Albrecht: Fraud Examination, 4e

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FINANCIALSTATEMENTFRAUD

True/False

1. False.Likeotherfrauds,financialstatementfraudisrarelyseenandmaybeconcealed
throughcollusionamongmanagement,employees,thirdparties,orinotherways.
2. True
3. True
4. False.Themostcommonmethodsusedinvolveimproperrevenuerecognition,the
overstatementofassets,andtheunderstatementofexpensesandliabilities,inthatorder.
5. True
6. True
7. False.TheFraudExposureRectangleisusedinidentifyingmanagementfraudexposures.In
additiontothethreecornersmentionedabove,therectangleincludesFinancialResultsand
OperatingCharacteristics.
8. False.Financialstatementfraudisusuallycommittedbythehighestindividualsinan
organizationandmostoftenonbehalfoftheorganizationasopposedtoagainstit.
9. True
10. False.Relationshipswithothers(e.g.,relatedparties)shouldbeexaminedbecauseunrealistic
andnonarmslengthtransactionsaresomeoftheeasiestwaystoperpetratefinancial
statementfraud.
11. True
12. False.WhileCFOsareofteninvolved,theCEO(ChiefExecutiveOfficer)ofanorganization
isthepersonthatcommits,motivatesandinstigatesmostfinancialstatementfraud.

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13. False.Onbehalfofanorganization,topmanagementalmostalwayscommitsfinancial
statementfraud.
14. False.Mostpeoplewhocommitmanagementfraudarefirsttimeoffenders.
15. False.Mostfinancialstatementfraudoccursinsmallerorganizationswhereoneortwo
individualshavealmosttotaldecisionmakingability.
16. False.Apersonengagedinzeroorderreasoningonlyconsidersconditionsthatdirectlyaffect
himselforherselfandnototherpeople.
17. True
18. True
19. True
MultipleChoice
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
ShortCases
Case1
Mostofthefraudsymptomsinthiscaserelatetomanagement,theboardofdirectors,and
relationshipswithothers.
Managementandtheboardofdirectors:Theseniorofficerswerefriends.Theyhadalotofpower
inthenewcompany,whichallowedthemtocolludeifneeded.Theirpositionsinthecompany
allowedthemtoinfluencedecisionsandoverrideinternalcontrolsastheywished.Theyowneda
largepercentageofthecommonstock,sotheyhadapersonalmotivationforthestockpricetobeas
highaspossible.Theycomprisedalargepercentageoftheboardofdirectors,sotheywereinsiders.
Relationshipswithothers:Thefactthatthepresidentofthelocalbankwasappointedtotheboard
ofdirectorsnotonlyrepresentedagreymemberintheboard(becausehehadloanedthecompany
money),butitcouldalsorepresentaconcernabouthowvalidthetransactionsarebetweenthe
companyandthebank.Isthebankgivingthecompanyextremelylaxcredittermsoran
unreasonablylowinterestrate?Arethetransactionswiththebankarmslength?Onemightalsobe
concernedaboutthecompanysrelationshipwithcityofficials,whofeelastrongmotivationtokeep
thiscompanyintownbecauseitbooststhecityseconomy,providesjobs,etc.
Case2
1. Indeterminingwhetherornotagoodsystemofinternalcontrolswouldhaveprevented
fraudulentbackdatingpractices,itisimportanttounderstandwhotheperpetratorswere.
Internalcontrolsaremosteffectiveinpreventingordetectingemployeeswhocommitfraud
whenactingalone.Whencollusion(twoormorepeopleareinvolved),internalcontrolsare
lesseffective.Whentopmanagementandthedirectorsareinvolved,aswasthecasewith
optionbackdating,theycanoftenoverrideinternalcontrols.Internalcontrolactivities
(procedures)suchassegregationofduties,properauthorizations,andsoforth,wouldntbe
nearlyaseffectiveinpreventingthistypeoffraudaswouldagoodcontrolenvironment(tone
atthetop.)Whileafewofthesefirmsbackdatingpracticeswerecaughtbyauditorsor
outsiders,mostbackdatingrevelationshavecomefromcompaniesthemselvesafter
thoroughlyexaminingalloptionsgrantedinthepast.
2. Thequestionofwhyexecutivesanddirectorswouldhaveallowedthisfraudulentpracticeis
atoughone.Hopefully,inmostcases,theoptionbackdatingwasknownbyonlyafew
people.Thoseindividualsprobablyengagedinthepracticebecauseoftheelementsofthe
fraudtriangle:(1)theyfeltapressuretoincreasetheircompensationgreed,(2)they

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Albrecht: Fraud Examination, 4e

perceivedanopportunitytobackdatewithoutgettingcaughtnoonehadbeenpaying
attentiontooptiondatinginthepast,and(3)theyrationalizedthatitwasokayeveryone
elsewasdoingit.Withrespecttotherationalization,theywerecorrect.Whileeveryone
wasntdoingit,lotsofcompanieswere.Thefactthatmanyothersareactingillegaldoesnt
makeitright.
3. Awhistleblowersystemallowsindividualstocallinanonymouslytoreportsuspected
violations.Awhistleblowersystemwouldprobablybethemosteffectivewaytocatchthis
kindoffraudbecauseindividualswhosawthedishonestactscouldreportviolationsby
companyexecutiveswithoutfearofreprisalbecausenooneknowswhotheanonymous
calleris.Whistleblowersystemsaremostimportantwhereinternalcontrolscanbe
overridden.Thefactthatawhistleblowersystemisinplacehelpspreventordeters
dishonestacts.Providingawayforeveryonewhocouldseefraudtoeasilyreportthatfraud
significantlyincreasesthelikelihoodthatdishonestactswillbereported.
Case3
Belowaresomeoftheredflagsthatfraudmaybeoccurring:

Successsincebeginningoperations
Rapidgrowthinrevenues
PressuretoperformwellfortheIPO
Increasedcommissionsasawaytoincreaserevenue
Personalrelationshipsbetweenexecutives
Changeinauditors
Disputewithauditoroverrevenuerecognitionaccounting
Infrequentboardofdirectorandauditcommitteemeetings
Closerelationshipsbetweentheboardandmanagement
Highlevelofstockoptionsheldbymanagement

Case4
Financialstatementfraudisverydifferentthanembezzlementandmisappropriation.Perpetratorsof
financialstatementfraudareusuallymembersoftopmanagementwhomanipulatefinancial
statementsinordertoboostearningsandincreasestockprices.Ontheotherhand,embezzlement
andmisappropriationtakeplacewhenemployeesstealfromtheorganizationsforwhichtheyare
working.Topmanagementbenefitsfromfinancialstatementfraudwhereasthebenefactorsof
embezzlementandmisappropriationarethemiddlemanagement,frontlineworkers,andotherswho
engageinthemisappropriationandembezzlement.
Case5
1. Managementanddirectors
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2.
3.
4.
5.
6.
7.

Organizationandindustry
Organizationandindustry
Relationshipswithothers
Financialresultsandoperatingcharacteristics
Relationshipswithothers
Managementanddirectors

CaseStudies
CaseStudy1
1.
TheChipmunkCompany
RatioAnalysis
LIQUIDITY RATIOS
Current ratio: current
assets/current liabilities
Quick ratio: (current assets
inventoryprepaid
expenses)/current liabilities
Sales/receivables: net
sales/net ending receivables
Number of days sales in A/R:
net ending receivables/(net
sales/365)
Inventory turnover: cost of
sales/average inventory

12/31/10

12/31/09

CHANGE

PERCENT
CHANGE

INDUSTRY
AVERAGE

2.310

2.491

0.181

7.27%

1.21

0.416

0.402

0.014

3.46%

0.35

16.05

17.78

1.73

9.73%

23.42

22.74

20.53

2.21

10.76%

15.58

1.48

1.39

0.09

6.37%

1.29

2. ANALYSIS:Thecurrentratiohasdeclinedbymorethan7percentduringtheyear,which
raisesafewquestions.Theremightbeapossibilityoffraudincashornearcash(current
assets).Thecollectionperiodofaccountsreceivableisalsoquestionable.Thereisalmostan
11percentincreaseindayssalesinaccountsreceivable,andthecompanyistakingmuch
longerthantheindustryaveragetocollectitsreceivables.Thisalsocouldindicatethatfraud
isoccurringasthecompanymaybechannelstuffingorcreatingfictitioussalesandaccounts
receivable.

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