1. Forensic and Investigative Accounting Chapter 3 Fraudulent Financial Reporting © 2007 CCH. All Rights Reserved. 4025 W. Peterson Ave. Chicago, IL 60646-6085 1 800 248 3248 www.CCHGroup.com

2. Chapter 3Forensic and Investigative Accounting2 An International Problem Fraud Fraud is an international phenomenon touching all countries. Transparency International (TI) is a global network including more than 90 locally established national chapters and chapters-in-formation, whose goal is to fight corruption in the national arena. TI produces a Transparency International Corruption Perception Index (CPI), which ranks more than 150 countries by their perceived levels of corruption, as determined by expert assessments and opinion surveys.

3. Chapter 3Forensic and Investigative Accounting3 SAS No. 2 Relevance Relevance Timeliness Timeliness Reliability Reliability Verifiability Verifiability Representational faithfulness Representational faithfulness Neutrality Comparability and consistency Materiality Feasibility or costs and benefits Statement of Financial Accounting Concepts No. 2 provides these nine qualities and characteristics that make financial information useful for investors, creditors, analysts, and other users of financial information:

4. Chapter 3Forensic and Investigative Accounting4 Three M’s of Financial Reporting Fraud Manipulation, falsification, or alteration of accounting records or supporting documents from which financial statements are prepared. Manipulation, falsification, or alteration of accounting records or supporting documents from which financial statements are prepared. Misrepresentation in or intentional omission from the financial statements of events, transactions, or other significant information. Misrepresentation in or intentional omission from the financial statements of events, transactions, or other significant information. Intentional misapplication of accounting principles relating to amounts, classification, manner of presentation, or disclosure. Intentional misapplication of accounting principles relating to amounts, classification, manner of presentation, or disclosure. Source: D.S. Hilzenrath, “Forensic Auditors Find What Some Companies Try to Hide,” The Washington Post, November 23, 2002, p.19.

5. Chapter 3Forensic and Investigative Accounting5 Fraud Schemes Based on SEC Releases 1. Fictitious and/or overstated revenues and assets. 2. Fictitious reductions of expenses and liabilities. 3. Premature revenue recognition. 4. Misclassified revenues and assets. 5. Overvalued assets or undervalued expenses and liabilities. (continued on next slide)

6. Chapter 3Forensic and Investigative Accounting6 Fraud Schemes Based on SEC Releases 6. Omitted liabilities. 7. Omitted or improper disclosures. 8. Equity fraud. 9. Related-party transactions. 10. Alter ego. 11. Minimizing income or inflating expenses to reduce tax liabilities.

7. Chapter 3Forensic and Investigative Accounting7 Shenanigans to Boost Earnings Recording revenue before it is earned. Recording revenue before it is earned. Creating fictitious revenue. Creating fictitious revenue. Boosting profits with nonrecurring transactions. Boosting profits with nonrecurring transactions. Shifting current expenses to a later period. Shifting current expenses to a later period. Failing to record or disclose liabilities. Failing to record or disclose liabilities. Shifting current income to a later period. Shifting current income to a later period. Shifting future expenses to an earlier period. Shifting future expenses to an earlier period.

8. Chapter 3Forensic and Investigative Accounting8 Internal vs. External Fraud InternalExternal EmployeeManagement Stock theft Lapping Check forgery Misappropriation of cash assets Expense accounts False insurance claims Lapping False financial statements Credit card fraud Check forgery Misappropriation of cash/assets False invoices Expense accounts Unnecessary purchases Product substitution

9. Chapter 3Forensic and Investigative Accounting9 Internal vs. External Fraud (contd.) InternalExternal EmployeeManagement Petty cash Check forgery Bribes/secret commission KickbacksKickbacks Bid rigging/price fixing Loans/investments Ghost vendors False representation of funds Diversion of sales Source: KPMG, Fraud Awareness Survey, Dublin: KPMG, 1995, pp. 10-12.

10. Chapter 3Forensic and Investigative Accounting10 Four Factors Contributing to Business Fraud 1. Motive 2. Opportunity 3. Lack of integrity (or rationalization) 4. Capacity—the person must have the necessary traits, abilities, or positional authority to commit the crime

11. Chapter 3Forensic and Investigative Accounting11 Components of Internal Controls Control environment Control environment Risk assessment Risk assessment Control activities or control procedures Control activities or control procedures Information and communication systems support Information and communication systems support Monitoring Monitoring Source: SAS No. 94, The Effect of Information Technology on the Auditor’s Consideration of Internal Control in a Financial Statement Audit, New York: AICPA.

12. Chapter 3Forensic and Investigative Accounting12 Types of Controls Preventive Controls Segregation of duties Required approvals Securing assets Passwords Using document control numbers Drug testing Job rotation Computer backup

13. Chapter 3Forensic and Investigative Accounting13 Types of Controls Detective Controls Reconciliations Reviews Event notifications Surprise cash count Counting inventory

14. Chapter 3Forensic and Investigative Accounting14 Types of Controls Corrective Controls Training Process redesign Additional technology Quality circle teams Budget variance reports

15. Chapter 3Forensic and Investigative Accounting15 Earnings Management Earnings management may be defined as the “purposeful intervention in the external financial reporting process, with the intent of obtaining some private gain.” – Katherine Schipper, “Commentary on Earnings Management,” Accounting Horizon, December 1989, p. 92.