02/06/2023

Fraudulent
Financial
Statement
ANIS CHARIRI
Fakultas Ekonomika & Bisnis
UNIVERSITAS DIPONEGORO

Introduction 2

 What is FSF?
 Timing differences?
 Fictitious revenues?
 Improper asset valuations?
 Concealed liabilities and
expenses?
 Improper disclosures?
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Financial Statement Fraud 3

Defined
Financial statement fraud is the
deliberate misrepresentation
of the financial condition of an • Deliberate
enterprise accomplished
through the intentional • misstatements
misstatement or omission of or omissions
amounts or disclosures in • deceive users
the financial statements to
deceive financial
statement users

Specifically 4

 Falsification, alteration, or manipulation

 Material intentional omissions or
misrepresentations
 Deliberate misapplication of accounting
principles, policies, and procedures
 Intentional omissions of or inadequate
disclosures or presentation
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Types of FSF 5

 Timing differences
 Fictitious revenues
 Improper asset valuations
 Concealed liabilities and
expenses
 Improper disclosures

Revenue Recognition Schemes

 Revenue is the biggest reason that financial
statements are restated

ACFE Survey:
• Fictitious
revenue = 48%
• Premature
revenue (timing
schemes) = 35%
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FSF#1: TIMING DIFFERENCES (IMPROPER

TREATMENT OF SALES)

• Channel stuffing
• Premature revenue
How? method
recognition (through sales
(Improper period person or
recognition and consignment)
Shifting revenues) • Long term
contract

Example: Enron used special purpose entities (SPEs)

to recognize all of the revenue from long-term
agreements in the current year

Red Flags – Timing Differences

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 Rapid growth or unusual profitability

 Negative CFO with positive NI
 Complex transactions
 ↑ number of days’ sales in
receivables
 ↓ number of days’ purchases in
accounts payable
C
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FSF#2: FICTITIOUS REVENUES

• Recording sales that • Fake sales,
never occurred How? customers
(revenues and • Legitimate
profits, and usually customers
assets) • Conditional
sales
For example
• Equity Funding scandal: used a fictitious revenues
• After 7 years, the fraud was exposed in 1973 by a recently fired
and disgruntled employee. Fraud = $2 billion of the $3 billion in
Receivables was phony.

Red Flags – Fictitious 10

Revenues
 Rapid growth
 unusual profitability
 Negative CFO with positive NI
 Related party/SPE transactions
 Complex transactions
 ↑ number of days’ sales in receivables
 Sales to unknown entities
 An unusual flow in sales
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Revenue-Related Transactions and Frauds

FSF#3: CONCEALED LIABILITIES (IMPROPER

RECORDING OF LIABILITIES)

Postpone the • Move those liabilities

(ie to a subsidiary)
recording of liabilities How?
(in the 12th month of • Liability/expense
omissions
the fiscal year) and
• Capitalized expenses
record that liability in
the first month of the • Warranties
next fiscal year • Provision/
Contingencies

Example:
Parmalat used this method of hiding liabilities over $1.3 billion, moving
liabilities to subsidiaries in the Caribbean, far from corporate headquarters
in Italy, and to companies audited by a different financial audit firm.
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Liability Frauds
(3rd Most Common)
 Not recording accounts payable
 Not recording accrued liabilities
 Recording unearned revenues as earned
 Not recording warranty or service
liabilities
 Not recording loans or keep liabilities off
the books
 Not recording provision/contingent
liabilities

Red Flags – Concealed 14

Liabilities
 Negative CFO with positive NI
 Significant estimates
 CEO obsession with GAAP selections
 Unusual ↑ in gross margin
 ↓ the number of days’ purchases in
accounts payable
 Out of line with competitors
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FSF#5: IMPROPER ASSET VALUATION

– Inflating receivables,
Inflating the inventory, and long-
amounts of How? lived assets
assets will create – capitalizing expenses,
a higher equity or deflating contra
and profit. accounts (allowance
for doubtful accounts,
depreciation,
amortization, etc.)

Example:
WorldCom : leases of telephone lines were clearly an expense. But
WorldCom’s CEO treat them as assets.
This moving millions of dollars of expenses to the balance sheet
made the income statement suddenly looked much better.

Asset Overstatement
Frauds
 Overstatement of current assets (e.g. marketable
securities)
 Overstating pension assets
 Capitalizing as assets amounts that should be
expensed
 Failing to record depreciation/amortization
expense
 Overstating assets through mergers and
acquisitions
 Overstating inventory and receivables (covered
earlier)
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Overstating Inventory
 The second most common way to commit financial
statement fraud is to overstate inventory.
Beginning Inventory OK
Purchases OK
Goods Available for sale OK
Ending Inventory High
Cost of Goods Sold Low
Income High

Inventory/Cost of Goods Sold Frauds

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Red Flags – 19

Improper Asset Valuation

 Negative cash flows with positive earnings.
 Declining business/economy
 Lots of assets based on estimates
 CEO obsession on GAAP choices
 Gross margin ↑ compared to industry

Red Flags – 20

Improper Asset Valuation

 ↑ the number of days’ sales in receivables
 ↑ number of days’ purchases in inventory
 ↓Allowances for bad debts, inventory
 Unusual change in the relationships
 Increasing assets when competitors are
reducing
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Disclosure Frauds
Three Categories of Disclosure Frauds:

Overall Misrepresentations Misrepresentations

misrepresentations in the in the footnotes to
about the nature of management the financial
the company or its discussions and statements
products, usually other non-financial
made through statement sections
news reports, of annual reports
interviews, annual
reports, and
elsewhere

Improper Disclosures 22

 Liability omissions
 Subsequent events
 Management fraud
 Related-party transactions
 Accounting changes
 Domination of management
 Ineffective board of directors
 Tone at the top
 Rapid growth or unusual profitability
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Red Flags – Improper 23

Disclosures
 Significant, unusual, or highly
complex transactions,
 Significant related-party
transactions
Tax Haven Countries
 Overly complex organizational
structure 1.Switzerland
 Known history of violations 2.Cayman
Islands
 Materiality justifications
3.Hong Kong
 Limitation of auditor access 4.Singapore
 tax haven bank accounts 5.Luxembourg
6.Guernsey
7.Panama

Earning Management? 24
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Costs I 26

 More than 50% of U.S. corporations are victims of fraud

with losses of more than $500,000
 Investors, employees, pensioners
 Enron, WorldCom, Quest,Global Crossing, and Tyco’s
 What might some other fraud costs be?
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Costs II 27

 Financial
reporting process
undermined
 Integrity of auditing profession
 Capital markets lose confidence
 Capital markets less efficient

Costs III 28

 Economic growth and prosperity

 Litigation costs
 Destroys careers
 Bankruptcy or substantial economic
losses
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Costs IV 29

 intervention
 Inefficiency
 Doubts re: audits
 Public confidence and trust

Deterrence of Financial 30

Statement Fraud

 Reduce pressures
 Reduce the opportunity
 Reduce rationalization
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Reduce Pressures to Commit 31

Financial Statement Fraud

 “tone at the top”.
 Unachievable goals.
 excessive pressure.
 Recognize changing market
 Fair compensation systems
 excessive external expectations
 Remove operational obstacles blocking
effective performance.

Reduce the Opportunity to Commit 32

Financial Statement Fraud

 internal accounting records.
 monitor the business transactions and
interpersonal relationships
 physical security system.
 Accurate personnel records.
 Strong supervisory and leadership
relationships.
 Clear and uniform accounting procedures
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Reduce Rationalization of 33

Financial Statement Fraud

 Tone @ the top.
 Strong policies.
 Training
 Anonymous tip procedure
 Communications
 Walk the talk

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