Chapter 11: Financial Statement Fraud

© 2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website in whole or in part.

Chapter 11 is the first of three chapters on financial statement fraud, also known as management fraud. This chapter discusses some of the numerous financial statement frauds discovered in corporate America in the last 15 years.

We discuss the common elements of those frauds and the conditions that led to the rash of financial statement fraud around the turn of the new millennium. Financial statement frauds almost always involve company management and are the result of pressures to meet internal or external expectations.

This chapter provides a framework for detecting financial statement fraud, which emphasizes the need to consider the context in which management is operating and being motivated.

To the Student

© 2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website in whole or in part.

1. Discuss the role that financial statements play in capital markets.

2. Understand the nature of financial statement fraud.

3. Become familiar with financial statement fraud statistics.

4. See how financial statement frauds occur and are concealed.

5. Outline the framework for detecting financial statement fraud.

6. Identify financial statement fraud exposures.

7. Explain how information regarding a company’s management and directors, nature of organization, operating characteristics, relationship with others, and financial results can help assess the likelihood of financial statement fraud.

Learning Objectives

© 2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website in whole or in part.

Financial Statement FraudMisstatement of financial statements can result from manipulating, falsifying, or altering accounting records.

Misleading financial statements cause serious problems in the market and the economy.

They often result in large losses for investors and in lack of trust in the market and accounting systems

© 2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website in whole or in part.

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

Elements of the Perfect Fraud Storm

© 2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website in whole or in part.

Nature of Financial Statement Fraud

Involves intentional deceit Involves attempted concealment Rarely seen Many false red flags Conviction is very difficult

© 2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website in whole or in part.

Detecting Financial Statement Fraud (slide 1 of 4)

Strategic ReasoningQuestions to ask:

◦ What types of fraud schemes are management likely to use to commit financial statement fraud?

◦ What typical tests are used to detect these schemes?

◦ How could management conceal their scheme of interest from the typical test?

◦ How could the typical test be modified so as to detect the concealed scheme?

© 2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website in whole or in part.

Detecting Financial Statement Fraud (slide 2 of 4)

Financial Statement Analysis

Focus on the changes in reported assets, liabilities, revenues, and expenses from period to period or

compare company performance to industry norms.

Nonfinancial Performance Measures

Research suggests that auditors, investors, regulators, or fraud examiners can benefit by using nonfinancial performance measures to assess the likelihood of fraud.

© 2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website in whole or in part.

Detecting Financial Statement Fraud (slide 3 of 4)Nonfinancial performance measures look for a discrepancy between the company’s financial and nonfinancial performance

Example:

Former HealthSouth CEO Richard Scrushy◦ The company’s revenues and assets were

increasing while the number of HealthSouth facilities decreased

© 2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website in whole or in part.

Detecting Financial Statement Fraud (slide 4 of 4) In addition to considering financial and

nonfinancial data to assess fraud risk, auditors can identify fraud risk exposures by examining four groups of fraud exposures.

© 2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website in whole or in part.