FRAUD EXAMINATION ALBRECHT, ALBRECHT, & ALBRECHT Revenue- and Inventory-Related Financial Statement Frauds Chapter 12

Learning Objectives Identify revenue-related financial statement fraud schemes. Understand revenue-related financial statement fraud schemes. Identify ways to proactively search for revenue-related financial statement fraud schemes.

Learning Objectives Understand the importance of, and ways to follow up on, revenue-related fraud symptoms. Identify inventory and cost of goods sold financial statement fraud schemes. Understand inventory and cost of goods sold financial statement fraud symptoms.

Learning Objectives Identify ways to search for inventory and cost of goods sold financial statement fraud schemes. Understand the importance of, and ways to follow up on, inventory and cost of goods sold fraud symptoms.

List Common Ways to Commit Revenue Fraud. Factoid Revenue fraud is the most common fraud committed. Manipulate Revenue Accounts Record Revenues Prematurely

Why Are Revenue Frauds so Common? GAAP (Generally Accepted Accounting Principles) allows too many alternative ways to recognize & record revenue. It is an easy fraud to commit. How is it done? Report Early Create Fictitious Revenues Hold Books Open 1 Year +

Complete the Chart 1 2 3 4 5 6 Typical Revenue – Related Transactions Sell goods & services to customers 1 Estimate uncollectible A/R 2 YES Accept From Customer 3 Goods Returned NO Write Off Receivables as Uncollectible 4 NO Receivable Paid YES Discount Taken YES NO Collect Cash After Discount Period 5 Collect cash within discount period 6

Discuss What to Look For? Analyze the balances & relationships within the statements. Look for unusual changes in revenue- related accounts balances from period to period (looking for trends), and Look for changes in revenue-related relationships from period to period.

What Kind of Changes Should You Look For? Compare the statement amounts & relationships with other data. Compare the company’s financial results & trends with those of similar firms in the same industry, and Compare financial statement amounts with the assets they are supposed to represent.

Discuss Revenue-Related Fraud Symptoms. Analytical symptoms Accounting or documentary symptoms Lifestyle symptoms Control symptoms Behavioral or verbal symptoms Tips and complaints

Complete this Table 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

What is the Formula for Measuring Period to Period Changes? Period 1 account balance Period 2 account balance Period 1 -

What is an Alternative to the Prior Formula? Make the Balance Sheet & Income Statement into Change Statements HOW? Perform Horizontal & Vertical Analysis Compare to Statements of Changes in Cash Circle the Preferred

Match Ratio to Name. Gross Profit Margin Sales Returns Total Sales Net Sales Sales Return % Net Sales A/R Sales Discount % A/R Turnover 365 A/R Turnover Number of Days in A/R Sales Discounts Gross Sales

Match Ratio to Explanation. A measure of profitability Allowance for Uncollectible Accounts Estimated uncollectible A/R, a contra-asset, Bad Debt Expense Common Size Financial Statements Financial statements converted to % Expense for revenues or receivable presumed uncollectible Earnings per Share

NO! They provide symptoms. You must investigate to Do Ratio, Vertical or Horizontal Analysis Tell if Fraud Has Been Committed? NO! They provide symptoms. You must investigate to determine if fraud exists.

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 Opportunity

Comment on Behavior & Lifestyle Flags. Enhanced Performance Revenue Fraud Indirect Benefit to Perpetrators Questions and Observation ??

Discuss TIPS. Ombudsman or Hotline People don’t know who to talk to People don’t want to wrongfully accuse someone else Whistleblower repercussions People 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 Discounts Net Revenues (Sales) -Cost of Goods Sold Gross Margin -Expenses Net Income Understated Overstated

Understated Purchases Review Effect of Overstating Inventory & Understating Purchases on Cost of Goods Sold. Overstated Ending Inventory Understated Purchases No Effect Understated Beginning Inventory +Purchases -Returns to Vendor -Purchase Discounts on Inventory Goods Available for Sale -Ending Inventory Cost of Goods sold

Complete Inventory Cycle. Purchase Inventory Determine Inventory Costs Return Goods? Take Discount? Count Inventory Inventory Counted? Pay Vendor Sell Inventory? Obsolete?

Identify Some Inventory Fraud Symptoms. Inventory moves are very visible Ask inventory handlers what moves & what doesn't Check Inventory Costs with Vendors Talk to Large Customers

Period-to-Period Changes Complete Chart. Analysis of Period-to-Period Changes Inventory Account Balances Focus on Changes in Statement Numbers Study Statement of Cash Flow Use Horizontal Analysis With Industry Competitors Compare Statement Results with Similar Companies Compare Company’s trends with those of similar companies Inventory Relationships Examine Changes in Relevant Ratios Use Vertical Analysis With Real-World Numbers Compare Statement Amounts with the Assets They Are Supposed to Represent

Discuss Inventory Fraud Symptoms. Analytical symptoms Accounting or documentary symptoms Lifestyle symptoms Control symptoms Behavioral or verbal symptoms Tips and complaints

Match Ratio to Name. Allowance for Doubtful Accounts Financial statements converted to % The expense of goods sold to customers Bad Debt Expense A contra receivable, estimated uncollectible A/R Cost of Goods Sold Common-Size Financial Statements Expensing estimated uncollectible A/R or revenues

Match Ratio to Name. Earnings Per Share Sales returned by customer for refund Determining when revenues are earned & can be reported on the income statement Revenue Recognition Sales Returns A measure of profitability