Financial Statement Fraud: Strategies for Detection and Investigation

"Education is by far the most important defensive weapon against frauds of all kinds. . . . One would be hard–pressed to find a better resource than Gerard Zack′s Financial Statement Fraud: Strategies for Detection and Investigation."
from the Foreword by Dr. Joseph T. Wells, CFE, CPA Founder and Chairman, Association of Certified Fraud Examiners

Investigate, detect, and avoid the costliest of all frauds

"Financial Statement Fraud is the forensic accountant′s guide to all of the GAAP and IFRS fraud schemes known to man, including which standards they violate along with actual case studies from settled cases. I highly recommend this book to fraud examiners, auditors, and audit students. Financial fraud schemes transcend national boundaries, and finally we have a forensic accounting book that does too. Financial Statement Fraud belongs in every accountant′s library. It details accounting fraud schemes by category, by standard (GAAP or IFRS), and provides interesting case studies of how the books were cooked without being caught during the audit process. It′s written for the practicing forensic accountant but perfect for audit students too. If you enjoy solving cases of cooked books and crooked CFOs, then this book is for you!"
Harry Markopolos CFA, CFE, bestselling author of No One Would Listen: A True Financial Thriller

"In his concise style, Mr. Zack provides accountants and investigators a clear road map to uncovering the most common frauds hidden in the financial statements of corporations and nonprofit organizations, citing real–world examples to illustrate each scheme he presents. We encountered several variations on these themes in our investigations of the Icelandic financial crisis of 2008. It is my hope that this book heralds the beginning of a new era of closer scrutiny of financial statements by auditors, investors, and regulators."
Jared Bibler, CFA, Office of the Special Prosecutor, Iceland, and formerly manager, FME Special Investigation Team, Iceland

"This book is a must–read for anybody relying on financial statements. Gerry provides a well thought out approach to dealing with the complex subject of fraud using many illustrative examples."
Wayne Berson, CEO, BDO USA, LLP

Foreword xiii

Preface xvii

Acknowledgments xxi

PART I REVENUE–BASED SCHEMES 1

Chapter 1 Introduction to Revenue–Based Financial Reporting Fraud Schemes 3

Revenue Recognition Principles 3

Changes Proposed by FASB and IASB 5

Overview of Revenue–Based Schemes 6

Chapter 2 Timing Schemes 9

Alteration of Records 9

Shipping Schemes 10

Percentage of Completion Schemes 12

Improper Estimates of Revenue Recognition Period 15

Multiple–Element Revenue Recognition Schemes 17

Customer Loyalty Programs 22

Channel Stuffing 24

Bill and Hold Schemes 27

Sales with Right of Return 29

Improper Pushing of Current Revenue to Future Periods 30

Use of Reserves as a Rainy Day Fund 32

Chapter 3 Fictitious and Inflated Revenue 33

Fictitious Revenue Schemes 33

Sales to Related Parties 37

Infl ated Revenue Schemes 41

Consignment or Financing Arrangements 43

Chapter 4 Misclassification Schemes 47

Recording Financing Arrangements as Revenue 47

One–Time Credits Reported as Revenue 49

Sales Incentive Schemes 50

Chapter 5 Gross–Up Schemes 57

Agent versus Principal 58

Barter and Round–Trip Transactions 59

Phony Revenue and Expenses 61

PART II ASSET–BASED SCHEMES 63

Chapter 6 Improper Capitalization of Costs 65

Start–Up Costs 66

Research and Development Costs 67

Property and Equipment 68

Software Development and Acquisition Costs 71

Website Costs 73

Intangible Assets 75

Advertising Costs 77

Other Deferrals and Prepaid Expenses 79

Inventory Capitalization Schemes 80

Inventory Flow Assumptions 81

Chapter 7 Asset Valuation Schemes 85

Fictitious Assets 85

Inventory Valuation Schemes 86

Inflating the Basis of Property and Equipment 88

Inflating the Basis of Assets Acquired in Noncash Transactions 89

Assets Acquired from Related Parties 92

Understating Depreciation and Amortization Expense 93

Investment Property 95

Improper Valuation of Investments Financial Assets 96

Loans 104

Equity Method Investments 108

Proportionate Consolidation 109

Improper Classification or Amortization of Intangible Assets 111

Impairment Losses Nonfinancial Assets 112

Investments in Insurance Contracts 115

Chapter 8 Fair Value Accounting 117

Fair Value Considerations 117

Methods of Measuring Fair Value 118

Internal versus Externally Developed Valuations 124

Inputs Used in Measuring Fair Value 127

PART III EXPENSE AND LIABILITY SCHEMES 129

Chapter 9 Shifting Expenses to Future Periods 131

Timing Schemes Involving Liabilities 131

Accounts Payable 131

Compensated Absences 132

Contingent Liabilities 133

Accrued Compensation 137

Improper Use of Liability Reserves 138

Chapter 10 Omissions and Underreporting of Liabilities 141

Debt 141

Guarantees 146

Pension Liabilities 149

Conditional Asset Retirement Obligations 152

PART IV OTHER FINANCIAL REPORTING SCHEMES 155

Chapter 11 Consolidations and Business Combinations 157

Fraudulent Reporting Involving Consolidations 157

Business Combinations 164

Chapter 12 Financial Reporting Fraud as a Concealment Tool 171

Financial Statement Fraud to Conceal Asset Misappropriations 171

Financial Statement Fraud to Conceal Illegal Acts 174

Chapter 13 Financial Statement Fraud by Not–for–Profit Organizations 177

Inflating the Value of Non–Cash Contributions 179

Improperly Reporting Contributions Raised for Others 179

Netting the Results of Fund–Raising Events 180

Improper Allocation of Costs Associated with Joint Activities 182

Misclassification of Expenses 185

Chapter 14 Disclosure Fraud 187

Categories of Disclosure Fraud 189

Common Disclosure Risks 189

PART V DETECTION AND INVESTIGATION 197

Chapter 15 Detecting Financial Statement Fraud 199

Motives for Financial Statement Fraud 200

Fraud Risk Indicators 202

Internal Control Indicators 202

Chapter 16 Financial Statement Analysis 209

Use of Analytical Techniques to Detect Fraud 209

Horizontal Analysis 210

Vertical Analysis 211

Budget Variance Analysis 212

Chapter 17 Ratio Analysis 215

Research on Ratio Analysis 216

Use of Operating Ratio Analysis to Detect Financial Statement Fraud 217

Another Useful Measure: Working Capital to Total Assets 225

Chapter 18 Other Detection Procedures 227

Analysis Utilizing Multiple Ratios 227

Ratios Involving Nonfinancial Data 231

Other Information and Disclosures in Financial Statements 232

Understandability of Financial Statement Disclosures 234

Testing of Journal Entries 235

Chapter 19 Fraud or Honest Mistake? 239

The Smoking Gun 240

Witnesses 240

Altered Documents 241

Multiple Records 242

Destruction of Evidence 242

Actions That Contradict Recommendations 243

Patterns of Behavior 244

Personal Gain 244

There s No Other Explanation for It 244

Chapter 20 Assessing (or Minimizing) Auditor Liability 245

Litigation against Auditors 246

Concealment from the Auditors 247

Auditing Standards 248

Consideration of the Risks of Material Misstatement 249

Improper or Inadequate Use of Analytical Procedures 254

Auditing Accounting Estimates and Fair Values 257

Revenue Recognition Risks 263

Insufficient Consideration of Related Party Transactions 266

Auditing Disclosures in the Financial Statements 266

Overreliance on the Management Representation Letter 267

Appendix: Financial Statement Fraud Indicators 269

Bibliography 275

About the Author 277

About the Website 279

Index 281

Index to Cases 287

GERARD M. ZACK, CFE, CPA, CIA, is a fraud examiner and forensic accountant with more than thirty years of experience performing audits and investigating fraud. In addition to providing antifraud services to clients, he serves on the faculty of the Association of Certified Fraud Examiners, where he conducts antifraud training on financial statement fraud and other topics. He has also spoken at AICPA and IIA events.