METHODS OF COMMITING FRAUD THROUGH

FINANCIAL STATEMENTS

Fraud includes the improper usage of resources and the misrepresentation of

facts to receive gain. It is related to the misallocation of resources, or the
distorted reporting of the existence and availability of resources. Fraud is a
parasite that maims and eventually kills an organization. After a while, it’s
contagious effect would find its way to another host organization.
It erodes the bottom lines and in the end or ultimately the very existence of
any organization is negatively impacted. Whatever an organization is, be it
non-profit or profit/business in nature, it cannot remain healthy to survive
and be competitive if fraud continues to go undetected and unchecked because
obviously any organizational resource that is misallocated or "misused"
threatens the continued existence of an organization. Some of the methods
through which financial frauds are committed are mentioned below:

1: Fictitious revenues
Fictitious or fabricated revenue involves the recording of the sale of goods or
services that did not occur. Fictitious sales usually involve fake or fictitious
customers, but they may involve legitimate customers. For example, a
fictitious invoice may be prepared for a legitimate customer where the goods
are not delivered or the services are not rendered. At the start of the next
accounting period, the sale is then reversed. Another method of using
legitimate customers' accounts is to alter invoices to include higher amounts
or quantities than are actually sold.
Profit and revenue recognition is based upon the following criteria:
· Definition
· Measurability
· Relevance
· Reliability
The term 'revenue' is not defined either in the Companies Acts or in any
current accounting standard. The nearest reference to it is in SSAP2
concerning the prudence concept:
More than one scheme may be used simultaneously in order to overstate
sales. In the following example, the company used fictitious sales, premature
or early recognition of revenue.

EXAMPLE
A person wanted to raise its financial standing and engineered fictitious transactions
over a period of more than seven years. Its management used shell companies to make a
number of fictitious sales. The sham transactions also involved the payment of money
for assets to the shell companies that would be returned to the parent company as
payment for fictitious sales. The scheme went undetected for so long that profits were
inflated by more than £50 million. However, the fraud aroused the suspicions of the
internal auditors. The scheme was uncovered and the perpetrators prosecuted in both
the civil and criminal courts.

A book keeping entry is made to record the purchase of fictitious fixed

assets. This debits fixed assets for the amount of the purchase and credits
cash for the payment in the usual way. A fictitious sales entry is then made
for the same amount as the false purchase, debiting debtors and crediting
sales.
To cover the fictitious sale, the cash payment to cover the purchase of
assets is returned as payment for the sales. For instance:

The effect of this completely fabricated sequence of events is to increase

both the company's assets and revenue.
Pressures are placed on owners and top management to perform by bankers,
shareholders, and even families and the community. The following examples are
instances in which they succumbed to the temptation to manipulate the
numbers.
EXAMPLE
In a similar case, a publicly traded textile company engaged in a series of false
transactions designed to improve its financial profile. Receipts from the sale of shares
were paid to the company purporting to be sales. The management even went so far as
to record a bank loan as profit. By the time the schemewas uncovered, the company
books had been overstated by £30,000, in this case a material amount.

The pressures to commit fraud sometimes come from within the organization.
Departmental budget requirements including profit and profit goals also
encourage financial statement fraud.

EXAMPLE
The accountant of a small company misstated financial records to disguise its financial
problems. He designed a series of book keeping entries to meet budget projections
and to cover up losses on the pension fund. Also, because of poor financial
performance, he consistently overstated profit. To hide this, he debited liability
accounts and credited the shareholders' equity account. The accountant finally
resigned, leaving a letter of confession but was later prosecuted in criminal court.

2: Uncompleted sales
These involve sales that are made on certain conditions that have not been
met, or not completed, by the end of the accounting period and ownership
has not yet passed to the purchaser. They should not be recognized as
revenue until completed. The most common examples of this are conditional
and consignment sales.

EXAMPLE
ABC person sells products that require further engineering before they are acceptable
to customers. However, it records these as revenue before this has been done. In some
cases, it may take weeks or even months. In other cases, the sale is specifically
contingent upon the customer's trial and acceptance of the goods.
The revenue account would require correcting to comply with the revenue
recognition criterion.

Additionally, a provision needs to be made for the unearned sales on Project

C. An entry needs to be made on the debit side of the Sales account to
reduce the sales for the period by ￡17,000 and carried down as a credit
balance to represent unearned sales. This balance should then cancel the
￡17,000 debtor on the balance sheet.

In January, the project is started and completed. The entries below show the
correct recording of the ￡15,500 of costs associated with the project:

Being the costs of Project C in the form of stock and wages. The effect of
these book keeping entries is to recognize revenue and expenses for the period
to which they actually relate, i.e. January, thereby matching them. This
example illustrates how easily the non-adherence to the matching principle
may cause a material misstatement in yearly Profit and Loss Accounts.
3: Concealed liabilities
As discussed earlier, understating liabilities and expenses is one of the ways in
which financial statements may be dishonestly manipulated to make a
company appear more profitable or more valuable than what it would
otherwise appear. Understating liabilities has a positive effect on the balance
sheet, in that the equity and net assets are increased by the amount of the
understatement. Understating expenses, on the other hand, has the effect of
inflating net profit. Overstated profit has the effect of overstating
shareholders' equity.
Concealed liabilities and expenses can be difficult to detect because often
there is no audit trail. There are three common methods for concealing them:
liability and expense omissions, capitalized expenses, and failure to disclose
warranty costs and liabilities.

4: Liability and Expenses Omissions

The easiest method of concealing liabilities and expenses is simply not to
record them. They may or may not be recorded at a later time, but this
does not change the fraudulent effect on the financial statements.
Because they are easy to conceal, omitted liabilities are probably one of the
most difficult to discover. A thorough review of all balance sheet date
transactions, such as increases and decreases in creditors, may help in the
discovery of omitted liabilities in financial statements.
Often, perpetrators believe they can perpetuate the fraud into future
periods. They often plan to compensate for the omitted liabilities with other
profit such as increased profits from future price Increases.

EXAMPLE
The owner of a publicly traded retailer falsified financial statements by concealing
liabilities and inflating stock. The objective was to increase profitability, thereby
attracting new investors. He planned to conceal the fraud by increasing selling prices
when the expenses were charged. However, a tip-off by an employee to the company's
audit committee caused an investigation.
5: Fraudulent Capitalization of expenses
The distinction between capital and revenue expenditure arises out of the
matching concept. Capital expenditure is expenditure that produces benefits
to the company over a future accounting period (probably more than one).
Manufacturing equipment costs are an example. Revenue expenditure, on the
other hand, is expenditure matched with current revenue whose benefits only
extend to the current accounting period. An example of this is wages, which
are costs for work done in the current accounting period, which is either
billed during the period or carried forward with stock as work in progress.
Capitalizing revenue expenditure is a way of increasing profits and assets as it
is charged against future profits rather than immediately. The effect is that
profit for the current period is overstated and for subsequent periods, it is
understated.
Often generally accepted accounting principles are not always clear about the
capitalization of costs so abuses may occur. The fraud examiner should be
diligent in ascertaining whether it is appropriate to capitalize expenditure and
consult relevant accounting standards.

6: Fraudulent charging of capital expenditure against profits

Just as capitalizing expenses is wrong, so is charging to the Profit and Loss
Account costs that should be capitalized. A company may want to minimize
its net profit for to tax reasons. Charging against profits an item that should
be depreciated over a period of time may help achieve lower net profits and,
therefore, less tax to be paid. Internal budget constraints also put pressure
on accounting staff into misallocating capital items as revenue costs.

7: Fraudulent accounting for returns, allowances and warranties

An incorrect liability for these will occur if the company fails to properly
account for potential product returns or repairs. It is inevitable that a
certain proportion of products sold will, for one reason or another, be
returned. It is the job of management to try to accurately estimate what
this will be and make provision for it.
In warranty liability fraud, the liability is either omitted altogether or
substantially understated. A similar case is accounting for the liability arising
from defective products (product liability).

EXAMPLE
A manufacturing company produced government armaments. Some did not meet
specifications and the company was liable for resolving this. Management decided to
recognize the cost as items were returned and the work was performed which would
be conducted over a considerable future period.
Failure to estimate and record the total warranty cost resulted in a material
understatement of costs and overstatement of profits for the periods in which the
contract revenues were received and the liability was not recorded.

8: Misleading disclosure
As was discussed earlier, accounting principles require that financial statements
and related notes include all the information necessary to prevent the user
from being misled. Management has an obligation to disclose all significant
information in an appropriate way. If not disclosed in the financial
statements, the necessary information should appear in the footnotes or
elsewhere in the report.
The information that is disclosed should also not be misleading. Fraud through
incorrect or misleading disclosure usually involves one of the following:
liability omissions, significant event omission, related-party transactions, and
accounting changes.

9: Liability omissions
Typical omissions include the failure to disclose loan covenants or contingent
liabilities. Loan covenants are agreements, in addition to, or part of, a
financing arrangement, which a borrower has promised to keep as long as the
financing is in place. Contingent liabilities are obligations a firm may be
required to pay, for example, a pending lawsuit. The company's potential
liability, if material, must be disclosed and explained.
10: Fraudulent treatment of significant events
These are events that, if not disclosed, may mislead the reader. Examples
include the impact of new products or technology. Obsolescence of goods or
manufacturing methods should also be reported if relevant.

EXAMPLE
Milbury pIc, a publicly quoted company, collapsed in 1988.. It was controlled by a
controversial entrepreneur, Jim Raper, through St Piran Ltd which had a majority
share holding. When Milbury encountered severe financial losses it decided not to
make a payment on a loan from St Piran. The consequence of this was that the
ownership of Milbury's main assets would transfer to St Piran. The small shareholders
in St Piran did not know that this would be the effect of such a minor default on the
loan. Milbury's accounts merely stated that the loan was 'secured'.

11: Related-party transactions

These occur when an officer of the company has a financial interest in a
transaction that has an economic effect on the company. They may take a
variety of forms. Many of them include transactions in the normal course of
business; for example, the purchase or sale of goods. Others include:
Transferring fixed assets. The transfer may be at a fair value on an arm's
length basis or it may be at book value or some other amount that differs
from market value. Outright gifts and capital contributions. Provision of
accommodation or management services. These may be charged at a fair and
reasonable amount for the services provided. Alternatively, they may be
unrelated to market value, either excessively high or low.
In the case of companies, the provisions for their disclosure are contained in
the Companies Act, 1985, sections 231-234 and the 5th, 6th and 7th
schedules. In the case of quoted companies, the Stock Exchange Listing
Requirements add certain matters. FRS 8 is intended to complement these.
The Companies Act does not use the term 'related party'. The provisions in
Part II of Schedule 6 to the Act require disclosure of certain transactions
with directors and persons connected with directors.
 A person connected with a director falls broadly into the following
categories:
 A director's spouse or children who are minors,
 A body corporate in which a director owns at least 20 per cent of the
shares or which is controlled by a director or any persons connected
with him are beneficiaries,
 A partner of the director (or a person connected with the director) in
his capacity as partner.

The principal areas the Act addresses are:

 Loans and similar transactions with directors and officers, Transactions
in which a director has an interest,
 Directors' share interests.

FRS 8 requires the following information to be disclosed in a reporting

entity's financial statements concerning its related parties:
 The name of the party that controls the reporting entity and, if
different, the name of the ultimate controlling party (whether or not
any transactions have taken place with those parties),
 Details of material transactions between the reporting entity and any
related parties,
 Details of balances due to, or from, related parties at the balance
sheet date.
 Standard, two or more parties are related parties when:
 One party has direct or indirect control of the other party; or
 The parties are subject to common control from the same source; or
 One party has influence over the other party; or
 The parties are subject to influence from the same source.
12: Changes in accounting policies
Changes of accounting policy arise when a choice is available between two or
more alternative accounting treatments. A 'change' does not occur if there is
change of accounting treatment because the transactions or events are
different from what they were previously.
A change of policy must be adequately explained and justified in the financial
statements. The Companies Act 1985 requires that where there is a change
of accounting policy (that is, a departure from the consistency principle) the
financial statements must disclose "particulars of the departure, the reasons
for it and its effect"

13: Misleading asset valuation

The cost principle requires that assets be recorded at their original cost.
However, the prudence principle overrules this by requiring a market valuation
to be used if it is lower than historical cost. The best example is stock,
which is required to be reported at the lower of cost or net market value
(Le. after selling costs). With the exception of property (which may be
stated in the balance sheet at a valuation if there has been a permanent
valuation change), it is rare for asset values to be increased. This may only
be done for permanent changes and not merely for current market values.
Sometimes, it is necessary to use an estimate with the hope that it is near
the true value. For example, estimates are used in determining warranty
costs, salvage value, and the useful life of a depreciated asset. Whenever
estimates are used, there is an additional opportunity for fraud.
Intentionally misleading valuations are sometimes referred to as "window
dressing."
Often, these are done to improve (i.e. inflate) the current ratio (current
assets/current liabilities) which is important to financial institutions that base
their lending decisions on certain liquidity ratios.
Many misleading asset valuation schemes involve the fraudulent overstatement
of stock or debtors. Other misleading asset valuations include the
misclassification of fixed and other assets, the treatment of start-up costs
and the incorrect capitalization of costs.
14: Misleading stock valuation
Stock must be valued at the lower of purchase price or production cost and
net realizable value. Consequently, obsolete stock should be written down or
written off altogether if it has no value. Failure to write down stock results
in the overstatement of asset values and the mismatching of the cost of the
goods sold with revenue.
Stock can also be incorrectly reported by the manipulation of stock count,
failure to adjust the stock account for the cost of goods sold, and by other
methods. The following example shows a stock valuation scheme may be
perpetrated by tampering of the stock count.

EXAMPLE
During the audit of a publicly traded pharmaceutical manufacturer, a misstatement
affecting the value of its stock was discovered. It was measured in metric volumes and,
as the count was taken, an employee moved the decimal unit to the right. The
discovery forced the company to restate its financial statements by writing down stock
by more than ￡1 million.
One of the most popular methods of overstating stock is by adding fictitious
items.

EXAMPLE
A small private company was owned by its chairman (who was also CEO) and three
other investors. The latter took no active part in the management of the business.
Over a period of years, he consistently made adjustments to falsely increase stock,
thereby reducing the cost of goods sold and increasing reported profit. When the
auditors discovered the fraud, he argued that he did not benefit directly from it.
Instead, his primary purpose was to give the impression of success to the other
owners, his family and the community.

15: Manipulating debtors

Debtors are subject to manipulation in the same way and in some cases the
schemes are conducted together. The most common schemes are:
· Fictitious debtors and
· Failing to write off accounts as bad debts (or failure to make proper
provisions).
· Fictitious fixed assets
· Capitalizing non-asset costs
· Misclassifying assets
EXAMPLE
The manager of a publicly traded company kept two versions of sales ledger. One set
accurately showed the age of the accounts. The other set was manipulated to show a
more favourable picture as his remuneration was based thereon. Late accounts were
re-dated and write offs were made to other accounts. As a result of the discovery of
this, the manager was demoted.

15.1: Fictitious debtors

These are common amongst companies with financial problems as well as with
those whose managers receive a commission based on sales. The typical entry
under fictitious debtors is to debit (increase) debtors and credit (increase)
sales. Of course, these schemes are more common at the end of the
accounting period.

15.2: Failure to write down or write off of bad debts

Companies are required to write off bad debts or provide for them in full.
Companies struggling for profits will often choose not to do this because of
the negative impact on profit.

15.3: Fictitious fixed assets

Fictitious fixed assets can be created by a variety of methods and schemes.
Some of the most common schemes are recording fictitious assets,
misrepresenting asset valuations and improperly capitalizing stock and start-up
costs.
One of the easiest methods of asset misrepresentation is in the recording of
fictitious assets. This affects the company's balance sheet totals and the
shareholders' equity account benefits.
Because company assets may be found in many different locations, this fraud
may be easily overlooked. One of the most common fictitious asset schemes is
simply to create fictitious documents. In other instances, the equipment is
held but leased and not owned, and this is not disclosed during the audit.
As with other assets, fixed assets should be recorded according to the
historical cost principle. Estimated values of assets should not usually be used.
Misrepresented asset values frequently goes hand in hand with other schemes.
Occasionally, it is advantageous to understate assets. For instance, in certain
government-related or regulated companies additional funding is often based
on asset amounts. This understatement can be done either directly or
through increased depreciation.

EXAMPLE
The management of a government-controlled company wanted to avoid cash
contributions to a central capital asset acquisition account. In order to achieve this,
they increased the provision for depreciation of fixed assets by ￡2 million over a six-
month period.

15.4: Capitalizing non-asset costs

Interest and finance charges incurred in the purchase of fixed assets should be
excluded from capital costs. For example, a company finances a capital
equipment purchase by paying for it by monthly payments. Only the original
cost of the asset should be capitalized. The subsequent interest payments
should be charged to the Profit and Loss Account and not added to the cost
of the asset. The fraud examiner should check the accounting treatment of
such transactions.

EXAMPLE
An investor in a private company applied to the Court for the rescission of purchase of
shares in the company, alleging that they had been made on the basis of misleading
financial information. A fraud examination revealed that assets were overvalued due to
capitalization of interest expenses and other finance charges. It was also discovered
that one of the owners had understated revenue by £100,000 which he had embezzled.
The parties subsequently settled out of court.

15.5: Misclassifying assets

In order to meet budget requirements, and other reasons, assets are
sometimes misclassified in the nominal ledger. For instance the manipulation
of asset accounts in order to distorting financial ratios and thereby meet
borrowing requirements.
The following is an example of an employee who intentionally misclassified the
purchase of stock to hide deficiencies in his purchasing ability.
EXAMPLE
A buyer employed by a retail jeweller’s feared censure for some bad purchases. Instead
of taking the blame, he attempted to cover them up by charging delivery costs to
individual stock accounts. This was not successful as the company's accountant
detected the fraud after initiating changes to control procedures. When the
accountant created a separation of duties between the buying function and the costing
activities, the dishonest employee was discovered and dismissed.

FRAUD DETECTION USING FINANCIAL

STATEMENTS
As a forensic accountant, you may not always have to reconstruct financial
statements, but you should not take the ones given on face value. It's more
a mindset than a method. The analysis of accounting records without such a
mindset is called auditing. Looking for signs of deception is forensic
accounting. An auditor, however, may help provide an investigative lead by
discovering the absence of a business purpose for a transaction. Or, an auditor
might find an insufficient amount of documentation for a transaction. All
these inconsistencies and out-of-ordinary transactions will be part of any
standard audit report. Forensic accountants will be looking further into these
matters for "suspect" transactions, and may very well start with the journals
or ledger to scrutinize the "Explanation" section of books. For example, a
capital investment account might mention the name of someone external to
the organization (e.g., "Loan from Malik Bashir"), and securitization of the
books might establish that Malik Bashir is also heavily involved in cash
disbursements for supplies or subcontracted services. The investigation then
proceeds from securitization to comparison, looking for comparable vendors or
subcontractors to see from such benchmarking if something is out of the
ordinary with him. The original source documents (cancelled checks) written
to him might be analyzed to see which bank they were cashed at. Those
source documents might reveal that the bank transferred the deposit to
another account or name that was on the State Department's Entities list.

Fraud is usually discovered when several small events, taken together, point
to a possible pattern of deception, and the following indicators are the classic
"red flags", according to the IRS (1999), which relate to fraud through
financial statements and accounting systems:
· Maintaining two sets of books and records (and/or destruction of books and
records)
· Concealment of assets (altered entries in asset categories)
· Large or frequent cash transactions (or frequent use of cashier's checks)
· Payments to fictitious companies or persons
· false invoices or billings (excessive billing discounts or double billing)
· purchase of over-valued assets (excessive spoilage or defects)
· Large Company loans to employees or other persons
· Using photocopies of source documents instead of originals
· Personal expenses paid with corporate funds
· Payee names left blank on checks and filled out later
· Second or third-party endorsements on corporate checks
· Unnecessary use of collection accounts
· Excessive use of exchange banks or clearing accounts