Fraud Investigations related to financial statements

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After major scandals such as West Management, Inc., Xerox, Enron, WorldCom, Sunbeam Corp., Adelphia, Freddie Mac, Lehman Brothers, AIG, and Bernard Madoff, of what appear to be financial statement reporting fraud and earnings manipulation, and without any doubt that the image of the accountant has been tarnished and affected many organizations and people involved. Nevertheless, Forensic accounting has attracted and gained status in the accounting and legal communities and has gotten a lot of respect and attention after the 9/11 attack; when the FBI had hired forensic accountants to shut down the cash flowing transactions into the terrorists network using financial sleuths, when it was determined that a number of perpetrators used debit cards that had been set up largely by untraceable cash (Crumbley, 2009).

The stock market capitalization of companies affected by financial statement fraud had been devastating. A 2006 report by GAO found that in the one day surrounding the initial announcement of a restatement due to financial statement fraud, the companies affected by frauds had lost almost 100 $ billion overnight in market capitalization.

Forensic accounting or forensic auditing cover spectrum of activities of work an accountant could be asked to perform investigation into the financial affairs of a corporation that is often associated with investigations into alleged fraudulent activity, and uses "intelligence- gathering technique" and accounting skills to quantify the financial monetary loss, if fraud had actually taken place, identify the sides of those involved, and present the findings to the clients and capable of providing credible expert witness testimony in the event of a court case (Kranacher, Riley, Wells (2011).

Traditional financial statement auditing procedures ensure that the financial statements are free from material misstatements, as cited in AICPA Statement on Auditing Standard (SAS) 99, however, Auditors are not currently responsible to plan and perform auditing procedures to detect misstatements that are not judged to be material; whether they are caused by errors or fraud. SAS 99 includes an additional guidance to the auditor to identify potential risk of misstatement "by assigning persons with specialized skills and knowledge … forensic … specialists." (AICPA, Professional Standards, vol. 1, AU sec. 316.50).

Company's accounting system can be exploited and hacked by anyone who has the intention of defrauding the organization and knows very well how to "Cook the Book",

Traditional financial statement audit does not look at every transaction, on the other hand, forensic examination search and try to determined why everything does not and should not add up.

Allegations of financial statements fraud involve investigations which often are resolved through court orders and forensic or fraud examiners involves the application of special accounting and law skills, auditing, finance, quantitative methods, and investigative ability to collect, analyze, interpret and evaluate evidence to reduce the complexity by extracting information and slicing away any deceptions (Sheetz 2007).

Forensic accounting could be asked to investigate financial statement fraud, also known fraudulent financial reporting and white collar crime investigation so as to cause a material misstatement in the financial statements with the intention of presenting the financial statements with favoritism. These types of financial frauds are perpetrated by upper managements and are usually the most to benefit from the financial statement fraud, from stock options, to job performance bonuses and promotions. According to the ACF's 2010 Report to the Nations on Occupational Fraud and Abuse, Fraudulent financial reporting comprised of 4.8 percent of the total fraud with the median loss is $4.1 million per schemes (Sheetz 2007).

The emphasis of this paper is to identify the kinds of financial statement fraud and schemes and the investigation process technique to identify financial frauds. However, I will not discuss financial statement errors and refers to an unintentional misstatement in the financial statement which includes mistakes in collecting, gathering data, and in the application of accounting principal (E.g. Measurement, recognition, classification, Presentation, and disclosures), from which the financial statements are prepared, and from incorrect accounting estimates arising from oversight or from misinterpretation of facts.

Paragraph 4 of SAS 82 states that "misstatements arising from fraudulent financial reporting are intentional misstatements to deceive financial statement users" of which I am not discussing in this papers and includes the following:

"Falsification, alteration, or manipulation of material financial records, supporting documents, or business transactions.

Material intentional omissions or misrepresentations of events, transactions, accounts, or other significant information from which financial statements are prepared.

Deliberate misapplication of financial reporting standards, procedures, and policy used to measure, recognize, report, and disclose economic events and business transactions.

Intentional omissions of disclosures or presentation of inadequate disclosures regarding accounting principles and policies and related financial amounts.

According to accounting and forensic professions, they recognize that the effect financial statement fraud is harmful in many aspects to an economy, organizations and individuals:

Undermines the reliability, quality, transparency, and integrity of the financial reporting process

Jeopardizes the integrity and objectivity of the auditing profession, especially auditors and auditing firms

Diminishes the confidence of the capital markets, as well as market participants, in the reliability of financial information

Makes the capital markets less efficient

Adversely affects the nation's economic growth and prosperity

Results in huge litigation costs

Destroys careers of individuals involved in financial statement fraud.

Causes bankruptcy or substantial economic losses by the company engaged in financial statement fraud.

Encourages regulatory intervention

Causes devastation in the normal operations and performance of alleged companies

Raises serious doubt about the efficacy of financial statement audits

Erodes public confidence and trust in the accounting and auditing profession. (Kranacher, Riley, Wells 2011)

Financial statement fraud schemes

Depending on the complexities of the industry in which the forensic accounting is engaged to engaged to conduct an investigation. Financial statement fraud schemes take the form of:

Balance Sheet : Overstatement of Assets & Understatement of liabilities

Income Statement: Overstatement of Revenue (P&L) and Understatement of expenses.

The Over-Understatement is typically used to fraudulently enhance fraudulent financial statements and fraudulent accounting entries involve a double entry system that affects at least two accounts and illustrated as follows:

Fictitious revenues:

Selling more or overstatement of revenue and it is considered largest items in the income statement and involves the recording of goods or services that did not occur, and often it involves fake, phantom or legitimate customers. FASB ASC 605-10-S99 revenue is recognized when (i) it is realized or realizable and (2) earned.

Selling with conditions: terms rights and risk of ownerships had not passed to the purchaser. FASB ASC 605-10-S99 states the revenue is recognized when (i) there is persuasive evidence of an arrangement, (ii) delivery has occurred or services have been rendered, (iii) the seller's price to the buyer is fixed or determinable, and (iv) collectability is reasonably assured.

The following are the Red flags that are associated with fictitious revenue:

Rapid growth or unusual profitability

Recurring negative cash flows or an inability to generate cash flows from operations

Significant transactions with related parties or special purpose entities not in the ordinary course of business.

"Substance over form": significant, unusual, or highly complex transactions.

Unusual growth in the number of days' sales in receivables

A significant volume of sales to entities with unknown ownership substance.

An unusual surge in sales by a minority or by corporate headquarters (ACFE, Fraud Examiners Manuals (2001).

B - Timing differences:

It involves the recording revenue and/or expenses in improper periods, and shifts revenues or expenses between one period and the next, increasing or decreasing earnings as desired.

Premature revenue recognition.

Long-Term contracts: the use either the completed-contract or the percentage-of-completion methods.

Multiple Deliverable: Product and service thus recognize revenue over a period of time.

Channel Stuffing: the buyer is encouraged to overbuy through the use of discounts or extend payment terms.

Recording expenses in the wrong period: Pressure to meet budget projections and goals (ACFE, Fraud Examiners Manuals (2001).

Improper asset valuations: Under the lower of cost or market value, where cost assets exceeds market

value, the assets must be written down to market value. And takes many form including Inventory valuation, Account receivable, Business combinations and fixed assets.

The following are the Red flags that are associated with Improper Assets Valuations:

Recurring negative cash flows from operations or an inability to generate cash flows from operations while reporting earnings and earnings growth

Significant declines in customer demand and increasing business failures in either the industry or overall economy

Assets, liabilities, revenues, or expenses based on significant estimates that involve subjective judgments or uncertainties that are difficult to corroborate

Non-financial management's excessive participation in or preoccupation with the selection of accounting principles or the determination of significant estimates Unusual increase in gross margin or margin in excess of industry peers.

Unusual growth in the number of days' sales in receivables

Unusual growth in the number of days' purchases in inventory

Allowances for bad debts, excess and obsolete inventory, and so on that are shrinking in percentage terms or are otherwise out of line with industry peers

Unusual change in the relationship between fixed assets and depreciation

Adding to assets while competitors are reducing capital tied up in assets

Concealed liabilities and expenses: Companies plan to compensate for their liabilities with visions of other

income sources, and it is just one of the most difficult fraud schemes to uncover and easiest methods of concealing liability from Multi-million judgments against a company from a recent court decision (ACFE, Fraud Examiners Manuals (2001).

The following are the Red flags that are associated with concealed liabilities and expenses:

Recurring negative cash flows from operations or an inability to generate cash flows from operations while reporting earnings and earnings growth

Assets, liabilities, revenues, or expenses based on significant estimates that involve subjective judgments or uncertainties that are difficult to corroborate

Non-financial management's excessive participation in or preoccupation with the selection of accounting principles or the determination of significant estimates

Unusual increase in gross margin or margin in excess of industry peers

Allowances for sales returns, warranty claims, and so on that are shrinking in percentage terms or are otherwise out of line with industry peers

Unusual reduction in the number of days' purchases in accounts payable

Reducing accounts payable while competitors are stretching out payments to vendors (ACFE, Fraud Examiners Manuals (2001).

Improper disclosures: accounting principal requires that financial statement includes all information

Necessary to prevent the financial statement users from being misled, and usually involve Liability omissions, Subsequent events, Management fraud, Related-party transactions, accounting changes (ACFE, Fraud Examiners Manuals (2001).

The following are the Red flags that are associated with improper disclosures:

Domination of management by a single person or small group (in a non-owner managed business) without compensating controls.

Ineffective board of directors or audit committee oversight over the financial reporting process and internal control.

Ineffective communication, implementation, support, or enforcement of the entity's values or ethical standards by management or the communication of inappropriate values or ethical standards

Rapid growth or unusual profitability especially compared to that of other companies in the same industry.

Significant, unusual, or highly complex transactions, especially those close to period end that pose difficult "substance over form" questions

Significant related-party transactions not in the ordinary course of business or with related entities not audited or audited by another firm

Significant bank accounts or subsidiary or branch operations in tax haven jurisdictions for which there appears to be no clear business justification

Overly complex organizational structure involving unusual legal entities or managerial lines of authority

Known history of violations of securities laws or other laws and regulations, or claims against the entity, its senior management, or board members alleging fraud or violations of laws and regulations

Recurring attempts by management to justify marginal or inappropriate accounting on the basis of materiality

Formal or informal restrictions on the auditor that inappropriately limit access to people or information or the ability to communicate effectively with the board of directors or audit committee ACFE, Fraud Examiners Manuals (2001).

In 2003, The AICPA had conducted a study as to reasons of why so many financial statements fraud involving executives:

Good economy was masking many problems

Moral decay in society

Executive incentives

Wall Street expectations-rewards for short-term behavior

Nature of accounting rules

Behavior of CPA firms Greed by investment banks, commercial banks, and investors

Educators failure

Notable financial statement fraud scandal cases:

Revenue/Accounts Receivable Frauds (Global Crossing, Quest, ZZZZ Best)

Inventory/Cost of Goods Sold Fraud (Phar-Mor)

Understating liability/expenses fraud (Enron)

Overstated assets frauds (WorldCom)

Increasing the depreciation time length for their property and equipments. Thus, it inflated earnings (West management Inc.) (Wikipedia 2011).

Forensic financial statement fraud examiner must understand the all types of fraud that has been carried out and how the fraud was committed and the mechanics of the fraud schemes, and is able to observe and explain significant trends in the financial information so that the credibility and the professionalism of the examiner cannot be undermined during the examination.

When management suspects internal frauds occurs at a company, the reaction always is to assume that an investigation must be started immediately, however, companies does not investigate fraud because of the cost involved. And when the fraud investigated, the larger the fraud, the in-depth investigation is going to be. When fraud in taken place, it is imperative that financial statement must be restated (Sheetz 2007).

In any investigation case, certain records will be requested by the leading forensic examiner will ask to review including corporate income tax returns, audited-provide better disclosures and footnote-, plus unaudited financial statements, contractual agreements, last year's bank statements as well as all cancelled checks and deposits tickets, loan agreements with banks, general ledgers, cash receipts and disbursement journals, payroll records and personnel information. Usually 2 to three years worth of records are requested. Once the records provided, investigation into underline documents begins. An off-balance sheet account is where transactions are occurring but not being included on the books of the business and information disclosed on a company's income tax return can help in the investigation. the first things the forensic examiner look to the control in place in finding fraud, and to determine the amount involved and the effects on the financial statements. Associations of Certified Fraud Examiners (ACFE) that 65% of the fraud cases investigated, less than 25% of the amount stolen is recovered. The intention of recovering significant money from the fraudsters is misguided. Companies usually conduct investigation because investigation is an important part in fraud detection efforts and finding out how fraud had been perpetrated and the persons involved to eliminate future frauds that perpetrated by individuals (Sheetz 2007).

The next step is taken is searching for fraud and source of information. Financial analysis should be undertaken such as ratio analysis aw well as other analytical techniques. Most financial statements frauds involve write0off, adjustments and miscellaneous account, and manual distribution. Investigations involve the use of internal, private, and public records should be utilized. Investigators should always look for fraud in little things (Sheetz 2007).

The final step in the investigation is the use investigating techniques; always involve the background check of the corporation and the individuals, searching for perpetrators associates and relatives, surveillance, digital data analysis, computer forensics, interview witnesses, confirmation with customers and vendors (Sheetz 2007).

Finally, once a proper foundation of fraud investigation is completed, the report should be moved into investigation procedures and findings of detailed discussion of documents examined, witnesses interviewed and investigative procedures performed of the accounting system and transaction examined and the conclusions of opinion reached of the investigation (Sheetz 2007).

If a case will end up in the hands of a jury, the investigator will prepare a deposition of what you have accomplished and how the conclusion reached (Sheetz 2007).

The most frequent types of improprieties involving financial statement fraud is revenue recognition, accounting for reserves, and accounting relating to business combinations (Deloitte Ctr.)

Close examination of year-end classifications and inconsistency of journal entries will show fraudulent and questionable transactions that got posted. A comparison of income tax returns to the financial statements for consistency must be applied (Sheetz 2007).

According to the FBI, first 5 years of post SOX, there were more than 400 cases of corporate fraud and the DoJ has processed about 1300 corporate fraud conviction involved CEOs, corporate presidents, corporate vice president, and CFOs. These convictions provide evidence of the persistent of financial statement reporting fraud scandals.

The Forensic accounting are increasingly in demand to fight corporate fraud and should play an important part in the prevention, detection and deterrence of fraud, and be able to help the audit committee, internal auditors and public accountant to ensure compliance with SAS No. 99 on top of Sarbanes-Oxley Act.

Thus, Forensic Examiner could fill a gap. According to GAAP, it states that "An auditor typically works within economic limits; the auditor opinion, to be economically useful, must be formed within a reasonable length of time and at reasonable cost." Thus, forensic investigation of fraud schemes in the financial statements will not be subject to such constraints. Doug Carmichael, former Chief Auditor for PCAOB, have suggested the additional procedures that should be used in forensic examination:

"Extensive use of Interviews and leveraging techniques designed to elicit sufficient information to prove and disprove a hypothesis.

Document inspection that may extend to authentication procedures and handwriting analysis." The ABO Reporter.

Fraudsters are becoming smarter and that fraud involving financial statement reporting is not detected due to the globalization of the trade, competitions, and the use of technology provide an opportunity for the frauds to be committed. Moreover, forensic accounting must adjust to the changes to combat the financial statement frauds.