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Albrecht: Fraud Examination, 4e

Chapter 11
FINANCIAL STATEMENT FRAUD
True/False
1. False. Like other frauds, financial statement fraud is rarely seen and may be concealed
through collusion among management, employees, third parties, or in other ways.
2. True
3. True
4. False. The most common methods used involve improper revenue recognition, the
overstatement of assets, and the understatement of expenses and liabilities, in that order.
5. True
6. True
7. False. The Fraud Exposure Rectangle is used in identifying management fraud exposures. In
addition to the three corners mentioned above, the rectangle includes Financial Results and
Operating Characteristics.
8. False. Financial statement fraud is usually committed by the highest individuals in an
organization and most often on behalf of the organization as opposed to against it.
9. True
10. False. Relationships with others (e.g., related parties) should be examined because unrealistic
and nonarms length transactions are some of the easiest ways to perpetrate financial
statement fraud.
11. True
12. False. While CFOs are often involved, the CEO (Chief Executive Officer) of an organization
is the person that commits, motivates and instigates most financial statement fraud.
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Albrecht: Fraud Examination, 4e
13. False. On behalf of an organization, top management almost always commits financial
statement fraud.
14. False. Most people who commit management fraud are first-time offenders.
15. False. Most financial statement fraud occurs in smaller organizations where one or two
individuals have almost total decision-making ability.
16. False. A person engaged in zero-order reasoning only considers conditions that directly affect
himself or herself and not other people.
17. True
18. True
19. True
Multiple Choice
1. e
2. d
3. e
4. c
5. d
6. d
7. a
8. c
9. a
10. d
11. c
12. a
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Albrecht: Fraud Examination, 4e
13. b
Short Cases
Case 1
Most of the fraud symptoms in this case relate to management, the board of directors, and
relationships with others.
Management and the board of directors: The senior officers were friends. They had a lot of power
in the new company, which allowed them to collude if needed. Their positions in the company
allowed them to influence decisions and override internal controls as they wished. They owned a
large percentage of the common stock, so they had a personal motivation for the stock price to be as
high as possible. They comprised a large percentage of the board of directors, so they were insiders.
Relationships with others: The fact that the president of the local bank was appointed to the board
of directors not only represented a grey member in the board (because he had loaned the company
money), but it could also represent a concern about how valid the transactions are between the
company and the bank. Is the bank giving the company extremely lax credit terms or an
unreasonably low interest rate? Are the transactions with the bank arms length? One might also be
concerned about the companys relationship with city officials, who feel a strong motivation to keep
this company in town because it boosts the citys economy, provides jobs, etc.
Case 2
1. In determining whether or not a good system of internal controls would have prevented
fraudulent backdating practices, it is important to understand who the perpetrators were.
Internal controls are most effective in preventing or detecting employees who commit fraud
when acting alone. When collusion (two or more people are involved), internal controls are
less effective. When top management and the directors are involved, as was the case with
option backdating, they can often override internal controls. Internal control activities
(procedures) such as segregation of duties, proper authorizations, and so forth, wouldnt be
nearly as effective in preventing this type of fraud as would a good control environment (tone
at the top.) While a few of these firms backdating practices were caught by auditors or
outsiders, most backdating revelations have come from companies themselves after
thoroughly examining all options granted in the past.
2. The question of why executives and directors would have allowed this fraudulent practice is
a tough one. Hopefully, in most cases, the option backdating was known by only a few
people. Those individuals probably engaged in the practice because of the elements of the
fraud triangle: (1) they felt a pressure to increase their compensationgreed, (2) they
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Albrecht: Fraud Examination, 4e
perceived an opportunity to backdate without getting caughtno one had been paying
attention to option dating in the past, and (3) they rationalized that it was okayeveryone
else was doing it. With respect to the rationalization, they were correct. While everyone
wasnt doing it, lots of companies were. The fact that many others are acting illegal doesnt
make it right.
3. A whistle-blower system allows individuals to call in anonymously to report suspected
violations. A whistle-blower system would probably be the most effective way to catch this
kind of fraud because individuals who saw the dishonest acts could report violations by
company executives without fear of reprisal because no one knows who the anonymous
caller is. Whistle-blower systems are most important where internal controls can be
overridden. The fact that a whistle-blower system is in place helps prevent or deters
dishonest acts. Providing a way for everyone who could see fraud to easily report that fraud
significantly increases the likelihood that dishonest acts will be reported.
Case 3
Below are some of the red flags that fraud may be occurring:
Success since beginning operations
Rapid growth in revenues
Pressure to perform well for the IPO
Increased commissions as a way to increase revenue
Personal relationships between executives
Change in auditors
Dispute with auditor over revenue recognition accounting
Infrequent board of director and audit committee meetings
Close relationships between the board and management
High level of stock options held by management
Case 4
Financial statement fraud is very different than embezzlement and misappropriation. Perpetrators of
financial statement fraud are usually members of top management who manipulate financial
statements in order to boost earnings and increase stock prices. On the other hand, embezzlement
and misappropriation take place when employees steal from the organizations for which they are
working. Top management benefits from financial statement fraud whereas the benefactors of
embezzlement and misappropriation are the middle management, frontline workers, and others who
engage in the misappropriation and embezzlement.
Case 5
1. Management and directors
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Albrecht: Fraud Examination, 4e
2. Organization and industry
3. Organization and industry
4. Relationships with others
5. Financial results and operating characteristics
6. Relationships with others
7. Management and directors
Case Studies
Case Study 1
1.
The Chipmunk Company
Ratio Analysis
LIQUIDITY RATIOS 12/31/10 12/31/09 CHANGE
PERCENT
CHANGE
INDUSTRY
AVERAGE
Current ratio: current
assets/current liabilities 2.310 2.491 0.181 7.27% 1.21
Quic ratio: !current assets"
in#entor$%prepai&
e'penses(/current liabilities 0.41) 0.402 0.014 3.4)% 0.3*
+ales/recei#ables: net
sales/net en&in, recei#ables 1).0* 17.78 1.73 9.73% 23.42
-u.ber o/ &a$s sales in A/0:
net en&in, recei#ables/!net
sales/3)*( 22.74 20.*3 2.21 10.7)% 1*.*8
1n#entor$ turno#er: cost o/
sales/a#era,e in#entor$ 1.48 1.39 0.09 ).37% 1.29
2. ANALYSIS: The current ratio has declined by more than 7 percent during the year, which
raises a few questions. There might be a possibility of fraud in cash or near cash (current
assets). The collection period of accounts receivable is also questionable. There is almost an
11 percent increase in days sales in accounts receivable, and the company is taking much
longer than the industry average to collect its receivables. This also could indicate that fraud
is occurring as the company may be channel stuffing or creating fictitious sales and accounts
receivable.
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