Chapter 7 Flashcards

Question

When the timing of revenue & expenses should occur? Example of overstatement due to mismatch? | Steps

Answer 1

Revenues and corresponding expenses should be matched in the same acc period - if not violate GAAP Matching principle **Step 1:** Record revenues according to rev recognition rules **Step 2:** Match expenses associated w/ revs in the same pd **FS fraud when:** Record rev in Dec and expense in Jan to overstate rev

Answer 2

* Inflated NI in the current pd * Under report income in the pd they should have been recorded

Answer 3

1. No written or verbal agreement exist 2. Verbal Agrmnt exists, but a **written agrmnt is customar**y 3. Written order exists, but **condition upon sale to end users** 4. Written order exists but **a right to return** 5. Written order, but side letter alters terms in way that **eliminate required elements** for an agreement 6. Transac is **w/ related party,** fact of which not disclosed | 6

Answer 4

1. Shipment has not been made & criteria for recognizing rev on bill-and-hold transac not met 2. **Shipment** made not to customer, but **to sellers agent**, to installer, or public warehouse 3. **Not all comp**onents required for operation were **shipped** 4. Items of **wrong specification** were shipped 5. Delivery not complete until installation and customer testing and acceptance has occurred 6. Services have **not been provided** at all 7. Services are being **performed over extended pd** and only a portion of services revs should have been recog in CY 8. Mix of **G or S in contract misttated** in order to improp accelerate revenu

Answer 5

* **Price is contingent** on some future event * Service or membership fee subject to u**npredictable cancellation** during contract pd * Transaction includes **o****ption to exhange product for others** * Payment terms **extended for substantial pd** and additional discounts and upgrades may be required to induce continued use and payment, not just switching to alt prods

Answer 6

- Collection is **contingent** on some future events - Customer does not have the **ability to pay**

Answer 7

**Completed Contract Method** - Revenue until project 100% completed - Construction costs held in inventory until completed **% of Completion Method** - Recognizes rev and exp as measureable progress on a project is made - *Vulnerable to manipulation* - used to prematurely recog revs and conceal contract over runs

Answer 8

Aka Trade loading **Sale of unusually large Q** of a product to distributors - encourage to overbuy through deep discounts or extended pmt time - steals from next pd sales - raises questions about A/R collectibility **Attractive in** industries w/ high gross margins

Answer 9

Timely recorded of expense is compromised - Occurs due pressure to meet budget projections & goals - Not properly matched against income they help produce

Answer 10

- Rapid growth or unusual profitability compared to other comps in industry - inability to gen cash flows from ops - Signif, unusual, or highly complex transact - Unusual increase in gross margin in excess of peer - Unusual growth in # of days in AR - Unusual decline in the number of days purchases in A/P

Answer 11

Significant impact on reported earnings - Expenses are hidden - Easier to commit than falsifying sales transactions

Answer 12

1. Liability/Expense Omissions 2. Capitalized Expenses 3. Failure to disclose warranty costs & liabilities

Answer 13

1. Easiest method of concealing liabilities 2. Hardest FS scheme to uncover 3. Perpetrators believe they can ceal their fraud in future periods | Liab and Expense omission

Answer 14

**Turn period expenses into costs that provide a Benefit to a company over more than 1 accounting period** - Overstate income in current period - Understate income in subsequent periods **Expensing cap expenditures** - Minimize income in CY for tax - Increase income in future periods WorldCom

Answer 15

Expense associated w/ sales returns and customer allowances - Record expense as contra sales account reduce net sales **Correct treatment:** Estimated warranty expense should be accrued as a liability

Answer 16

- Inability to **generate cash flows from op**s while earnings grow - Assets, liabs, rev, or exp that **subjective judgements hard to corroborate** - Nonfin **management's excessive participation** in selection of accounting or determination of signif estimates - Unusual **increase in gross margins** excess of peers - Allowances for **sales return and warrantly claim out of line** w/ industry peers - Unusual **reduction in # days purchases in AP** - Reducing AP while competitors stretching out pmts to vendors

Answer 17

Disclosures absent that are supposed to prevent user of FS from being misled

Answer 18

**1.Liability Omission:** failure to disclose loan covenants or failure to disclose contingent liabilities **2. Subsequent Events:** Events occurring or becomingknown that may have a signif effect on FS - should be disclosed **3. Management Fraud:** Must disclose fraud committed by officers, execs, and ppl in trust position - likely lied to auditors - illegal **4. Related Party Transactions:** Must disclose if dealings with entity that is significantly influenced by the company - legal if disclosed - TYCO **5. Accounting Changes:** Must restate and disclose changes in accounting princips, estimates, and reporting entities

Answer 19

1. Domination of mgmnt or small group, lack of controls 2. Ineffective BoD or audit comm oversight of fin rep process and IT 3. Ineffective commun, implement, support, or inforcement of entities ethical standards by management 4. Rapid growth or unusual profitability, especially compated to other comps in industry 5. Signif, unsual or highly complex transacs, especially those close to period end - difficult substance over form questions 6. Signif related party transacts or with entities not audited 7. Signif bank accounts in tax haven jurisdiction 8, Overly complex org structure involv legal entities 9. Known violations with securities laws and violators in positions of power 10. Repeated attempts by management to justify marginal or inapprop accounting on basis of materiality 11. Formal or informal restriction on auuditon inappropriately limiting access to ppl with info

Answer 20

Misclassification of LT assets as current assets - window dressing

Answer 21

1. Inventory Valuation 2. Accounts Receivable 3. Business combination 4. LT Assets

Answer 22

- Lower of cost or market value - Manipulation of physical inventory count - inflation of unit costs used to price out inventory - Failing to relieve inventory for COGS - Phantom Inventory

Answer 23

Should be reported net realizable value **Fictitous A/R:** - Common at end of acc pd - False confirmations of balance to auditors **Failure to write down:** - Required to accrue loss on uncollectible receivables - Record impairmnet of long lived assets and goodwill

Answer 24

Must allocate purchase price to tangible and intanglible * Changes in goodwill accounting **Companies tempted to** - Over allocate purchase price to in process R&D assets - Reduce goodwill amortization and speed up expense deduction - Establish excessive reserves for various expenses to release at a future date

Answer 25

**Book fictituous assets:** - Fraud over looked because assets found in many different locations **Misrepresenting asset value:** - should be recorded at cost, but may use market value to inflate assets - Enron **Understate Assets:** directly or improper depreciation **Capitalizing nonasset cost:** Excluded from the cost of a purchased asset are interest and finance charges - should be interest expense **Misclassify Assets:** to manipulate financial ratios and comply with convenants | s

Answer 26

1. **Recurring negative CFO** or inability to generate cash flows 2. **Significant declines in constumer demand** and increasing business failures in either the industry 3. Assets, Liabilities, revs, or exp based on **signif estimates w/ subjective judgments** 4. Nonfinancial mngmts **excessive participation** in the selection of acc principles or estimate determination 5. Unusual **growth in gross margin** to peers 6. Unusual **growth in # of days in receivable** 7. Unsual **growth in the # of days purchases in inventory** 8. **Allowances** for bad debt, obsolete inventory and other measure **shrinking in % terms** 9. Unusual change in **relationship btw LT assets and depreciation** 10. **Adding to assets** while competitors reducing capital tied up in assets

Answer 27

Technique for analyzing the relationship btw items on an I/S, BS, or SCF by expressing components as % - **AKA Common Sizing** **Discussion:** % of component with respect to a base item - Relationship within each accounting pd

Answer 28

Technique for analyzing the % change in indiv FS items from one year to the next - First year is base - If more than 2 pds, each pd change computed as % of prior year **Discussion:** % comparisons from one accountign period to the next

Answer 29

Small, immaterial frauds

Answer 30

- Means of measuring the relationship btw different FS amounts - Usually used to compare FS ratios with industry average - highligh signif change in key ares of an org from one yr to the next or over pds

Answer 31

Small, immaterial scale

Answer 32

- **Cash flows** examined in **relation** to a company's **reported income** over time **in comparison** to competitors in the industry - FS fraud creates unexpected and irreconcilable difference btw income and CFs

Answer 33

- **Nonfinancial measure (NFMs):** Production facilities, retail outlets, production capacity, weather data, and # of employees - less vulnerable to manipulation - **NFMs** correlate w/ performance to serve as an effective benchmark for evaluating FS data

Answer 34

1. Minority of auditors use NFMs as information source for testing & do not increase their reliance of NFMs when NFMs point to a fraud red flag 2. Presence of high fraud risk alone is insufficient to increase auditor consideration of inconsistent NFMs 3. Auditor are able to react appropriately to an inconsistency if they are effectively prompted 4. Influence of a prompt on auditor reliance on NFMs and account balance expectation is stronger when fraud risk is assessed as high

Answer 35

- Financial statement fraud is more complex than deterring asset misappropriation - 89% of FS frauds involve a CEO or CFO - Using Authority to override most internal controls

Answer 36

1. Reduce pressures to commit FS fraud 2. Reduce the opportunity to commit FS fraud 3. Reduce the ground for rationalizing FS fraud

Answer 37

- Establish effective board oversight of **tone at the top** created by mngmt - Board & Senior management should offer own action as **examples of approp conduct** - **Avoid** setting **unachievable or unreasonable** fin goals - **Avoid applying excessive pressure** on employees to achieve unrealistic goals - **Change goals if changed mkt conditions** require it - Ensure compensation systems are **fair and do not create unwarranted incentives** - **Discourage excessive external expectations** of future corp performance - **Remove operational obstacles** to effective performance

Answer 38

- Maintain **accurate and complete** int acc record - Carefully **monitor bus transacs & interpersonal relationships** of suppliers, buyers, purchasing agents, sales reps, and others in transacs - Establish a **physical security system** to secure company asset assets - **Separation of duties**, if sharing control of one are - **Maintain accurate personnel record:** background checks - **Encourage strong supervisory relationships** and leadership within groups to enforce acc proced - Establish c**lear & uniform acc proceds** w/ no exception claus -

Answer 39

* Promote **strong values**, based on integrity * Policies clearly **defining prohibited behavior** * Provide regular **training to all employees** and communicate prohib behavior * Establish confidential advice & **reporting mechanism** for communicating inappropriate behavior * Have senior exec communicate to emp that **integrity priority** * Management **practices what it preaches** * Clearly **define consequences** of violating the rules

Chapter 7 Flashcards

Financial Statement Fraud (63 cards)