Fraud Examination 3rd Edition Albrecht

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 Chapter 11

Financial Statement Fraud

Discussion Questions

1. The schemes that Rite Aid used to inflate its profits included the following.

• Upcharges — Rite Aid systematically inflated the deductions it took against amounts
owed to vendors for damaged and outdated products. For vendors who did not require
the unusable products to be returned to them, Rite Aid applied an arbitrary multiplier to
the proper deduction amount, which resulted in overcharging its vendors by amounts
that ranged from 35% to 50%. These practices, which Rite Aid did not disclose to the
vendors, resulted in overstatements of Rite Aid's reported pretax income of $8 million
in FY 1998 and $28 million in FY 1999.

• Stock Appreciation Rights (SARs) — Rite Aid failed to record an accrued expense
for stock appreciation rights it had granted to employees in a program that gave the
recipients the right to receive cash or stock in amounts tied to increases in the market
price of Rite Aid stock. Rite Aid should have accrued an expense of $22 million in FY
1998 and $33 million in FY 1999 for these obligations.

• Reversals of Actual Expenses — In certain quarters, Bergonzi directed that Rite Aid's
accounting staff reverse amounts that had been recorded for various expenses incurred
and already paid. These reversals were completely unjustified and, in each instance,
were put back on the books in the subsequent quarter, thus moving the expenses to a
period other than that in which they had in fact been paid. The effect was to overstate
Rite Aid's income during the period in which the expenses were actually incurred. For
example, Bergonzi directed entries of this nature that caused Rite Aid's pretax income
for the second quarter of FY 1998 to be overstated by $9 million.

• "Gross Profit" Entries — Bergonzi directed Rite Aid's accounting staff to make
improper adjusting entries to reduce cost of goods sold and accounts payable in every
quarter from the first quarter of FY 1997 through the first quarter of FY 2000 (but not
at year end, when the financial statements would be audited). These entries had no
substantiation and were intended purely to manipulate Rite Aid's reported earnings. For
example, as a result of these entries, Rite Aid overstated pretax income by $100 million
in the second quarter of FY 1999.

• Undisclosed Markdowns — Rite Aid overstated its FY 1999 net income by

overcharging vendors for undisclosed markdowns on those vendors' products. The
vendors did not agree to share in the cost of markdowns at the retail level, and Rite Aid
misled the vendors into believing that these deductions, taken in February 1999, were
for damaged and outdated products. As a result, Rite Aid overstated its FY 1999 pretax
income by $30 million.

142  Chapter 11
• Vendor Rebates — On the last day of FY 1999, Bergonzi directed that Rite Aid record
entries to reduce accounts payable and cost of goods sold by $42 million to reflect
rebates purportedly due from two vendors. On March 11, 1999, nearly two weeks after
the close of the fiscal year, Bergonzi directed that the books be reopened to record an
additional $33 million in credits. All of these entries were improper, as Rite Aid had not
earned the credits at the time they were recorded and had no legal right to receive them.
Moreover, due to Rite Aid's pass-through obligations in agreements with its own
customers, Rite Aid would have been obligated to pass $42 million out of the $75
million through to third parties. The $75 million in inflated income resulting from these
false entries represented 37% of Rite Aid's reported pretax income for FY 1999.

• Litigation Settlement — In the fourth quarter of FY 1999, Grass, Bergonzi, and

Brown caused Rite Aid to recognize $17 million from a litigation settlement.
Recognition was improper, as the settlement was not in fact consummated in legally
binding form during the relevant period.

• "Dead Deal" Expense — Rite Aid routinely incurred expenses for legal services, title
searches, architectural drawings, and other items relating to sites considered but later
rejected for new stores. Rite Aid capitalized these costs at the time they were incurred.
Rite Aid subsequently determined not to construct new stores at certain sites. Under
Generally Accepted Accounting Principles, Rite Aid should have written off the
pertinent "dead deal" expenses at the time that it decided not to build on each specific
site. Such write-offs would have reduced reported income in the relevant periods.
Instead, Rite Aid continued to carry these items on its balance sheet as assets. By the
end of FY 1999, the accumulated dead deal expenses totaled $10.6 million.

• "Will-Call" Payables — Rite Aid often received payment from insurance carriers for
prescription orders that were phoned in by customers but never picked up from the
store. Rite Aid recorded a "will-call" payable that represented the total amount of these
payments received from insurance carriers that Rite Aid would be obligated to return to
the carriers. In the fourth quarter of FY 1999, Rite Aid improperly reversed this $6.6
million payable. When Rite Aid's general counsel learned of this reversal, he directed
that the payable be reinstated. Bergonzi acquiesced in the reinstatement, but then
secretly directed that other improper offsetting entries be made that had the same effect
as reversing the payable.

• Inventory Shrink — When the physical inventory count was less than the inventory
carried on Rite Aid's books, Rite Aid wrote down its book inventory to reflect this
"shrink" (i.e., reduction presumed due to physical loss or theft). In FY 1999, Rite Aid
failed to record $8.8 million in shrink. Additionally in FY 1999, Rite Aid improperly
reduced its accrued shrink expense (for stores where a physical inventory was not
conducted), producing an improper increase to income of $5 million.

Chapter 11  143
 2. Below are the most notable abuses that occurred between 2000 and 2002.

• Misstated financial statements and “cooking the books”: Examples included Qwest,
Enron, Global Crossing, WorldCom, and Xerox, among others. Some of these frauds
involved twenty or more people helping to create fictitious financial results and mislead
the public. While not all related to fraud, the number of financial statement restatements
were 323 in 2003, 330 in 2002, 270 in 2001, and 233 in 2000.
• Inappropriate executive loans and corporate looting: Examples included John Rigas
(Adelphia), Dennis Kozlowski (Tyco), and Bernie Ebbers (WorldCom).
• Insider trading scandals: The most notable example was Martha Stewart and Sam
Waksal, both of whom have been convicted for selling ImClone stock.
• Initial Public Offering (IPO) favoritism, including spinning and laddering:
Spinning involves giving IPO opportunities to those who arrange quid pro quo
opportunities, and laddering involves giving IPO opportunities to those who promise to
buy additional shares as prices increase. Examples included Bernie Ebbers of
WorldCom and Jeff Skilling of Enron.
• Excessive CEO retirement perks: Companies including Delta, PepsiCo, AOL Time
Warner, Ford, GE, and IBM were highly criticized for endowing huge, costly perks and
benefits, such as expensive consulting contracts, use of corporate planes, executive
apartments, and maids to retiring executives.
• Exorbitant compensation (both cash and stock) for executives: Many executives,
including Bernie Ebbers of WorldCom and Richard Grasso of the NYSE, received huge
cash and equity-based compensation that has since been determined to be excessive.
• Loans for trading fees and other quid pro quo transactions: Financial institutions
such as Citibank and JP Morgan Chase provided favorable loans to companies like
Enron in return for the opportunity to make hundreds of millions of dollars in
derivatives transactions and other fees.

144  Chapter 11
 • Bankruptcies and excessive debt: Because of the abuse described above and other
similar problems, seven of the United States’s ten largest corporate bankruptcies in
history occurred in 2001 and 2002. These seven bankruptcies were WorldCom (largest
ever at $101.9 billion), Enron (second largest ever at $63.4 billion), Global Crossing
(fifth largest ever at $25.5 billion), Adelphia (sixth largest ever at $24.4 billion), United
Airlines (seventh largest at $22.7 billion), PG&E (eighth largest at $21.5 billion), and
Kmart (tenth largest at $17 billion). Four of these seven included some kind of fraud.
• Massive fraud by employees: While not in the news nearly as much as financial
statement frauds, there has been a large increase in fraud against organizations; some of
these frauds are as high as $2 to $3 billion dollars.

3. The fraud triangle provides insight into why recent ethical compromises occurred. We
believe there were nine factors that came together to create what we call the perfect fraud storm.
In explaining this perfect storm, we will use examples from recent frauds.

The first element of the perfect storm was the masking of many existing problems and unethical
actions by the good economy of the 1990s and early 2000s. During this time, most businesses
appeared to be highly profitable, including many fledgling “dot-com” companies that were
testing new (and many times unprofitable) business models. The economy was booming, and
investment was high. In this period of perceived success, people made nonsensical investments
and other decisions. The advent of “investing over the Internet” for a few dollars per trade
brought many new, inexperienced people to the stock market. History has now shown that
several of the frauds that have been revealed since 2002 were actually being committed during
the boom years but that the apparent booming economy hid the fraudulent behavior. The
HealthSouth fraud, for example, began in 1986 and was not caught until 2003.

The booming economy also caused executives to believe that their companies were more
successful than they were and that their companies’ success was primarily a result of good
management. Academic researchers have found that extended periods of prosperity can reduce a
firm’s motivation to comprehend the causes of success, raising the likelihood of faulty
attributions. In other words, during boom periods, many firms do not correctly ascribe the
reasons behind their successes. Management usually takes credit for good company performance.
When company performance degrades, boards often expect results similar to those in the past
without new management styles or actions. Since management did not correctly understand past
reasons for success, they incorrectly think past methods will continue to work. Once methods
that may have worked in the past only because of external factors fail, some CEOs may feel
increased pressure. In certain cases, this pressure contributed to fraudulent financial reporting
and other dishonest acts.

The second element of the perfect fraud storm was the moral decay that has been occurring in the
United States and the rest of the world in recent years. Whatever measure of integrity one uses,
dishonesty appears to be increasing. For example, researchers have found that cheating in school,
one measure of dishonesty, has increased substantially in recent years. The following table
(which is not given to the students in the text) summarizes some of these studies.

Chapter 11  145
Ethical Measure
High schoolers who said they
had cheated on an exam in last
twelve months.
Middle school students who
said they had cheated on an
exam in last twelve months.
College students across the
nation admitted to cheating in
high school.
High school students
admitting to cheating on exam
in last year
High school students who had
cheated in past twelve months
Students who had stolen
Willing to lie to get a job
Number of students self-
reporting instances of
unpermitted collaboration at
nine medium to large state
universities
Percentage of American high
school students who judged
cheating to be “common”
among their peers
The number of high school
students who admitted using a
cheat sheet on a test
Students who admitting to
letting others copy their work
Year % Year % Study Authors
1996 64 1998 70 Josephson Institute of
Ethics
1996 N/A 1998 54 Josephson Institute of
Ethics
1940s 20% Now 75- Stephen Davis,
98% psychology professor at
Emporia State University
1992 61% 2002 74% Josephson Institute of
Ethics survey of 12,000
students
2000 71% 2002 74% Josephson Institute of
Ethics
2000 35% 2002 38% Josephson Institute of
Ethics
2000 28% 2002 39% Josephson Institute of
Ethics
1963 11% 1993 49% Donald L. McCabe of
Rutgers University
1940s 20% 1997 88% Who’s Who among
American High School
Students survey of 3,210
“high achievers” in 1997
1969 34% 1989 68% Study by Fred Schab at
the University of Georgia
1969 58% 1989 98% Study by Fred Schab at
the University of Georgia

The third element of the perfect fraud storm was misplaced executive incentives. Executives of
most fraudulent companies were endowed with hundreds of millions of dollars in stock options
and/or restricted stock that made it far more important to keep the stock price rising than to
report financial results accurately. In many cases, this stock-based compensation far exceeded
executives’ salary-based compensation. For example, in 1997, Bernie Ebbers, the CEO of
WorldCom, had a cash-based salary of $935,000. Yet, during that same period, he was able to
exercise hundreds of thousands of stock options, making millions in profits and received
corporate loans totaling $409 million for purchase of stock and other purposes.1 The attention of

1
Gary Strauss, “Execs Reap Benefits of Cushy Loans,” USATODAY.com, December 2002,
<http://www.usatoday.com/money/companies/management/2002-12-23-ceo-loans_x.htm>.

146  Chapter 11
many CEOs shifted from managing the firm to managing the stock price. At the cost of countless
billions of dollars, managing the stock price all too often turned into fraudulently managing the
financials.

The fourth element of the perfect storm, and one closely related to the last, was the often-
unachievable expectations of Wall Street analysts that targeted only short-term behavior.
Company boards and management, generally lacking alternative performance metrics, used
comparisons with the stock price of “similar” firms and attainment of analyst expectations as
important de facto performance measures. These stock-based incentives compounded the
pressure induced by the analyst expectations. Each quarter, the analysts, often coached by
companies themselves, forecasted what each company’s earnings per share (EPS) would be. The
forecasts alone drove price movements of the shares, imbedding the expectations in the price of a
company’s stock. Executives knew that the penalty for missing the “street’s” estimate was
severe; even falling short of expectations by a small amount would drop the company’s stock
price by a considerable amount. Consider the following example of one of the frauds that
occurred recently.

For this company, the “street” made the following EPS estimates for three consecutive quarters:2

Firm 1st Qtr 2nd Qtr 3rd Qtr

Morgan Stanley $0.17 $0.23
Smith Barney 0.17 0.21 $0.23
Robertson Stephens 0.17 0.25 0.24
Cowen & Co. 0.18 0.21
Alex Brown 0.18 0.25
Paine Webber 0.21 0.28
Goldman Sachs 0.17
Furman Selz 0.17 0.21 0.23
Hambrecht & Quist 0.17 0.21 0.23

Based on these estimates, the consensus estimate was that the company would have EPS of $0.17
in the first quarter, $0.22 in the second quarter, and $0.23 in the third quarter. As has now been
shown, the company’s actual earnings during the three quarters were $0.08, $0.13, and $0.16,
respectively. In order not to miss the “street’s” estimates, management committed a fraud of $62
million or $.09 per share in the first quarter, a fraud of $.09 in the second quarter, and a fraud of
$0.07 in the third quarter.

The complaint in this case read (in part) as follows:

“The goal of this scheme was to ensure that [the company] always met Wall Street’s
growing earnings expectations for the company. [The company’s] management knew
that meeting or exceeding these estimates was a key factor for the stock price of all
publicly traded companies and therefore set out to ensure that the company met Wall
Street’s targets every quarter regardless of the company’s actual earnings. During

2
The data relating to this case are real but proprietary. Because litigation is still ongoing, the source and name of the
company have not been revealed.

Chapter 11  147
 the period 1998 to 1999 alone, management improperly inflated the company’s
operating income by more than $500 million before taxes, which represents more
than one-third of the total operating income reported by [the company].”

The fifth element in the perfect storm was the large amounts of debt and leverage each of these
fraudulent companies had. This debt placed tremendous financial pressure on executives not only
to have high earnings to offset high interest costs but also to report high earnings to meet debt
and other covenants. For example, during 2000, Enron’s derivates-related liabilities increased
from $1.8 billion to $10.5 billion. Similarly, WorldCom had over $100 billion in debt when it
filed history’s largest bankruptcy. During 2002 alone, 186 public companies, including
WorldCom, Enron, Adelphia, and Global Crossing, filed for bankruptcy in the United States with
$368 billion in debt.3

The sixth element of the perfect storm was the nature of U.S. accounting rules. In contrast to
accounting practices in other countries such as the U.K. and Australia, American generally
accepted accounting principles (GAAP) are much more rule based than principles based.4 One
perspective on having rules-based standards is that if a client chooses a particular questionable
method of accounting that is not specifically prohibited by GAAP, it is hard for auditors or
others to argue that the client cannot use that method of accounting. The existing general
principles already contained within GAAP notwithstanding, when auditors and other advisors
sought to create competitive advantages by identifying and exploiting possible loopholes, it
became harder to make a convincing case that a particular accounting treatment is prohibited
when it “isn’t against the rules.” Professional judgment lapsed as the general principles already
contained within GAAP and SEC regulations were ignored or minimized. The result was that
rather than deferring to existing, more general rules, specific rules (or the lack of specific rules)
were exploited for new, often complex financial arrangements as justification to decide what was
or was not an acceptable accounting practice.

As an example, consider the case of Enron. Even if Arthur Andersen had argued that Enron’s
Special Purpose Entities (SPEs) were not appropriate, it would have been impossible for them to
make the case that they were against any specific rules. Some have suggested that one of the
reasons it took so long to get plea bargains or indictments in the Enron case was because it was
not immediately clear whether GAAP or any laws had actually been broken.

A seventh element of the perfect fraud storm was the opportunistic behavior of some CPA firms.
In some cases, accounting firms used audits as loss leaders to establish relationships with
companies so they could sell more lucrative consulting services. The rapid growth of the
consulting practices of the “Big 5” accounting firms, which was much higher than the growth of
other consulting firms, attested to the fact that it is much easier to sell consulting services to
existing audit clients than to new clients. In many cases, audit fees were much smaller than
consulting fees for the same clients, and accounting firms felt little conflict between

3
“Bankruptcy Filings Reach All-Time High in 2002,” The Business Journal, January 2002,
<http://www.bizjournals.com/portland/stories/2002/12/30/daily17.html>.
4
In 2003, the SEC acknowledged that U.S. GAAP may be too “rule-based” and wrote a position paper arguing for
more “principles” or “objectives-based” accounting standards.

148  Chapter 11
independence and opportunities for increased profits. In particular, these alternative services
allowed some auditors to lose their focus and become business advisors rather than auditors. This
is especially true of Arthur Andersen, which had spent considerable energy building its
consulting practice only to see that practice split off into a separate firm. Privately, several
Andersen partners have admitted that the surviving Andersen firm and some of its partners had
vowed to “out consult” the firm that separated from them and became preoccupied with that
goal.

The eighth element of the perfect storm was greed by executives, investment banks, commercial
banks, and investors. Each of these groups benefited from the strong economy, the high level of
lucrative transactions, and the apparently high profits of companies. None of them wanted to
accept bad news. As a result, they sometimes ignored negative news and entered into bad
transactions.5 For example, in the Enron case, various commercial and investment banks made
hundreds of millions from Enron’s lucrative investment banking transactions on top of the tens
of millions in loan interest and fees. None of these firms alerted investors about derivative or
other underwriting problems at Enron. Similarly, in October 2001, after several executives had
abandoned Enron and negative news about Enron was reaching the public, sixteen of seventeen
security analysts covering Enron still rated the company a “strong buy” or “buy.”6 Enron’s
outside law firms were making high profits from Enron’s transactions as well. These firms also
failed to correct or disclose any problems related to the derivatives and special purpose entities
but in fact helped draft the requisite associated legal documentation. Finally, the three major
credit rating agencies, Moody’s, Standard & Poor’s, and Fitch/IBC—who all received substantial
fees from Enron—did nothing to alert investors of pending problems. Amazingly, just weeks
prior to Enron’s bankruptcy filing, after most of the negative news was out and Enron’s stock
was trading for $3 per share, all three agencies still gave investment grade ratings to Enron’s
debt7.

Finally, the ninth element of the perfect storm was three types of educator failures. First,
educators had not provided sufficient ethics training to students. By not forcing students to face
realistic ethical dilemmas in the classroom, graduates were ill equipped to deal with the real
ethical dilemmas they faced in the business world. In one allegedly fraudulent scheme, for
example, participants included virtually the entire senior management of the company, including
but not limited to its former chairman and chief executive officer, its former president, two
former chief financial officers and various other senior accounting and business personnel. In
total, it is likely that there were over twenty individuals involved in the earnings overstatement
schemes. Such a large number of participants points to a generally failed ethical compass for this
group. Consider another case of a chief accountant. A CFO instructed the chief accountant to

5
A March 5, 2001 Fortune article included the following warning about Enron: “To skeptics, the lack of clarity
raises a red flag about Enron’s pricey stock…the inability to get behind the numbers combined with ever higher
expectations for the company may increase the chance of a nasty surprise. Enron is an earnings-at-risk story…”
Bethany McLean, “Is Enron Overpriced,” Fortune.com, 5 March, 2001,
<http://www.fortune.com/fortune/print/0,15935,369278,00.html>. Even with this bad news, firms kept investing
heavily in Enron and partnering or facilitating Enron’s risky transactions.
6
Peter G. Fitzgerald, “Stock Analyst Disclosure,” Peter G. Fitzgerald, U.S. Senator, Illinois,
<http://fitzgerald.senate.gov/legislation/stkanalyst/analystmain.htm>.
7
Ben White, “Do Rating Agencies Make the Grade? Enron Case Revives Some Old Issues,” Council of
Development Finance Agencies, 31 January 2002, <http://www.cdfa.net/cdfa/press.nsf/pages/275>

Chapter 11  149
increase earnings by an amount somewhat over $100 million. The chief accountant was skeptical
about the purpose of these instructions but did not challenge them. Instead, the chief accountant
followed directions and allegedly created a spreadsheet containing seven pages of improper
journal entries—105 in total—that he determined were necessary to carry out the CFO’s
instructions. Such fraud was not unusual. In many of the cases, the individuals involved had no
prior records of dishonesty, and yet when they were asked to participate in fraudulent
accounting, they did so quietly and of free will.

A second educator failure was not teaching students about fraud. One of the authors has taught a
fraud course to business students for several years. It is his experience that most business school
graduates would not recognize a fraud if it hit them between the eyes. The large majority of
business students do not understand the elements of fraud, perceived pressures and opportunities,
the process of rationalization, or red flags that indicate the possible presence of dishonest
behavior. And, when they see something that does not look right, their first reaction is to deny a
colleague could be committing dishonest acts.

A third educator failure is the way we have taught accountants and business students in the past.
Effective accounting education must focus less on teaching content as an end unto itself and
instead use content as a context for helping students develop analytical skills. As an expert
witness, one of the authors has seen too many cases where accountants applied what they thought
was appropriate content knowledge to unstructured or different situations only to find out later
that the underlying issues were different than they had thought and that they totally missed the
major risks inherent in the circumstances.

Because of these financial statement and other problems that caused such a decline in the market
value of stocks and a loss of investor confidence, a number of new laws and corporate
governance changes have been implemented by the SEC, PCAOB, NYSE, NASDAQ, FASB,
and others.

4. Financial statements are important to the efficiency of America’s capital markets because
they provide meaningful disclosures of where a company has been, where it is currently, and
where it is going. For the markets to work efficiently, accurate information about the companies
whose stocks are listed must be publicly available. Information makes the markets operate
efficiently, and financial information is some of the most important information to help investors
and creditors make investment and credit decisions.

5. Financial statement fraud is intentional misstatements or misrepresentations about the

financial position or financial results of an organization in an organization’s financial statements.
Financial statement fraud can result from manipulation, falsification, or alteration of accounting
records or from omitting critical information from the financial statements. For
misrepresentations in the financial statements to represent financial statement fraud, the
misrepresentations must be intentional. Unintentional misrepresentations are called errors and
are different than financial statement fraud.

150  Chapter 11
6. Top executives and officers of an organization most often commit financial statement fraud.
The most common person involved, according to empirical research, is the CEO, but CFOs and
other executives are often involved as well.

7. CEOs are often perpetrators of financial statement fraud because they have ultimate
responsibility for the success of an organization. In that position, they often perceive and
personalize the kinds of fraud pressures and opportunities that were discussed in the chapter
(e.g., the need to meet Wall Street earnings expectations.):

8. Creating fictitious journal entries, fictitious documentation, and altering the numbers in the
financial statements often conceal financial statement frauds. The most common financial
statement frauds are misstatements of revenues and receivables followed by misstatements of
inventory and cost of goods sold.

9. An audit committee provides a third-party view to the financial situation of a company. The
audit committee has an intimate knowledge of the company that is not matched by outsiders. An
audit committee should ensure that appropriate controls are in place and provide a check and
balance to the major decisions of management. Management generally has a tougher time hiding
fraud from an actively involved audit committee.

10. Some examples of motives/pressure to commit financial statement fraud are:

• To meet analyst’s expectations
• CEO bonuses are often tied to performance
• High stock prices may need to be supported by high income
• CEOs typically have stock option packages or hold large amounts of company stock,
tying their personal net worth to the success of the company
• Debt covenants may require certain levels of financial performance

11. The four different areas that must be examined when trying to detect financial statement
fraud are management and directors, relationships with others, organization and industry, and
financial results and operating characteristics. For each of these, there are several elements that
must be examined as discussed in the chapter.

12. Some of the ways that financial statement fraud schemes can be identified are by looking for
related-party transactions, using various means such as horizontal and vertical analysis to look
for unusual relationships or balances in the financial statements, investigating the backgrounds
and motivations of executives and officers, and looking for organization structures that do not
make sense.

13. The reason members of management and the board of directors must be examined when
searching for financial statement fraud exposures is because it is people, specifically
management and board members, who commit financial statement fraud. Without such
individuals manipulating the financial statements, there would be no financial statement fraud.
To determine if management or board members are involved in financial statement fraud, it is
important to examine their motivations, backgrounds, and decision-making ability and power
within the organization.

Chapter 11  151
14. Relationships with others are important areas to look at when searching for financial
statement fraud. Hiding the truth in related companies (such as the related-party partnerships
(SPEs) in the Enron case) or using sham or unrealistic transactions with related parties to
overstate revenues, inventories, or other financial statement accounts often are ways of
committing financial statement fraud. One of the easiest ways to commit financial statement
fraud is to enter into transactions with fictitious organizations that appear to be independent but
are really related parties. In addition, relationships with financial institutions, auditors, or lawyers
that appear unusual or problematic can often signal that something is not right.

15. It is always important to evaluate the relationship between a company and its auditors when
considering financial statement fraud. Fraud can occur much more easily if auditors lack
independence. Auditors also have a difficult time detecting fraud if their access to a company
and its records is unreasonably limited. Another factor impacting an auditor’s ability to uncover
fraud is unreasonable time constraints. Disputes with auditors about accounting issues can also
be indicative of fraud. It is especially important to evaluate the company/auditor relationship
when there has been a change in auditors. Companies rarely change auditors without a major
motivation to do so. As a result, auditor changes can often signal underlying fraud problems.

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

152  Chapter 11
10. False: Relationships with others (e.g. related parties) should be examined because
unrealistic and non-“arm’s-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.

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

Chapter 11  153
9. a

10. d

11. c

12. a

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 gray 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 arm’s-length? One might
also be concerned about the company’s relationship with city officials, who feel a strong
motivation to keep this company in town because it boosts the city’s 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, etc. wouldn’t 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,

154  Chapter 11
 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 compensation—greed, (2) they
perceived an opportunity to backdate without getting caught—no one had been paying
attention to option dating in the past, and (3) they rationalized that it was okay—everyone
else was doing it. With respect to the rationalization, they were correct. While everyone
wasn’t doing it, lots of companies were. The fact that many others are acting illegal doesn’t
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 deter 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.
a) Success since beginning operations
b) Rapid growth in revenues
c) Pressure to perform well for the IPO
d) Increased commissions as a way to increase revenue
e) Personal relationships between executives
f) Change in auditors
g) Dispute with auditor over revenue recognition accounting
h) Infrequent Board of Director and Audit Committee meetings
i) Close relationships between the board and management
j) 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

Chapter 11  155
embezzlement and misappropriation are the middle management, frontline workers, and others
who engage in the misappropriation and embezzlement.

Case 5.

a. Management and directors

b. Organization and industry
c. Organization and industry
d. Relationships with others
e. Financial results and operating characteristics
f. Relationships with others
g. Management and directors

Extensive Cases

Extensive Case 1.

1.
The Chipmunk Company
Ratio Analysis

PERCENT INDUSTRY
LIQUIDITY RATIOS: 12/31/08 12/31/07 CHANGE CHANGE AVERAGE

Current ratio
current assets/current liabilities 2.310 2.491 -0.181 -7.27% 1.21
Quick ratio
(current assets—inventory–prepaid expenses)/
current liabilities 0.136 0.402 -0.266 -66.17% 0.35
Sales/Receivables
Net sales/net ending receivables 16.05 17.78 -1.73 -9.73% 23.42
Number of days sales in A/R
Net ending receivables/(net sales/365) 22.74 20.53 2.21 10.76% 15.58
Inventory turnover
Cost of sales/average inventory 1.37 1.39 0.02 -1.44% 1.29

2.
LIQUIDITY
The current ratio has declined by more than 7% 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% increase in accounts
receivable, and the company is taking much longer than the industry average to collect its
receivables.

156  Chapter 11
Extensive Case 2.

1.
a. A financial analyst would have greatly benefited by investigating management and
directors, because the major players in Bre-X had histories of fraud, unethical, and illegal acts.
Chances are that if they were unethical in the past, they would still be today. By investigating
management and directors, an analyst would have had an immediate red flag of fraud.

b. Although investigating the company’s relationship with other entities may not have signaled
any immediate red flags, an analyst could have understood more about the company, its
affiliates, and the risk that is involved.

c. An analyst who would have investigated the organization and its industry would have
realized that mining in Canada has a long history of scandals and fraud. Penny stock scandals
and other such scandals are often perpetrated via the Canadian stock exchanges. An analyst who
would have investigated the industry would realize the inherent risk that is associated with
mining.

d. By investigating the financial results and operating characteristics of Bre-X Minerals, an

analyst may have realized that the financial results were especially high for pure speculation. The
company was brand new and had no history of financial results. The quantity of gold that they
were supposed to have discovered had never in fact been mined in large quantities. The only
gold that had actually been taken was small samples, which could easily have been tampered
with.

2. At Bre-X Minerals height, the price of gold on the open market dropped because of the
anticipation of the new gold supply. When the entire operation proved to be a scam, many
investors lost money. Furthermore, the Canadian stock market lost credibility and reputation. As
a result of the scam and the chaos that followed, the entire Canadian stock market was forced to
shut down for a period of time.

3. Greed by executives, investment banks, commercial banks, and investors; educator failure;
unachievable expectations of investors and others; unrealistic compensation for executives;
moral decay; and the good economy of the 1990s all contributed to both the perfect fraud storm
as well as the Bre-X Minerals scandal.

4. The major motivation to commit fraud was the greed and moral decay of executives. This
was not the first time that these individuals had been convicted of fraud. The executives loved to
live a lavish lifestyle and would do just about anything to maintain their desired lifestyle.

Extensive Case 3

1. If zero-order reasoning were employed, an independent auditor would not consider conditions
that affect the auditee. The independent auditor would only be interested in conditions that

Chapter 11  157
directly affect him or her. The audit plan often takes into account costs and benefits associated
with specific assurance levels in the audit. Therefore, zero-order reasoning would most likely be
that the auditor simply follows the already established audit plan.

2. If first-order reasoning were employed, the auditor would consider conditions affecting the
auditee when planning the audit. The auditor should notice that the level of returned product
was quite high for the previous year. Also, because allowances for future returns were too low
on the books compared to the actual returns from the prior year, the auditors should consider
altering the audit plan. The auditor should have tried to observe the location where the actual
returned goods were stored. The auditor should also try to trace the steps of several returns
through the accounting process to determine if all appropriate recordings are made. The auditor
could also do more extensive analytical and substantive testing to make sure that allowances for
returns and sales of product are at appropriate levels. In performing these procedures, the auditor
would likely rely heavily on typical procedures performed in prior audits and not consider that
the client may be concealing a fraud in a manner that the typical procedures won’t detect.

3. If higher-order reasoning were employed, the auditor considers additional layers of

complexity, including how management may anticipate the auditor’s behavior. The auditor may
adjust the audit plan by introducing unexpected audit procedures in response to what the auditor
believes management may be doing to conceal a fraud based on management’s strategic
reasoning. Thus, the auditor may perform an unexpected inspection of the location of where
returned goods are held. The auditor would realize that management would steer the auditor
away from storage locations of returned goods because management realized that the auditor
would want to perform physical inspection of inventory. Realizing that management was
applying strategic reasoning to conceal a fraud, the auditor would interview employees who
worked where these goods may be stored and perform unexpected inspections of these goods to
get an accurate count of the magnitude of returned goods and attempt to unveil a fraud.

The auditor could also use technology such as ACL or Picalo to look for transactions that are
abnormal in nature or that have abnormal timing. The auditor could also interview other
personnel regarding their job functions, performance of tasks, and the recording of non-routine
accounting entries in order to determine if discrepancies exist between stories. This may provide
the auditors with further insight into which areas of the audit to alter in their attempt to uncover
the concealment of a fraud.

Internet Assignments

1. The first part of the assignment has no prescribed answer because student searchers will go
several different directions, depending on word combinations used. Some of the key points of the
CFO.com article are:

• The oversight board inspectors observed that auditors were taking shortcuts in their
overall approach to detecting client fraud. Specifically they lacked in the following
areas:
o brainstorming fraud risks
o responding when things seem risky

158  Chapter 11
 o digging into financial misstatements
o detecting potential fraud with management’s overrides of controls
• A recent PCAOB inspection report of auditors found the following:
o Many auditors have been found to detect fraud simply by checking off items on
standard audit programs and checklists.
o The PCAOB reports found that many accountants failed to expand their audit
procedures when fraud risks seemed more serious for particular clients.
o Some auditors also only skimmed the surface in searching for ill-advised
management overrides of journal entries.

2. With respect to motivation, Enron executives reaped millions of dollars as they sold their
stock in the company before the stock price plummeted. This happened even though these
executives allegedly knew of the troubled finances of the company and hid this information from
Wall Street and analysts. These actions show that the executives had incentive to commit fraud
since they were in a position to profit greatly from the inflated stock prices.

With respect to related-party transactions, there were many “off-the-book” partnerships (SPEs)
that were shrouded in secrecy. This network of nearly 3,000 partnerships was called the
“Braveheart” network. The partnerships borrowed over $110 million from a Canadian bank, and
that amount immediately showed up as income. This happened repeatedly but was never reported
or disclosed in Enron’s financial statements.

Debates

1.
Pro: Yes, this is true. Just ask an average person on the street what they think about the
accounting industry, and they will likely give you a derogatory response. Even informed users
will argue that there is no good way to account for intangibles such as good will, which make up
much of certain companies’ financial statements these days. Proof that companies are playing the
earnings game with financial statements is all around us. How else would companies meet
earnings forecasts set by analysts such a high percentage of the time?

Con: It is a complex world and a complex business environment in which we find ourselves.
There are no easy answers as to how we can represent the true financial position of a company.
The accounting profession has done an amazing job at capturing this information and at holding
companies to strict standards; however, this is not to say that everything is perfect. Accounting
standards will have to continually evolve to match the business environment. Companies will
have to be held to higher standards, since they are the ones who are trying to play the earnings
game and not necessarily the auditors. In addition, it is the companies themselves who guide
Wall Street’s forecasts.

2.
Earnings management is acceptable for the reasons below.
1. Increased stock value for meeting forecasted earnings.
2. Giving management a chance to correct a bad quarter (period).
3. Less pressure on management for missed earnings.

Chapter 11  159
 4. GAAP providing legitimate ways to manage earnings.
5. GAAP is not that precise and there are lots of acceptable accounting alternatives.

With earnings management:

1. Financial statements are not accurate.
2. Stockholders are misled.
3. Earnings management is a precursor to fraud, especially if results do not improve.
4. Some earnings management is fraud and other types of earnings management are
precursors to fraud.

Based on the evidence and the definition of financial statement fraud, earnings management may
or may not be financial statement fraud. The most problematic part of earnings management is
that it often leads to management fraud because management gets in the habit of changing
numbers to meet expectations (as in the PharMor case).

Answers to Stop & Think Questions

Question #1:

Had Finn not complied with Monus’s expense manipulation requests early on, would the Phar-
Mor fraud have progressed to the extent it did? Also, how would Finn’s career have been
different?

Had Finn not complied with Monus’ expense manipulation requests early on, then the Phar-Mor
fraud may have not happened or at least continued for very long. Had Finn reported Monus’
actions early on to the proper people, then the perpetuated fraud may not have happened. Finn
may have prevented the eventual downfall of Phar-Mor and retained his position. Conversely,
Finn may have been fired by Monus because he would not agree to participate in the fraudulent
financial reporting. The outcome of how Finn’s career would have ended up is uncertain, but he
probably would not have had to face the consequences of participating in fraudulent activities.

Question #2

If auditors and investigators modified their typical procedures and regularly used a few
unexpected procedures to look for fraud, how would his affect a potential perpetrator’s
opportunity to conceal a fraud?

If auditors and investigators modified the typical procedures used to look for fraud and regularly
used a few unexpected procedures to look for fraud, it would be more difficult for fraud to be
perpetrated. Potential fraud perpetrators would need to be more creative and need to engage in
strategic reasoning themselves to prevent getting caught. This limits the perpetrators opportunity
to commit fraud.

160  Chapter 11
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