FRAUD EXAMINATION ALBRECHT, ALBRECHT, & ALBRECHT Financial Statement Fraud CHAPTER 11

Learning Objectives 1. Understand the role that financial statements play in U.S. businesses. 2.Describe the nature of financial statement fraud. 3.Become familiar with financial statement fraud statistics 4.See how financial statement frauds occur and are concealed.

Learning Objectives 5.Understand the framework for detecting financial statement fraud. 6.Identify financial statement fraud exposures. 7.Explain how information regarding a company’s management and directors, nature of organization, characteristics, relationship with others, and financial results can help assess the likelihood of financial statement fraud.

What Are Some Problems with Financial Statements?  Misstated “Cooked”  Inappropriate executive loans and corporate looting  IPO favoritism, spinning & laddering  Excessive retirement perks  Exorbitant compensation  Loans for trading fees  Massive employee fraud

Review the Fraud Triangle.

What Are the Elements of the Perfect Fraud Storm? 1.Management lacked understanding of the causes for success of their companies 2.Moral decay occurring in the United States and around the world 3.Misplaced executive incentives 4.Wall Street’s unachievable expectations that targeted only short-term performance 5.The large amount of debt and leverage each of the fraudulent companies had placing tremendous pressure on executives

What Are the Elements of the Perfect Fraud Storm? 6.The nature of U.S. accounting rules 7.The opportunistic behavior of some CPA firms 8.The greed by executives, investment banks, commercial banks, and investors 9.Three types of failure by educators 1.Failure to provide sufficient ethical training 2.Failure to teach students about fraud 3.Failure to teach less about content as an end in itself and to focus more content in the context of helping them develop analytical skills

Financial Statement Fraud Statistics.  Infrequent  300 over 10 years  Costly  Last 23.7 months  Mean $25 million  CEO in 72%, CFO, COO  Computer hardware/software  78% of firms on NASDAQ

 Most had no audit committee  Most directors were insiders  Family relationships between directors  56% audited by Big Eight or Big Six  25% changed auditors during fraud  Significant number of class action suits  Many resignations-few served jail time Financial Statement Fraud Statistics.

What Are the Motives for Financial Statement Fraud? High Stock Prices Bond or Stock Offerings Increase Personal Wealth To Meet Expectations Competition

Discuss Detecting Financial Statement Fraud.

Complete the Fraud Exposure Rectangle Fraud Exposure Rectangle Management & Directors The Organization & Its Industry Company’s Relationship with Other Entities Financial Results & Operating Characteristics

Discuss Management & Directors. Backgrounds Motivations Influence on Decision Making Financial Statements Requires Management’s Participation Work “ON” Behalf of the Organization

Comment On & Explain Relationships with Others.  Related Party Transactions  With Financial Institutions & Bond Holders  Improper or Unrealistic Transactions  Auditors  Attorneys  Investors  Regulators

Describe Questionable Organizations & Industries.  Structures designed to hide fraud  Unduly complex organizations  Legitimate purpose for each business segment  Active or passive board of directors  Active or passive independent audit committee  Active, independent internal audit  Board of directors with few outsiders  Offshore activities without an apparent business purposes

 Is it a new business without a proven business history?  Have recent significant changes occurred in the nature of the organization?  Is monitoring of significant controls adequate?  Are accounting and IT staff organized and effective?  Is it a declining industry with increasing business failures and declining demand? List What to Ask About Organization & Industry.

What Approach is Taken to Examine Financial Statements? Non-Traditional Examine Footnotes Comparisons of Financial Statement Balances with Similar Organizations

Large Volumes Of Inventory Requires Large Volumes of Space See if Activities Match Between Organization & Standard Operations Comparisons of Financial Statement Balances with Similar Organizations What Approach is Taken to Examine Financial Statements?

Define the Acronyms. 1.COSO is 2.SEC is 3.GAAP is Committee of Sponsoring Organizations Securities and Exchange Commission Generally Accepted Accounting Principles

Match Terms & Definitions. 10-K 10-Q AAER SEC Document released by SEC when a company commits financial statement fraud Annual report publicly traded companies file with SEC Government Agency responsible for regulating stock trading & financial Statements of Public companies Quarterly report publicly traded companies file with SEC

Match Terms & Definitions. Financial Statement Fraud Financial Statements Treadway Commission Reports summarizing cash & profits of an organization Intentionally misstating financial statements It recommended changes in financial statements