EFFECT OF FRAUD ON FINANCIAL STATEMENTS

(1)

Fraud in financial statements typically takes the form of:

Overstated ASSETS / REVENUE

Understated LIABILITIES / 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 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.

The schemes typically used have been divided into five classes. 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 is common for schemes to involve a combination of several methods. The five classifications of financial statement schemes are:

A. Fictitious Revenues / Aggressive Revenues Recognition B. Timing Differences C. Improper Asset Valuations D. Concealed Liabilities and Expenses E. Improper Disclosures

A- Fictitious Revenues / Aggressive

Revenues Recognition
Fictitious or fabricated revenues involve the recording of goods or services sales that did not occur. It involves 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 are not delivered. At the beginning of the next accounting period, the sale might be reversed to help conceal the fraud, Another method is to use legitimate customers and artificially inflate or alter invoices reflecting higher amounts or quantities than actually sold.

REAL LIFE EXAMPLE (1)

In one recent case, a, foreign subsidiary of a U.S. company recorded several large fictitious sales to a series of companies. They invoiced the sales but did not collect any of the accounts receivable. which became severely past due.
The manager of the foreign subsidiary arranged false confirmations of the accounts receivable for audit purposes and even hired actors to pretend to be the customers during a visit from US management.

REAL LIFE EXAMPLE (1)

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 in order to meet unrealistic revenue goals set by U.S. management.

SALES WITH CONDITIONS

Sales with conditions are those that have terms that have not been completed and the rights and risks of ownership have not passed to the purchaser. For example 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.

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PREMATURE /EARLY REVENUES RECOGNITION

The following four conditions must be present to recognize revenues (See Accounting principles re: Revenue Recognition). Convincing 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.

1.
2. 3. 4.

RECOGNITION OF REVENUE FROM LONGTERM CONTRACTS [i]

Long-term contracts pose special problems for revenue recognition. Long-term construction contracts, for example, use either the completed contract method or the percentage of completion method, depending partly on the circumstances.

The Completed Contract method does not record

revenue until the project is 100% complete. Construction costs are held in an inventory account until completion of the project.

RECOGNITION OF REVENUE FROM LONGTERM CONTRACTS [ii]

The Percentage of Completion method recognizes

revenues and expenses as measurable progress on a project is made, but this method is particularly vulnerable to manipulation. By the percentage of completion and the estimated costs to complete a construction project in order to recognize revenues prematurely and conceal contract overruns.

CHANNEL STUFFING / TRADE LOADING [1]

This involves refers to the sale of an unusually large quantity of a product to distributors, who are encouraged to overbuy through the use of deep discounts and/or extended payment terms.
This practice is especially attractive in industries with high gross margins (cigarettes, pharmaceuticals, perfume, soda concentrate, and branded consumer goods) because it can increase short-term earnings. The downside is that by stealing from the next period's sales, it makes it harder to achieve sales goals in the next period, sometimes leading to increasingly disruptive levels of channel stuffing and ultimately a restatement.

CHANNEL STUFFING / TRADE LOADING [2]

Although orders are received, the terms of the order might raise some question about the collectibility of accounts receivable and there maybe side agreements that grant a right of return, effectively making the sales into consignment sales.

There may be a greater risk of returns for certain products if they cannot be sold before their shelf life expires. This is particularly a problem for pharmaceuticals because retailers will not accept drugs with a short shelf life remaining. As a result, "channel stuffing" should be viewed skeptically as in certain circumstances it may constitute fraud.

CHANNEL STUFFING / TRADE LOADING [3] EXAMPLES

a. The SEC's complaint against Bausch & Lomb indicated that the company's internal estimates showed that it might take distributors up to two years to sell the quantity of contact lenses the company was trying to get them to purchase in the last two weeks of its 1993 fiscal year.
b. The SEC's complaint against the former Chairman and CEO and the former CFO of Sunbeam Corporation included that they failed to disclose that Sunbeam's 1997 revenue growth was in part achieved at the expense of future results, by offering discounts and other incentives to customers to sell merchandise immediately that would otherwise have been sold in later periods.

FICTITIOUS /EARLY RECOGNITION OF REVENUES RED FLAGS

1. Rapid growth or unusual profitability, especially compared to that of other companies in the same industry. 2. Recurring negative cash flows from operations or an inability to generate cash flows from operations while reporting earnings and earnings growth. 3. Significant transactions with related parties or special purpose entities not in the ordinary course of business or where those entities are not audited or are audited by another firm.

FICTITIOUS /EARLY RECOGNITION OF REVENUES RED FLAGS

4. Significant, unusual, or highly complex transactions, especially those close to period end that pose difficult "substance over form" questions.

5. Unusual growth in the number of days sales in receivables.

6. A significant volume of sales to entities whose substance and ownership is not known.

7. An unusual surge in sales by a minority of units within a company, or of sales recorded by corporate headquarters.

B- 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 can be done to shift revenues or expenses between one period and the next, increasing or decreasing earnings as desired.

TIMING DIFFERENCE RED FLAGS

1) Rapid growth or unusual profitability, especially compared to that of other companies in the same industry. 2) Recurring negative cash flows from operations or an inability to generate cash flows from operations while reporting earnings and earnings growth.

3) Significant, unusual, or highly complex transactions, especially those close to period end that pose difficult "substance over form" questions.

TIMING DIFFERENCE RED FLAGS

4) Unusual increase in gross margin or margin in excess of industry peers.

5) Unusual growth in the number of days sales in receivables.

6) Unusual decline in the number of days purchases in accounts payable.