Financial Statement Fraud

Strategies for Detection and Investigation

Gerard M. Zack

• Publisher: Wiley
• Year: 2012
• ISBN:
  9781118421475
• Edition: 1
• Topic: Business
• Subtopic: Auditing
• Index: Business

Valuable guidance for staying one step ahead of financial statement fraud

Financial statement fraud is one of the most costly types of fraud and can have a direct financial impact on businesses and individuals, as well as harm investor confidence in the markets. While publications exist on financial statement fraud and roles and responsibilities within companies, there is a need for a practical guide on the different schemes that are used and detection guidance for these schemes. Financial Statement Fraud: Strategies for Detection and Investigation fills that need.

• Describes every major and emerging type of financial statement fraud, using real-life cases to illustrate the schemes
• Explains the underlying accounting principles, citing both U.S. GAAP and IFRS that are violated when fraud is perpetrated
• Provides numerous ratios, red flags, and other techniques useful in detecting financial statement fraud schemes
• Accompanying website provides full-text copies of documents filed in connection with the cases that are cited as examples in the book, allowing the reader to explore details of each case further

Straightforward and insightful, Financial Statement Fraud provides comprehensive coverage on the different ways financial statement fraud is perpetrated, including those that capitalize on the most recent accounting standards developments, such as fair value issues.

PART ONE

Revenue-Based Schemes

SIXTY-ONE PERCENT of the financial statement frauds studied in connection with the 2010 report, Fraudulent Financial Reporting 1998-2007, An Analysis of U.S. Public Companies , from the Committee of Sponsoring Organizations of the Treadway Commission (COSO) involved misstatements of revenue, making this the single most common category of financial statement fraud. This statistic has been rather consistent over time. In an analysis of SEC AAERs issued from 1982 to 2005, it was reported by Dechow, Ge, Larson, and Sloan that 54 percent of 676 misstatements involved incorrect reporting of revenue.

Since accounting inherently involves two sides to every transaction, when a revenue account is misstated, some other account is likely to be misstated as well. The schemes covered in this part of the book, however, are driven by a desire by the perpetrators to misstate revenue. The other accounts that are affected may be assets, liabilities, expenses, or even other revenue accounts. But, the motive behind the schemes described in this part is to misstate one or more revenue accounts.

CHAPTER ONE

Introduction to Revenue-Based Financial Reporting Fraud Schemes

REVENUE RECOGNITION PRINCIPLES

U.S. GAAP describes revenues as inflows or other enhancements of an entity's assets or settlements of its liabilities (or a combination of both) from delivering or providing goods, rendering services, or other activities that constitute the entity's ongoing major or central operations. Under IFRS, revenue is defined in IAS 18, Revenue, as “The gross inflow of economic benefits during the period arising in the course of the ordinary activities of an entity when those inflows result in increases in equity, other than increases relating to contributions from equity participants.”

The primary accounting standard governing revenue recognition under IFRS is IAS 18, a comprehensive standard covering numerous considerations. In addition, rules have been published dealing with certain specific types of revenue (e.g., IAS 11 on construction contracts, SIC 31 on barter transactions, etc.).

Under U.S. GAAP, there is currently not a comprehensive revenue standard that is analogous to IAS 18. Instead, there is very broad guidance found in ASC 605, supplemented by standards dealing with specific types of revenue (e.g., revenue from software at ASC 985-605-25) or specific industries (e.g., the music industry at ASC 928-605-25).

As of the writing of this book, however, FASB and IASB are involved in a joint project that will result in changed revenue recognition principles under both U.S. GAAP and IFRS. An exposure draft of a new standard, Revenue from Contracts with Customers, was published by FASB in January 2012, with a comment period that ended in March 2012. FASB and IASB had previously jointly issued an exposure draft in November 2011.

For obvious reasons, this book is based on accounting rules currently applicable under U.S. GAAP and IFRS, as well as cases that have been brought forward pertaining to alleged violations of those rules. The proposed new accounting principles will be briefly explained in the next section.

Under ASC 605, revenue should be recognized when it is earned and either realized or realizable. Reference is then made to more comprehensive guidance published by the SEC. The SEC's Staff Accounting Bulletin (SAB) Topic 13 identifies the following criteria that should all be met in order to demonstrate that revenue is realized or realizable and has been earned:

• Persuasive evidence of an arrangement exists
• Delivery of the goods has occurred or the services have been rendered
• The price is fixed or determinable
• Collectibility is reasonably assured

Under IAS 18, revenue from the sale of goods should only be recognized if all five of the following criteria have been met:

1. All significant risks and rewards associated with ownership of the goods have been transferred.

2. The seller does not retain any ownership-like managerial involvement or control over the goods that were sold.

3. The amount of revenue can be measured reliably.

4. It is probable that the economic benefits associated with the transaction will flow to the seller.

5. Transaction costs can be measured reliably.

With respect to recognition of revenue from the provision of services, only the third, fourth, and fifth criteria from the preceding list should be applied. However, in addition, the stage of completion of the project at the end of the reporting period must be able to be measured reliably.

CHANGES PROPOSED BY FASB AND IASB

The goals of FASB and IASB in proposing a new approach to revenue recognition are to:

1. Remove inconsistencies in existing requirements and improve comparability of revenue recognized under U.S. GAAP and IFRS (hopefully, some of the differences explained in this book will go away once the new standard takes effect)

2. Provide a more robust framework for addressing revenue recognition issues, a framework that can be applied to a wide variety of different revenue arrangements

3. Reduce the number of different revenue recognition rules currently in effect, thereby simplifying research and application of accounting principles

Since the new rules are still in exposure draft format as of the writing of this book, a detailed explanation of them seems pointless. However, a few key points from the draft warrant mentioning.

The core principle of the new standard is that revenue should be recognized to depict the transfer of goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. Five steps would be undertaken to apply this principle:

1. Identify the contract(s) with the customer

2. Identify the separate performance obligations

3. Determine the transaction price

4. Allocate the transaction price

5. Recognize revenue when a performance obligation is satisfied

These steps borrow, with some modification, some of the existing revenue recognition concepts, such as the multiple-element revenue arrangement rules introduced in Chapter 2. And the existing basic requirements associated with persuasive evidence, delivery, a determinable price, and collectibility are by no means eliminated. Rather, they are updated and clarified in a manner designed to apply to a wide variety of revenue arrangements.

OVERVIEW OF REVENUE-BASED SCHEMES

Revenue schemes focus on manipulating revenue. This normally means falsely increasing reported revenue, but in some cases the reverse can be true. Revenue schemes are classified into the following categories:

• Timing schemes
• Fictitious or inflated revenue
• Misclassification schemes
• Gross-up schemes

Think of these categories as the when, why, where, and how of revenue recognition.

Timing schemes shift revenue that belongs in one accounting period to another. Over the course of two or more periods, combined, the fraud self-eliminates. However, since each accounting period stands on its own and must conform to relevant accounting principles, timing schemes represent a form of financial statement fraud. Most commonly, revenue is recognized too soon in the financial statements. This is known as premature revenue recognition.

The rationalization behind prematurely recognizing revenue is simple. The company is borrowing future revenues for today, holding out hope that it can make up for this difference in the next period. This is often done when a company begins to lag behind revenue expectations. The mentality of individuals perpetrating timing schemes is that they feel they will always figure out a way to make the next period successful. They feel that they just need to get through the current period and all will be okay.

Fictitious and inflated revenue both involve fabricating additional revenue to improve profits, decrease losses, or simply appear larger. Fictitious revenue refers to amounts that have been recognized that have no basis whatsoever. Either the customer is fake, the transaction is fake, or both. Inflated revenue, however, starts from a legitimate transaction with a real customer. But, the value of the transaction has been inflated in some manner.

Misclassification schemes do not affect the bottom line of the reporting entity. However, these schemes can have a material impact on certain important financial measures by classifying a transaction improperly, resulting in the transaction appearing on the wrong line of the financial statements.

The final category, gross-up schemes, is designed to accomplish one objective—to make the company appear larger. As with misclassification schemes, the bottom line is not impacted. Rather, revenue and costs or expenses are overstated in equal amounts. This technique is utilized when growth or a specific revenue goal is desired and the company is falling short.

The remaining chapters of Part I will explain how each of these four types of revenue-based schemes are perpetrated.

CHAPTER TWO

Timing Schemes

ALTERATION OF RECORDS

A sales transaction is often supported by several types of records: contracts, sales orders, sales journals, shipping documents, and many others. Physically changing information in any of these may be all that is necessary to perpetrate a revenue recognition fraud scheme. Two examples of record alteration in connection with timing schemes are:

1. Backdating of agreements. This method is as simple as it sounds. Sales or revenue arrangements that are finalized in one accounting period are falsely dated as though they were executed in the preceding period. This technique may or may not require the knowledge of the customer. Backdating of shipping documents is a variation on this technique and can be used to accomplish the same goal.

2. Keeping the accounting records open past the end of the period. Similar to the backdating of an agreement, this technique allows for sales of the subsequent period to be recorded as though they occurred in the preceding period. Years ago, when many businesses maintained their accounting records manually, this was accomplished simply by entering an inaccurate (earlier) date for a transaction in the sales journal. In an automated environment, keeping accounting records open beyond the end of a period can be accomplished either by entering an incorrect date, or overriding a computer-generated date during the input stage of a transaction or by making changes to the computer program itself.

An example of the latter occurred in the case of Sensormatic Electronics Corporation in 1994 and 1995. According to the SEC, as described in AAER 1017, on the last day of the quarter, Sensormatic would bring down the computer system that recorded and dated shipments to customers. As a result, the computer date would continue to reflect the last day of the quarter, resulting in the false recording of shipments made after the end of the quarter as though they were shipped before the end of the quarter.

Another example of keeping the books open beyond the end of the quarter involved Computer Associates International, Inc. (CA). In its complaint, the SEC charged CA with premature revenue recognition on software contracts from 1998 through 2000. The CA scheme was very simple. The company kept the books open for several days after the end of each quarter, allowing contracts executed by customers or CA after the end of the quarter to be recognized as though they were executed within the quarter just ended. CA would often conceal this practice by “using licensing contracts that falsely bore preprinted signature dates for the last day of the quarter that had just expired, rather than the subsequent dates on which the contracts actually were executed.” This enabled CA to meet analysts' expectations. In the first quarter after ceasing this practice, CA missed its earnings estimate and its stock price fell by 43 percent in one day.

Finally, the case of Del Global Technologies Corp. involved a complete second set of sales and accounts receivable records, one supported with fake invoices or shipping documents, to support the early recognition of revenue from 1997 through 2000. Del Global is described more fully in the next section, on shipping schemes.

SHIPPING SCHEMES

The shipping department can be utilized to prematurely recognize revenue. By doing so, shipping documents become available as support for a sale that should not really be recognized until the next period.

One such method is to ship goods prior to a sale being fully consummated. This may occur when a sale is in the latter stages of negotiation and the company anticipates completion soon. The shipping department is then directed to ship the goods on one of the last days of the accounting period in order to recognize a sale.

Another variation on the preceding scheme is for shipment to intentionally be done in a manner that results in a lengthy period in transit, ensuring that the customer does not receive the goods prior to signing the sales agreement (or prior to a previously agreed-upon date). For example, a company may ship goods at the end of one accounting period, recording the sale in that period, but utilize a delayed shipment scheme so that the goods do not arrive at the customer's location until well into the next period, which is when the customer has requested delivery. In the Sensormatic Electronics Corporation case (see preceding section and SEC AAER 1017) the company instructed carriers to delay delivery of goods in order to meet customers' expectations that goods would arrive in the subsequent quarter. These requested delays resulted in deliveries beyond normal transit times, ranging from just a few days to as much as a few weeks.

In some cases, shipments might even be made to some intermediary warehouse prior to delivery to the customer, thus arranging for a delay. Taking this approach one step further, in the Sensormatic case, goods were shipped to another warehouse that was leased ...