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FRAUD BASICS

Financial Statement Fraud

Excerpted from the NEW Fraud Examiners Manual, 2003 U.S. Edition ©2003 Association of Certified Fraud Examiners, Austin, TX

Fictitious revenues and timing differences are two of five classifications of common financial statement schemes.

Fraud in financial statements takes the form of overstated assets or revenue or understated liabilities and expenses.

Overstating assets and revenues falsely reflects a financially stronger company by inclusion of fictitious asset costs or artificial revenues. Understated liabilities and expenses are shown through exclusion of costs or financial obligations. Both methods result in increased equity and net worth for the company. This overstatement and/or understatement results in increased earnings per share or partnership profit interests or a more stable picture of the company's true situation.

Because the maintenance of financial records involves a double-entry system, fraudulent accounting entries always affect at least two accounts and, therefore, at least two categories on the financial statements. While the areas described below reflect their financial statement classifications, keep in mind that the other side of the fraudulent transaction exists elsewhere. It's common for schemes to involve a combination of several methods.

The five classifications of financial statement schemes are fictitious revenues, timing differences, improper asset valuations, concealed liabilities and expenses, and improper disclosures.

We'll deal here with just fictitious revenues and timing differences. (See the ACFE's Fraud Examiners Manual for further discussion of the other three classifications.)

Fictitious Revenues

Fictitious or fabricated revenues involve the recording of goods or services sales that didn't occur. Fictitious sales most often involve fake or phantom customers but can also involve legitimate customers. For example, a fictitious invoice can be prepared (but not mailed) for a legitimate customer although the goods aren't delivered or the services aren't rendered. At the beginning of the next accounting period, the sale might be reversed to help conceal the fraud, but this may lead to a revenue shortfall in the new period, creating the need for more fictitious sales. Another method is to use legitimate customers and artificially inflate or alter invoices reflecting higher amounts or quantities than actually sold.

In December of 1999, the Securities and Exchange Commission issued Staff Accounting Bulletin No. 101, “Revenue Recognition in Financial” (SAB 101) to give additional guidance on revenue recognition and to rein in some of the inappropriate practices. SAB 101 indicates that revenue generally is realized or realizable and earned when all of the following criteria are met:

• Persuasive evidence of an arrangement exists.
  
• Delivery has occurred or services have been rendered.
  
• The seller's price to the buyer is fixed or determinable.
  
• Collectibility is reasonably assured.

SAB 101 concedes that revenue may be recognized in some circumstances in which delivery has not occurred but sets out strict criteria that limit the ability to record such transactions as revenue.

CASE IN POINT: A foreign subsidiary of a U.S. company recorded several large fictitious sales to a series of companies. They invoiced the sales but didn't collect any of the accounts receivable, which became severely past due. The manager of the foreign subsidiary arranged for false confirmations of the accounts receivable for audit purposes and even hired actors to pretend to be the customers during a visit from U.S. management. Background checks on the customers would have revealed that some of the companies were fictitious while others were either undisclosed related parties or operated in industries that would have no need of the goods supposedly supplied. An investigation revealed that the manager of the foreign subsidiary directed the scheme to record fictitious revenues to meet unrealistic revenue goals set by U.S. management.

In some cases, companies go to great lengths to conceal fictitious sales. A sample journal entry from this type of case is detailed below. A fictional entry is made to record a purported purchase of fixed assets. This entry debits fixed assets for the amount of the alleged purchase and the credit is to cash for the payment:

• Date
  
• Description
  
  
• Reference
  
  
• Debit
  
  
• Credit
  
  
• 12/01/03
  

Fixed Assets

104

350,000





Cash

101



350,000

A fictitious sales entry is then made for the same amount as the false purchase, debiting accounts receivable and crediting the sales account. The cash outflow that supposedly paid for the fixed assets is “returned” as payment on the receivable account, though in practice the cash might never have moved if the fraudsters hadn't bother to falsify that extra documentary support.

Date

Description

Reference

Debit

Credit

12/01/03

Accounts Rec.

120

350,000





Sales

400



350,000

12/15/03

Cash

101



350,000



Accounts Rec.

120



350,000

The result of the completely fabricated sequence of events is an increase in both fixed assets and revenue. The debit alternatively could have been directed to other accounts such as inventory or accounts payable or simply left in accounts receivable if the fraud was committed close to year end and the receivable could be left outstanding without attracting undue attention.

Sales with Conditions

Sales with conditions are those that have terms that haven't been completed and the rights and risks of ownership haven't passed to the purchaser. They don't qualify for recording as revenue. These types of sales are similar to schemes involving the recognition of revenue in improper periods since the conditions for sale may become satisfied in the future, at which point revenue recognition would become appropriate.

What Red Flags are Associated with Fictitious Revenues?

• Rapid growth or unusual profitability especially compared to that of other companies in the same industry.
  
• Recurring negative cash flows from operations or an inability to generate cash flows from operations while reporting earnings and earnings growth.
  
• Significant transactions with related parties or special purpose entities not in the ordinary course of business or where those entities aren't audited or are audited by another firm.
  
• Significant, unusual, highly complex transactions especially those close to period end that pose difficult “substance over form” questions.
  
• Unusual growth in the number of days sales in receivables.
  
• A significant volume of sales to entities whose substance and ownership is not known.
  
• An unusual surge in sales by a minority of units within a company or of sales recorded by corporate headquarters.
  
• Timing Differences (Including Premature Revenue Recognition)

Financial statement fraud might also involve timing differences, that is, the recording of revenue and/or expenses in improper periods. This might be done to shift revenues or expenses between one period and the next, increasing or decreasing earnings as desired.

Premature Revenue Recognition

Generally, revenue should be recognized in the accounting records when the four criteria set out in SEC Staff Accounting Bulletin No. 101 have been satisfied.

One or more of these criteria is typically not met when managers recognize revenues prematurely.

Following are examples of common problems with premature revenue recognition:

PERSUASIVE EVIDENCE OF AN ARRANGEMENT DOESN'T EXIST

• No written or verbal agreement exists.
  
• A verbal agreement exists but a written agreement is customary.
  
• A written order exists but is condition upon sale to end users (such as a consignment sale).
  
• A written order exists but contains a right or return.
  
• A written order exists, but a side letter alters the terms in ways that eliminate the required elements for an agreement.
  
• The transaction is with a related party, which hasn't been disclosed.

DELIVERY HASN'T OCCURRED OR SERVICES HAVEN'T BEEN RENDERED

• Shipment hasn't been made and the criteria for recognizing revenue on “bill-and-hold” transactions set out in SEC Staff Accounting Bulletin No. 101 haven't been met.
  
• Shipment has been made not to the customer but to the seller's agent, an installer, or to a public warehouse.
  
• Some but not all of the components required for operation were shipped.
  
• Items of the wrong specification were shipped.
  
• Delivery isn't complete until installation and customer testing and acceptance has occurred.
  
• Services haven't been provided at all.
  
• Services are being performed over an extended period and only a portion of the service revenues should've been recognized in the current period.
  
• The mix of goods and services in a contract has been misstated in order to improperly accelerate revenue recognition.

THE SELLER'S PRICE TO THE BUYER ISN'T FIXED OR DETERMINABLE

• The price is contingent upon some future events.
  
• A service or membership fee is subject to unpredictable cancellation during the contract period.
  
• The transaction includes an option to exchange the product for others.
  
• Payment terms are extended for a substantial period and additional discounts or upgrades may be required to induce continued use and payment instead of switching to alternative products.
  
• Financial statement fraud is the deliberate misrepresentation of the financial condition of an enterprise accomplished through the intentional misstatement or omission of amounts or disclosures in the financial statements to deceive financial statement users.

This type of fraud is usually a means to an end rather than an end in itself. When people “cook the books” they may doing it to “buy more time” to quietly fix business problems that prevent their entities from achieving its expected earnings or complying with loan covenants. It may also be done to obtain or renew financing that wouldn't be granted or would be smaller if honest financial statements were provided. People intent on profiting from crime may commit financial statement fraud to obtain loans they can then siphon off for personal gain or to inflate the price of the company's shares, allowing them to sell their holdings or exercise stock options at a profit. However, in many past cases of financial statement fraud, the perpetrators have gained little or nothing personally in financial terms. Instead the focus appears to have been preserving their status as leaders of the entity – a status that might have been lost had the real financial results been published promptly.

Regardless, you need to be prepared to see the telltale signs long before it becomes a raging problem for your entity. Ultimately, these principles will help you prevent any hatching financial statement fraud schemes. For more information study the ACFE's Fraud Examiners Manual

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