Cooking the books. Fudging the numbers. Taking a big bath. Thanks to myriad high-profile cases of financial statement fraud, phrases like these have become familiar jargon for the investing public. Likewise, most CPAs are acutely aware of the fine line separating aggressive earnings management from earnings manipulation. But how well-versed are you in the red flags of falsified financial statements? Take this quiz and see how your knowledge about detecting and investigating financial statement fraud stacks up.
1. Assessing whether financial statement fraud has occurred includes determining the intent of the parties responsible for the contents of the financial statements.
2. Which of the following might be a red flag of a concealed liabilities and expenses scheme?
a. Gross margin significantly lower than industry average
b. An unusual increase in the number of days’ purchases in accounts payable
c. An unusual change in the relationship between fixed assets and depreciation
d. Significant reductions in accounts payable while competitors are stretching out payments to vendors
3. Which of the following is NOT a required element of an audit conducted in accordance with AU section 316, Consideration of Fraud in a Financial Statement Audit?
b. Knowledge of the company’s business
c. Use of a fraud risk factor checklist
d. Brainstorming session
4. Which of the following steps would be most helpful in determining whether reported revenue includes fictitious sales?
a. Analyzing credits to accounts receivable recorded during the subsequent period
b. Examining vendor complaints
c. Consulting with sales management about the validity of the sales
d. Performing a search for unrecorded liabilities
5. During the annual audit of Carp Pharmaceuticals Inc.’s financial statements, Edward Lasher, the company’s auditor, came across some fishy findings. The company’s accounts receivable were higher than expected, and, upon further investigation, Lasher discovered that the company recorded several unusually large sales at the end of the fiscal year, all with extended payment terms and generous return policies. Since the company has been experiencing some serious financial challenges, Lasher is suspicious of these transactions. Based on these findings, which of the following types of financial statement fraud schemes might be occurring?
a. Expense omission
b. Channel stuffing
c. Unrecorded warranties
d. Factoring fraud
6. Which of the following audit procedures would be most helpful in detecting contingent liabilities that have been fraudulently omitted from the company’s financial statements?
a. Computing the number of days’ purchases in accounts payable
b. Reviewing the bank cutoff statement
c. Examining correspondence with and invoices from attorneys
d. Observing the inventory count
7. An unusual relationship between sales and which of the following can provide an indicator of a fictitious revenues scheme?
a. Cost of goods sold
b. Sales returns
c. Shipping expense
d. All of the above
8. Lorinda Dawson is the external auditor for Nealson Industries, a public manufacturing company. As she performs the preliminary analytical procedures, she finds that the quick ratio, which has typically remained fairly consistent, increased from 1.3 to 3.7 during the previous year. Based on this information, what type of financial statement fraud scheme might be occurring?
a. Inflated inventory
b. Capitalized expenses
c. Fictitious accounts receivable
d. Overstated fixed assets
9. An unusual growth in the number of days’ sales in accounts receivable can be a red flag for which of the following financial statement fraud schemes?
a. Improper asset valuation
b. Timing differences
c. Fictitious revenues
d. All of the above
10. DB Enterprise Inc. has been struggling for the last few years and is in danger of defaulting on several loan covenants. The company’s CEO, Nathaniel Silver, is facing significant pressure from the board of directors to turn the company around. To improve the company’s financial appearance, Silver undertakes a scheme to capitalize some of the company’s operating expenses. Which of the following procedures would likely be most helpful in bringing this scheme to light?
a. Obtaining a bank confirmation
b. Analyzing depreciation and amortization expenses
c. Computing the collection ratio
d. Performing a search for unrecorded liabilities
1. (a) For misstated financial statements to be considered fraudulent, the misstatements or omissions must have been made with the intent to deceive financial statement users. While this distinction is necessary to avoid criminalizing unintentional errors, determining the intent of the financial statement creators is difficult, to say the least—much more so than, say, determining whether an employee intentionally embezzled $40,000 from an employer. Consequently, detecting and investigating suspected financial statement fraud can be especially challenging.
2. (d) A noticeable and unexpected reduction in accounts payable, especially during a period when competitors are experiencing a credit crunch, may indicate that the company’s financial statements do not reflect all of the amounts owed to the organization’s creditors. Other red flags that management is concealing liabilities or expenses include: a gross margin in excess of industry peers; an unusual reduction in the number of days’ purchases in accounts payable; and reported earnings growth coupled with recurring negative cash flows from operations. While there may be a legitimate reason for the company’s accounts payable balance to decrease significantly, any unusual fluctuation in the financial statements should wave a red flag to the auditor that fraud might be afoot and additional investigation is necessary. Additionally, without proper knowledge of both the organization’s specific situation and the competitive environment in which it operates, the auditor might miss the warning signs that all is not as reported.
3. (c) Although consideration of fraud risk factors is an important part of the audit process, AU section 316 was issued, in part, to reduce the practice of approaching the risk of fraud with a checklist mentality during the audit process. Instead, AU section 316 requires auditors to focus on the specific circumstances within and surrounding the client organization when considering the risks of fraud. To this end, the standard stresses the importance of maintaining professional skepticism throughout the audit engagement and strongly emphasizes that knowledge of the company’s business is a key requirement for an effective audit. Additionally, AU section 316 instructs auditors to hold a formal brainstorming session during which the audit team discusses areas that might be susceptible to fraud.
4. (a) Fabricated sales often are reversed in subsequent periods. Analyzing credits posted to accounts receivable in the subsequent period can help the auditor determine whether any credit memos were used to remove illegitimate sales from the books. Such analysis might include comparing the ratio of credits to prior-period sales over time and against expected amounts, scrutinizing any customers or product lines with disproportionate credits, and examining all credit memo documentation. The auditor would generally not want to consult with sales management about the legitimacy of any questionable sales transactions, as doing so might alert any parties involved in manipulation to the possibility of detection. Examining vendor complaints and performing a search for unrecorded liabilities are important audit tests that can help identify fraud pertaining to liabilities and expenses, but are not particularly helpful in uncovering fictitious sales transactions.
5. (b) The practice of encouraging customers to purchase more than they can use, often by offering deep discounts or extending payment terms, to prop up current earnings is known as channel stuffing. Often, the purchasers return the excess goods later after the company has recorded the profits from the sale. In some egregious instances of channel stuffing, companies have shipped products to customers without their knowledge, consent or desire for the goods, all for the purpose of increasing reported revenues in the current period. While many channel stuffing schemes fall into that gray area between aggressive earnings management and outright fraud, the tactics involved in channel stuffing enhance current earnings at the expense of future sales, which leads to a slippery slope of needing to artificially boost future earnings as well.
6. (c) Depending on the deemed certainty of the underlying event, organizations are required to disclose contingent liabilities—defined as situations involving a potential loss that will be resolved when some future event occurs (or fails to occur)—in the financial statements. Because the rules governing the recording of contingent liabilities require management to estimate the certainty and amount of the loss involved, contingencies provide an area of opportunity for unscrupulous managers looking to fraudulently understate or omit liabilities that should be included in the financial statements. Examples of contingencies that might need to be reported include pending litigation, income tax disputes, product defects, and guarantees of the obligations of others. Consequently, to detect unrecorded contingent liabilities, the auditor should examine documents pertaining to legal expenses incurred by the company, such as invoices and letters from attorneys, which will provide information on any pending or threatened litigation the company is facing. Additionally, the auditor should inspect all tax-related filings and communications to ensure that any potential tax deficiencies or assessments are appropriately reflected in the financial statements. A review of the minutes of the board of directors’ meetings will also help highlight any significant situations that might involve a contingent liability.
7. (d) A legitimate increase in revenues should be accompanied by proportional changes in other accounts. Clearly, if more goods are sold, the expenses related to the production and delivery of those products—cost of goods sold and shipping expenses, respectively—will increase. Similarly, additional sales generally translate into an increased amount of expected product returns. However, an excessive increase in returns after the year-end would imply that the sold goods were shipped without authorization, possibly due to a channel stuffing scheme. Unusual trends in the relationship between sales and any of these related accounts should be scrutinized; if no sensible reason is found, a fictitious revenue scheme may be to blame.
8. (c) The quick ratio (also called the acid test ratio) is calculated as: (cash + marketable securities + accounts receivable) divided by current liabilities. An unexpectedly inflated quick ratio indicates an abnormal decrease in current liabilities or an unusual increase in cash, marketable securities or accounts receivable. While all of the schemes provided as possible answers to this question would result in overstated assets, the reporting of fictitious accounts receivable is the one that would affect the accounts used in the computation of the quick ratio.
9. (d) The number of days’ sales in accounts receivable (also called days’ sales outstanding or the collection ratio) indicates how long it takes the company, on average, to collect on its receivables. This ratio is calculated as: (average accounts receivable during period divided by credit sales for period) multiplied by the number of days in period. Any manipulation that causes an increase in the accounts receivable balance or a decrease in the reported credit sales for the period will artificially inflate this ratio. Thus, an improper asset valuation scheme that involves an overstatement of accounts receivable will cause an unusual growth in the number of days’ sales in accounts receivable, as will a fictitious revenues scheme in which the fake sales are left to linger in accounts receivable at the end of the period. Similarly, timing differences schemes—for example, inappropriately accelerating revenues into an earlier period—may skew either accounts receivable or sales, depending on how the scheme is affecting the current period. Consequently, if a CPA encounters an unexpected or unexplainable value for this ratio, he or she should consider whether other red flags or fraud risks indicate which area may be at risk for misstatement.
10. (b) Most fraudsters who misclassify expenses as assets to prop up the company financials do so by capitalizing the costs as fixed or intangible assets. Thus, comparing the depreciation and amortization expense amounts with the average asset balance can help determine the reasonableness of these expenses in relation to the amount of assets the company reports. If either depreciation expense as a percentage of fixed assets or amortization expense as a percentage of intangible assets is much lower than in prior years, this might indicate the fraudulent classification of operating expenditures as capital expenditures.
If you answered nine or 10 questions correctly, congratulations. Your arsenal of antifraud knowledge is well-armed and ready to aid in the fight against fraudulent financial statements. Keep up the good work.
If you answered seven or eight questions correctly, you’re on the right track. Use the resources on the previous page to continue to build on your knowledge of fraud detection and investigation. If you answered fewer than seven questions correctly, you may want to brush up on your antifraud knowledge. The resources are a good place to start. Enhancing your understanding of fraud detection and investigation concepts will help ensure that you have what it takes to keep manipulated financial statements from slipping by on your watch.
Andi McNeal (firstname.lastname@example.org) is director of research for the Association of Certified Fraud Examiners.
To comment on this article or to suggest an idea for another article, contact Loanna Overcash, senior editor, at email@example.com or 919-402-4462.
“What’s Your Fraud IQ?” Sept. 09, page 48
“What’s Your Fraud IQ?” May 09, page 52
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How Fraud Hurts You and Your Organization (#056513HS)
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