02 Financial Statement Fraud Flashcards

Question

What financial statement fraud scheme involves recording revenues and expenses in improper periods? A. Improper asset valuations B. Concealed expenses C. Timing differences D. Improper disclosures

Answer 1

C. Timing differences ## Footnote Financial statement fraud often involves timing differences—that is, the recording of revenues or expenses in improper periods. This can be done to shift revenues or expenses between one period and the next, increasing or decreasing earnings as desired. This practice is also referred to as income smoothing.

Answer 2

A. Lapping accounts ## Footnote The five classifications of financial statement schemes are: * Fictitious revenues * Timing differences * Concealed liabilities and expenses * Improper disclosures * Improper asset valuations

Answer 3

A. Total assets will be understated ## Footnote Typically, a fraudster’s goal when committing a financial statement fraud scheme is to make the entity look stronger and more profitable. This goal is often achieved by concealing liabilities and/or expenses. To do this, he might fraudulently understate liabilities or improperly capitalize a cost that should be expensed. Just as capitalizing expenditures that should be expensed is improper, so is expensing costs that should be capitalized. Improperly expensing costs will result in a lower net income, as well as understated assets. There are several reasons an entity might want to make itself look worse than it actually is. For example, the organization might want to minimize its net income due to tax considerations. Expensing an item that should be depreciated over a period of time would help accomplish just that—net income would be lower and so would taxes. The result for the current accounting period is that total assets will be understated and expenses will be overstated.

Answer 4

A. True ## Footnote Accounting principles require that financial statements include all the information necessary to prevent a reasonably discerning user of the financial statements from being misled. Disclosures only need to include events and transactions that have or are likely to have a material impact on the entity’s financial position.

Answer 5

D. Accounts receivable ## Footnote Fictitious or fabricated revenues involve the recording of sales of goods or services that did not occur. Fictitious sales most often involve fake customers, but can also involve legitimate customers. At the end of the accounting period, the sale will be reversed (as will all revenue accounts), which will help to conceal the fraud. Recording the sales revenue is easy, but the challenge for the fraudster is how to balance the other side of the entry. A credit to revenue increases the revenue account, but the corresponding debit in a legitimate sales transaction typically either goes to cash or accounts receivable. Since no cash is received in a fictitious revenue scheme, increasing accounts receivable is the easiest way to get away with completing the entry. Unlike revenue accounts, however, accounts receivable are not reversed at the end of the accounting period. They stay on the books as an asset until collected. If the outstanding accounts never get collected, they will eventually need to be written off as bad debt expense. Mysterious accounts receivable on the books that are long overdue are a common sign of a fictitious revenue scheme.

Answer 6

C. Financial statement fraud ## Footnote 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.

Answer 7

A. True ## Footnote Sales with conditions are those that have terms that have not been completed such that the rights and risks of ownership have not passed to the purchaser. In most cases, such sales cannot be recorded as revenue. These types of sales are similar to schemes involving the recognition of revenue in improper periods since the conditions for sale might become satisfied in the future, at which point revenue recognition would become appropriate. The most common examples of sales with conditions are conditional sales and consignment sales.

Answer 8

A. Recording expenses in the wrong period ## Footnote Most improper asset valuations involve the fraudulent overstatement of inventory or receivables, with the goal being to strengthen the appearance of the balance sheet and/or certain financial ratios. Other improper asset valuations include manipulation of the allocation of the purchase price of an acquired business in order to inflate future earnings, misclassification of fixed and other assets, or improper capitalization of inventory or start-up costs. Improper asset valuations usually take the form of one of the following classifications: * Inventory valuation * Accounts receivable * Business combinations * Fixed assets

Answer 9

A. Uncollected accounts receivable are a red flag of fictitious revenue schemes. ## Footnote Fictitious or fabricated revenues involve the recording of sales of goods or services that did not occur. Fictitious sales most often involve fake customers, but can also involve legitimate customers. At the end of the accounting period, the sale will be reversed (as will all revenue accounts), which will help to conceal the fraud. Recording the sales revenue is easy, but the challenge for the fraudster is how to balance the other side of the entry. A credit to revenue increases the revenue account, but the corresponding debit in a legitimate sales transaction typically either goes to cash or accounts receivable. Since no cash is received in a fictitious revenue scheme, increasing accounts receivable is the easiest way to get away with completing the entry. Unlike revenue accounts, however, accounts receivable are not reversed at the end of the accounting period. They stay on the books as an asset until collected. If the outstanding accounts never get collected, they will eventually need to be written off as bad debt expense. Mysterious accounts receivable on the books that are long overdue are a common sign of a fictitious revenue scheme.

Answer 10

C. To obtain favorable terms on financing ## Footnote Unlike some other types of fraud (such as embezzlement), the motivation for financial statement fraud does not always involve personal gain. Most commonly, financial statement fraud is used to make a company’s earnings look better on paper. Financial statement fraud occurs through a variety of methods, such as valuation judgments and manipulating the timing of transaction recording. These more subtle types of fraud are often dismissed as either mistakes or errors in judgment and estimation. Some of the more common reasons why people commit financial statement fraud include: To encourage investment through the sale of stock To demonstrate increased earnings per share or partnership profits interest, thus allowing increased dividend/distribution payouts To cover inability to generate cash flow To avoid negative market perceptions To obtain financing, or to obtain more favorable terms on existing financing To receive higher purchase prices for acquisitions To demonstrate compliance with financing covenants To meet company goals and objectives To receive performance-related bonuses

Answer 11

B. False ## Footnote 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. Note that financial statement fraud, much like all types of fraud, is an intentional act.

Answer 12

A. True ## Footnote Events occurring or becoming known after the close of the period that could have a significant effect on the entity's financial position must be disclosed. Fraudsters typically avoid disclosing court judgments and regulatory decisions that undermine the reported values of assets, that indicate unrecorded liabilities, or that adversely reflect upon management’s integrity. A review of subsequent financial statements, if available, might reveal whether management improperly failed to record a subsequent event that it had knowledge of in the previous financial statements. Public record searches can also help reveal this information.

Answer 13

B. False ## Footnote Typical liability omissions include the failure to disclose loan covenants or contingent liabilities. Loan covenants are agreements, in addition to or as part of a financing arrangement, that a borrower has promised to keep as long as the financing is in place. The agreements can contain various types of covenants, including certain financial ratio limits and restrictions on other major financing arrangements. Contingent liabilities are potential obligations that will materialize only if certain events occur in the future. A corporate guarantee of personal loans taken out by an officer or a private company controlled by an officer is an example of a contingent liability. Under generally accepted accounting principles, the company’s potential liability must be disclosed if it is material.

Answer 14

A. True ## Footnote Fictitious or fabricated revenues involve the recording of sales of goods or services that did not occur. Fictitious sales most often involve fake customers, but can also involve legitimate customers. Recording the sales revenue is easy, but the challenge for the fraudster is how to balance the other side of the entry. A credit to revenue increases the revenue account, but the corresponding debit in a legitimate sales transaction typically either goes to cash or accounts receivable. Since no cash is received in a fictitious revenue scheme, increasing accounts receivable is the easiest way to get away with completing the entry. However, accounts receivable stay on the books as an asset until they are collected. If the outstanding accounts never get collected, they will eventually need to be written off as bad debt expense. Mysterious accounts receivable on the books that are long overdue are a common sign of a fictitious revenue scheme.

Answer 15

B. False ## Footnote Horizontal analysis is a technique for analyzing the percentage change in individual income statement or balance sheet items from one year to the next. The first period in the analysis is considered the base period, and the changes in the subsequent period are computed as a percentage of the base period. Vertical analysis is the expression of the relationship or percentage of component items to a specific base item on the income statement or balance sheet. Ratio analysis is a means of measuring the relationship between any two different financial statement amounts. The relationship and comparison are the keys to any of these types of financial analyses.

Answer 16

D. Percentage-of-completion method ## Footnote Long-term contracts can cause special problems for revenue recognition. In many countries, for example, revenues and expenses from long-term construction contracts can be recorded using either the completed-contract method or the percentage-of-completion method, depending on the circumstances. The completed contract method does not record revenue until the project is 100 percent complete. The percentage-of-completion method, on the other hand, recognizes revenues and expenses as measurable progress on a project is made. This method is particularly vulnerable to manipulation because managers can falsify the percentage of completion and the estimated costs to complete a construction project in order to recognize revenues prematurely and conceal contract overruns.

Answer 17

A. Timing differences ## Footnote Financial statement fraud might involve timing differences—that is, the recording of revenues or expenses in improper periods. This can be done to shift revenues or expenses between one period and the next, increasing or decreasing earnings as desired. Early revenue recognition is a common type of timing difference scheme since companies are often trying to make themselves look as profitable as possible. This practice is also referred to as income smoothing.

Answer 18

A. Ratio analysis ## Footnote Ratio analysis is a means of measuring the relationship between two different financial statement amounts. The relationship and comparison are the keys to the analysis, which allows for internal evaluations using financial statement data. Traditionally, financial statement ratios are used in comparisons to an entity’s industry average. They can be very useful in detecting red flags for a fraud examination.

Answer 19

B. False ## Footnote The debt-to-equity ratio is computed by dividing total liabilities by total equity. This ratio is one that is heavily considered by lending institutions. It provides a clear picture of the comparison between the long-term and short-term debt of the company and the owner's financial injection plus earnings to date. Debt-to-equity requirements are often included as borrowing covenants in corporate lending agreements.

Answer 20

B. Channel stuffing ## Footnote There are three common methods for concealing liabilities and expenses: * Omitting liabilities and/or expenses * Improperly capitalizing costs rather than expensing them * Failing to disclose warranty costs and product-return liabilities

Answer 21

B. Recording revenue in Year 1 when the payment is received, even though the service won’t be performed until Year 2 ## Footnote Financial statement fraud often involves timing differences—that is, the recording of revenues or expenses in improper periods. This can be done to shift revenues or expenses between one period and the next, increasing or decreasing earnings as desired. This practice is also referred to as income smoothing. Examples of timing difference fraud schemes include: Premature revenue recognition—in general, revenue should be recognized in the accounting records when a sale is complete—that is, when title of the goods has passed from the seller to the buyer, or when the services have been rendered. Long-term contracts—in many countries, revenue on long-term contracts can be recognized under one of two methods. The completed-contract method does not record revenue until the project is 100 percent complete. The percentage-of-completion method, on the other hand, recognizes revenues and expenses in proportion to what percentage of the project is complete. Recording expenses in the wrong period—per the matching principle, expenses must be recognized in the same period as the corresponding revenues. The timely recording of expenses is sometimes compromised due to pressures to meet budget projections and goals.

Answer 22

C. Related-party transaction ## Footnote Related-party transactions occur when a company does business with another entity whose management or operating policies can be controlled or significantly influenced by the company or by some other party in common. There is nothing inherently wrong with related-party transactions, as long as they are fully disclosed. If the transactions are not fully disclosed, the company might injure shareholders by engaging in economically harmful dealings without their knowledge. The financial interest that a company official might have might not be readily apparent. For example, common directors of two companies that do business with each other, any corporate general partner and the partnerships with which it does business, and any controlling shareholder of the corporation with which he/she/it does business are all illustrations of related parties. Family relationships can also be considered related parties, such as all direct descendants and ancestors, without regard to financial interests. Related-party transactions are sometimes referred to as self-dealing.

Answer 23

A. Assets would be falsely overstated, giving the appearance of a stronger company

02 Financial Statement Fraud Flashcards

(47 cards)