sales.

There may be a greater risk of returns for certainproducts if they cannot be sold before their shelf lifeexpires.

This is particularly a problem for pharmaceuticalsbecause retailers will not accept drugs with a short shelflife remaining. As a result, "channel stuffing" should beviewed skeptically as in certain circumstances it may

constitute fraud.


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CHANNEL STUFFING / TRADE LOADING [3]EXAMPLES

a. The SEC's complaint against Bausch & Lomb indicatedthat the company's internal estimates showed that itmight take distributors up to two years to sell thequantity of contact lenses the company was trying to getthem to purchase in the last two weeks of its 1993 fiscalyear.

b. The SEC's complaint against the former Chairman andCEO and the former CFO of Sunbeam Corporationincluded that they failed to disclose that Sunbeam's 1997revenue growth was in part achieved at the expense offuture results, by offering discounts and other incentivesto customers to sell merchandise immediately that wouldotherwise have been sold in later periods.


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FICTITIOUS /EARLY RECOGNITIONOF REVENUES

RED FLAGS

1. Rapid growth or unusual profitability, especially comparedto that of other companies in the same industry.

2. Recurring negative cash flows from operations or aninability to generate cash flows from operations whilereporting earnings and earnings growth.

3. Significant transactions with related parties or special

purpose entities not in the ordinary course of business orwhere those entities are not audited or are audited byanother firm.


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FICTITIOUS /EARLY RECOGNITIONOF REVENUES

RED FLAGS4. Significant, unusual, or highly complex transactions,

especially those close to period end

that pose difficult "substance over form" questions.5. Unusual growth in the number of days sales in receivables.

6. A significant volume of sales to entities whose substanceand ownership is not known.

7. An unusual surge in sales by a minority of units within acompany, or of sales recorded by corporate headquarters.


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Financial statement fraud might also involve timingdifferences, that is, the recording of revenue and/orexpenses in improper periods. This can be done to shiftrevenues or expenses between one period and the next,

increasing or decreasing earnings as desired.

B- TIMING DIFFERENCES (INCLUDING

PREMATURE REVENUE RECOGNITION)


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TIMING DIFFERENCERED FLAGS

1) Rapid growth or unusual profitability, especiallycompared to that of other companies in the same

industry.

2) Recurring negative cash flows from operations or aninability to generate cash flows from operations whilereporting earnings and earnings growth.

3) Significant, unusual, or highly complex transactions,especially those close to period end that pose difficult"substance over form" questions.


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TIMING DIFFERENCERED FLAGS

4) Unusual increase in gross margin or margin in excessof industry peers.

5) Unusual growth in the number of days sales inreceivables.

6) Unusual decline in the number of days purchases in

accounts payable.

Documents

Effect of Fraud on Financial Statements01