2. These are interesting times
Number and size of financial statement frauds are i
ncreasing.
Number and size of frauds against organizations ar
e increasing.
Some recent frauds include several people—as man
y as 20 or 30 (seems to indicate moral decay).
Many investors have lost confidence in credibility
of financial statements and corporate reports.
More interest in fraud than ever before—now a cou
rse on many college/university campuses.
3. Financial Statement Fraud
• Misstatement of financial statements can result fro
m
manipulating, falsifying, or altering accounting
records.
• Misleading financial statements cause serious
problems in the market and the economy.
• Often result in large losses for investors, lack of tru
st
in the market and accounting systems
4. What are Financial Statements
?
Balance Sheet
Income Statement
Cash flow Statement
Fund Statement
5. Elements of the Perfect Fraud Sto
rm
A Booming Economy
Decay of Moral Values
Misplaced Incentives
High Analysts’ Expectations
High Debt Levels
Focus on Accounting Rules Rather than Principles
Lack of Auditor Independence
Greed
Educator Failures
6. Why Fraud is a Costly Business P
roblem
Fraud Losses Reduce Net Inc
ome Rs. for Rs.
If Profit Margin is 10%, Reve
nues Must Increase by 10 ti
mes Losses to Recover Affec
t on Net Income
Losses……. Re.1
Revenue….Rs.10
Fraud Robs Income
Revenues Rs.100 100%
Expenses 90 90%
Net Income Rs. 10 10%
Fraud 1
Remaining Rs. 9
To restore income to Rs. 10, ne
ed 10 more Rs. of revenue to g
enerate 1 more Re. of income.
7. Financial Statement Fraud
Financial statement fraud causes a decr
ease in market value of stock approxima
tely 500 to 1,000 times the amount of the
fraud.
$7 million fraud $2 billion drop in
stock value
8. Types of Fraud
Fraudulent Financial Sta
tements
Employee Fraud
Vendor Fraud
Customer Fraud
Investment Scams
Bankruptcy Frauds
Miscellaneous Frauds
The common element is
deceit or trickery!
9. Detecting Financial Statement Frau
d
Strategic Reasoning
Questions to ask:
– What types of fraud schemes is management likely to us
e to commit financial statement fraud?
– What typical tests are used to detect these schemes?
– How could management conceal the scheme of interest f
rom the typical test?
– How could the typical test be modified so as to detect the
concealed scheme?
.
10. Detecting Financial Statement Frau
d
Financial Statement Analysis
Focus on the changes in reported assets, liabilities, revenues, and expenses f
rom period to period or by comparing company performance to industry nor
ms.
Non-financial performance measures
Research suggests that auditors, investors, regulators, or fraud examiners can
benefit by using non-financial performance measures to assess the likeliho
od of fraud.
Non-financial Performance Measures look for a discrepancy between the co
mpany’s financial and nonfinancial performance
11. Detecting Financial Statement Fra
ud
In addition to considering financial and non-financial data to a
ssess fraud risk, auditors can identify fraud risk exposures by
examining four groups of fraud exposures
1. Management & Board
2. Relationships With Others
3. Organization & Industry
4. Financial Results & Operating Characteristics
12. Financial Statement Frauds
Harshad Mehta
Talking of scams, how can we forget Harshad Mehta. He was known to have fooled
many investors by taking advantage of loop holes in the system. This was proba
bly the most publicized scam and came to be know as the Harshad Mehta scam
.
Harshad and his associates initiated a securities scam by diverting funds of about R
s 5,000 crore from the banks to stockbrokers between April 1991 to May 1992. A
fter the scam was exposed, the stock markets crashed and Mehta was arrested
and banned from trading in the stock markets.
Ketan Parekh
Following the footsteps of Mehta, Ketan Parekh had bigger plans. He conn
ed banks and exchanges like the Allahabad Stock Exchange and the C
alcutta Stock Exchange, and bought shares in fictitious names to manip
ulate the share prices in companies. Ketan was a chartered accountant
who used to run a family business, named NH Securities.
13. Satyam Scam India's one of the biggest corporate scandal affecting Ind
ia-based company Satyam Computer Services in 2009 in which Satyam
Company's chairman Ramalinga Raju confessed that he manipulated a
ccounts to show increased sales, profits and margins from 2003 to 200
8. CBI took over the investigation and filed three partial charge sheets o
ver the course of the year. It later merged those three partial charge she
ets into a single charge sheet. On April 9, 2015, B. Ramalinga Raju, alo
ng with 9 others were pronounced guilty in the Satyam Scam.
Roop Bhansali scam CRB was once a top-notch investment banking fi
rm, started by C R Bhansali. Roop Bhansali, through mutual funds, fixe
d deposits and debentures collected money from investors. With the hel
p of non-existent companies he is raised money and transferred to his o
ther shell companies or others who invested with him.
14. Urata Roy Subrata Roy case is also called Sahara India Pariwar inves
tor fraud case. In this case Subrata Roy, the chairman of the Sahara Ind
ia failed to return Rs 24,000 crore plus interests to its investors as direct
ed by the Supreme Court of India.
Eventually, he was arrested by Uttar Pradesh police on a Supreme Court w
arrant. Then Supreme court of India granted interim bail on condition th
at he should deposit Rs 10,000 crore with Securities and Exchange Boa
rd of India(SEBI). Subrata was eventually taken into judicial custody an
d sent to Tihar jail, along with two other Sahara directors, for failing to d
eposit Rs 10,000 crore to SEBI as per Supreme court of India orders.
Saradha Scam Chit-fund company Saradha Group's Chairman Sudipta Sen
ran various investment schemes and collected money from many investors i
n West Bengal and Odisha.
15. NSEL Scam Money from investors were siphoned off as the most of the un
derlying commodities did not exist and the buying and the selling of commo
dities was being only conducted only on paper. Investors were attracted by
offering fixed returns on paired contracts in commodities. And it was lately, f
ound out the stocks were missing. The NSEL is a company promoted by Fin
ancial Technologies India Ltd and the NAFE. Jignesh Shah along with Shre
ekant Javalgekar were accused of the scam.
Coal Scam Coal allocation scam also know as Coalgate scam is a political
scandal concerning the Indian government's allocation of the nation's coal d
eposits to public sector entities (PSEs) and private companies. There was w
rongful allocation of coal deposits among government employees without co
mpetitive bidding.
2G Spectrum Scam It was a telecommunications scam and political scand
al in which politicians and government officials under undercharged mobile t
elephone companies for frequency allocation licenses. According to CAG, fo
rmer Telecom minister A Raja has evaded norms and carried out the dubiou
s 2G license awards in 2008.
16. Why so many financial statement fr
auds all of a sudden?
1. Good economy was masking many problems
With increasing stock prices, increasing profit
s and increasing wealth for everyone, no one
worried about potential problems.
How to value a dot.com company:
– Take their loss for the year
– Multiply the result by negative 1 to make it positive
– Multiply that number by at least 100
– If stock price is less than the result…buy; if not, buy
anyway
17. 2. Moral decay in society
3.Executive incentives
4.Nature of accounting rules
5.Behavior of CPA firms
18. 6.Greed by investment banks, com
mercial banks, and investors
Incentives to commit financial statement frauds are very
strong. Investors want decreased risk and high returns.
Risk is reduced when variability of earnings is decreased.
Rewards are increased when income continuously improves.
Which firm will have the higher stock price?
Firm A Firm B
19. 7.Educator failures
Need to teach Ethics more
Need to teach students/public about fraud
—offer a “fraud detection and prevention” c
ourse
Need to teach students/public how to think
– We have taught them how to copy, not to think
– We have asked them to memorize, not to think
– We have done what is easiest for us and easie
st for our students/public.
20. Financial frauds indicators check list
Cash-only transactions.
Poorly reconciled cash expenses or customer accounts.
Rising costs with no explanation or that are not commensurate with an incre
ase in revenue.
Large volume of refunds to customers.
Unusually large inventories.
Unusual transactions or inter-account transfers (even for small amounts).
Remuneration disproportionately linked to activities such as sales.
Employees known by others to be under external financial pressure.
Employees who appear to make a greater than normal number of mistakes,
especially where these lead to financial loss through cash or account transa
ctions.
Employees with unexplained sources of wealth.
Employees with competing or undeclared external business interests.
Employees who submit inconsistent and/or unreasonable expense claims.
Employees at the highest level of performance (eg sales) where there might
be a concern that they are achieving this through suspect activity.
21. Most common Financial State
ment Frauds
Revenue/Accounts Receivable Frauds
Inventory/Cost of Goods Sold Frauds
Understating Liability/Expense Frauds
Overstating Asset Frauds
Overall Misrepresentation
22. Revenue Related Financial State
ment Frauds
By far, the most common accounts mani
pulated when perpetrating financial state
ment fraud are revenues and/or account
s receivable.
Accounts Receivable xxx
Revenues xxx
(Income Assets )
23. Transaction Accounts Involved Fraud Schemes
1. Estimate all
uncollectible
accounts receivable
Bad debt expense,
allowance for
doubtful accounts
1. Understate allowance for doubtful
accounts, thus overstating receivables
2. Sell goods and/or
services to
customers
Accounts receivable,
revenues (e.g. sales
revenue) (Note: cost
of goods sold part of
entryh is included in
Chapter 5)
2. Record fictitious sales (related parties,
sham sales, sales with conditions,
consignment sales, etc.)
3. Recognize revenues too early (improper
cutoff, percentage of completion, etc.)
4. Overstate real sales (alter contracts,
inflate amounts, etc.)
3. Accept returned
goods from
customers
Sales returns,
accounts receivable
5. Not record returned goods from
customers
6. Record returned goods after the end of
the period
4. Write off
receivables as
uncollectible
Allowance for
doubtful accounts,
accounts receivable
7. Not write off uncollectible receivables
8. Write off uncollectible receivables in a
later period
5. Collect cash after
discount period
Cash, accounts
receivable
9. Record bank transfers as cash received
from customers
10. Manipulate cash received from related
parties
6. Collect cash within
discount period
Cash, sales
discounts, accounts
receivable
11. Not recognize discounts given to
customers
Revenue-Related Transactions and Frauds
24. Overstating Inventory
(2nd Most Common)
The second most common way to comm
it financial statement fraud is to overstat
e inventory.
Beginning Inventory OK
Purchases OK
Goods Available for sale OK
Ending Inventory High
Cost of Goods Sold Low
Income High
25. Transaction Accounts Involved Fraud Schemes
1. Purchase inventory Inventory, accounts
payable
1. Under-record purchase
2. Record purchases too late
3. Not record purchases
2. Return merchandise to
supplier
Accounts payable,
inventory
4. Overstate returns
5. Record returns in an earlier period (cutoff
problem)
3. Pay vendor w ithin
discount period
Accounts payable,
inventory, cash
6. Overstate discounts
7. Not reduce inventory cost
4. Pay vendor w ithout
discount
Accounts payable, cash Considered in another chapter
5. Inventory is sold; cost
of goods sold is
recognized
Cost of goods sold,
inventory
8. Record at too low an amount
9. Not record cost of goods sold nor reduce
inventory
6. Inventory becomes
obsolete
Loss on w rite-dow n of
inventory, inventory
10. Not w rite off or w rite dow n obsolete inventory
7. Inventory quantities
are estimated
Inventory shrinkage,
inventory
11. Over-estimate inventory (use incorrect ratios,
etc.)
8. Inventory quantities
are counted
Inventory shrinkage,
inventory
12. Over-count inventory (double counting, etc.)
9. Inventory cost is
determined
Inventory, cost of goods
sold
13. Incorrect costs are used
14. Incorrect extensions are made
15. Record fictitious inventory
Inventory/Cost of Goods Sold Frauds
26. Understating Liability Frauds
(3rd Most Common)
Not recording accounts payable
Not recording accrued liabilities
Recording unearned revenues as earne
d
Not recording warranty or service liabiliti
es
Not recording loans or keep liabilities off
the books
Not recording contingent liabilities
27. Asset Overstatement Frauds
(4th Most Common)
Overstatement of current assets (e.g. marketa
ble securities)
Overstating pension assets
Capitalizing as assets amounts that should be
expensed
Failing to record depreciation/amortization exp
ense
Overstating assets through mergers and acqui
sitions
Overstating inventory and receivables (covere
d earlier)
28. Disclosure Frauds
Three Categories of Disclosure Frauds:
1. Overall misrepresentations about the nature of the co
mpany or its products, usually made through news re
ports, interviews, annual reports, and elsewhere.
2. Misrepresentations in the management discussions a
nd other non-financial statement sections of annual r
eports and other reports.
3. Misrepresentations in the footnotes to the financial st
atements.
