C254

What does SAP No. 1 define an audit as?

...an audit is more than just fraud detection.

Disclosure fraud categories

1). Overall misrepresentations about the nature of the company or its products 2). Misrepresentation in management discussion and other non financial statements 3). Misrepresentations in the footnotes to the financial statements.

Fraud Symptoms

1. Analytical Symptoms 2. Documentary Symptoms 3. Lifestyle Symptoms 4. Tips and Complaints

(NS) What is the incentive to committing fraud on the Selling of Finished Products?

(NS) If a company understates the amount of Sales of Finished Products, then it will not have to keep as much in an allowance account for Warranty (service) Liability.

Having an unduly complex organization structure should most likely be categorized as a symptom of:

1. Fraud

What are two common ways that companies overstate their assets during mergers and acquisitions?

1. Inappropriately use Market Value instead of Book Value. 2. Improperly allocation book values to assets.

What are three ratios that are useful for detecting Overstatement of Asset Fraud?

1. Individual FA account balances/Total FAs 2. Total Def Chgs/Total Assets 3. Def Chg W-offs (amort)/Def Chg Bal

What are three common ways to overstate Fixed Assets?

1. Inflated amounts are recorded in non-arm's-length purchase transactions. 2. Assets are not "written-down" to their appropriate Book, Market, or Residual values. 3. Assets that simply do not exist are fictitiously recorded in the Financial Statement accounts.

Overstated fixed assets generally get on the financial statements in one of three ways

1. Inflated amounts are recorded in non-arm's-length purchase transactions. 2. Assets that simply do not exist are fictitiously recorded in financial statement accounts. 3. Assets are not written down to their appropriate book, market, or residual values because insufficient depreciation is recorded, the assets are obsolete, or values of the assets are otherwise impaired.

Four corners of Fraud Exposure Rectangle

1. Management and Directors 2. Relationships with other entities 3. Financial Results and Operating Characteristic 4. Organization and Industry

Which of the following are considered Control Fraud Symptoms?

1. Management override of significant internal controls relating to the revenue cycle. 2. New, unusual, or large clients that appear to have bypassed usual customer-approval process.

Which victims typically suffer the harshest outcomes associated with asset fraud:

1. Stockholders

Easiest statement scheme

3. Asset overstatement schemes are easier to identify than other types of financial statement fraud because the overstated assets are always included in the numbers on the balance sheet.

According to the financial statement fraud detection framework, fraud is rarely detected by:

4. Analyzing the Financial Statements

Revenue is a Revenue account. What type of account is Unearned Revenue?

A Liability

Symptoms involving activities, relationships, or unusual events (too big, too small, off-season, etc.) are part of which fraud symptom category?

Analytical Symptoms

What type of account does the offsetting entry go to when Payables increases?

Assets, like Inventory.

Which of the following now needs to be documented (but wasn't required in the past) in audit work papers, according to SAS No. 99.

Brainstorming session of possible fraudulent areas.

What is the Current Ratio?

CA/CL

Which organization developed the internal control framework that most organizations use?

COSO

If _____________ is understated, then ________________ will directly be overstated (less tax effect).

Cost of Good Sold, Net Income

Which type of fraud symptoms usually provides the best opportunity to find contingent liabilities that should be recorded

Documentary Symptoms Documentary symptoms provide the best opportunity to find contingent liabilities that should be recorded (See topic 6 for more information).

The AICPA has had one major goal in issuing auditing standards about fraud, but never really met its goal until SAS No. 99. What was that goal?

Eliminate the gap between financial statements users' expectations and auditors' assurances.

A Variable Interest Entity (VIE) can be:

Equity Investments, Leases, Forward Contracts

What is the most efficient method to analyze recorded amounts from one period to another?

Examine changes from period to period in study of statement of cash flows

Which of the following types of fraud is likely the most common type of footnote disclosure fraud? Failure to disclose material, related-party transactions Failure to disclose all related parties Failure to disclose important aspects of a Company's operations Failure to disclose contingent liabilities

Failure to disclose material, related-party transactions GAAP does not require disclosure of all related parties, only the material transactions that occurred with related parties.

Typically, analytical fraud symptoms are most helpful in determining asset overstatements related to mergers or restructurings because the auditor is comparing trends and changes. (T/F)

False.

The reordering of expenses to more closely match projections and budgets is an acceptable practice when its net effect on the bottom line is unchanged.

False. Any manipulation of financial statements that is not a true and accurate representation of results is always fraud.

Studies that look at the frequency of various types of financial statement fraud generally put inappropriate disclosure fraud as one of the top four most common forms of fraud with over 20% of all financial statement fraud cases involving this method. (T/F)

False. Inappropriate disclosure frauds are generally reported in the studies to be a small percentage of the types of financial statement fraud (e.g., 1 percent).

After an auditor finds symptoms of fraud, the auditor should not alter the audit approach so as to make sure proper documentation is recorded. (T/F)

False. Proper documentation techniques should already be a habit, regardless of the method of testing and investigating. Also, altering the audit approach adds the element of surprise required by SAS 99

A Contingent Liability is an actual Liability reported on the Financial Statements (T/F)

False. A Contingent Liability does not become a full-fledged liability on the Financial Statements until the likelihood of repayment is "reasonably probable." Until then, the Contingent Liability is simply disclosed.

Disclosing misleading information is not considered financial statement fraud if it is contained in the Management's Discussion and Analysis (MD&A) section of a Company's annual report. (T/F)

False. Disclosures in the MD&A section of an annual report are considered part of the financial statements and can constitute financial statement fraud if they are misleading.

One of the major purposes of the Statement of Cash Flows is to show, on an accrual basis, the Company's sources and uses of cash. (T/F)

False. The statement of cash flows shows a Company's sources and uses of cash but not on an accrual basis.

Which of the following provides the best statement regarding the means by which financial statement fraud gets started

Financial reporting fraud is like starting down a slippery slope - once started, it is hard to stop, especially if the organization needs profits.

Why can't Forgery and Collusion be easily detected by auditors?

Forgery: Auditors are not trained to detect forgery. Collusion: People can lie about Collusion

What is one key paradigm shift reiterated by SAS No. 99?

Fraud detection is an ongoing process, not just a step in planning the audit.

The COSO definition of inappropriate disclosure fraud

Fraud that involves the issuance of fraudulent or misleading statements or press releases without financial statement line item effects.

The AICPA and the Cohen Commission (the commission on auditor's responsibility) fought over something specific concerning the fall of Equity Funding in the 1970's. This conflict highlighted a major communication issue between auditors and financial statement users during much of the 20th century. What was this conflict about?

How much responsibility should the auditor take when endeavoring to detect (or fails to detect) fraud.

Which of the following elements is not included in the ad hoc approach to dealing with fraud but is included in the pro-active approach to dealing with fraud incidents? Implementation of controls to remedy or fix the problem Inconsistent resolution Ad hoc investigation All of the above are included in the ad hoc approach to dealing with fraud

Implementation of controls to remedy or fix the problem. Because fraud is a crisis for companies that follow the ad hoc approach to dealing with fraud, they rarely, if ever, pro-actively assess what they can learn from the fraud incident or put controls in place to prevent the problem from occurring again.

Within the misstatement of revenues concept, there are two schemes that are used most often. What are they?

Improper Timing of Revenues and Fictitious Revenues.

There are over 15 ways of manipulating cost of goods sold. To what end does a fraudster usually do this?

Increase Net Income

Section 404 of the Sarbanes-Oxley Act of 2002, provided for increased scrutiny over which area of corporate governance:

Internal controls design, implementation and effectiveness. Section 404 of SOX is probably the most well-known section of Sarbanes-Oxley that requires management to select an internal control framework and then assess the effectiveness and report annually on both the design and operational effectiveness of that framework.

What types of Frauds is the Gross Profit Margin useful for detecting?

Inventory Fraud, Cost of Goods Sold Fraud, and Revenue-Related Financial Statement Fraud.

What did Audit Standard No. 99 do that previous standards didn't?

It establishes black and white standards to evaluate whether the auditor did their job correctly, especially in their search for fraud.

Which of the following is an Asset Overstatement Symptom?

Last minute asset adjustments by the entity that significantly improve financial results. Missing documents related to assets. Availability of only photocopied documents to support asset transactions when documents in original form are supposed to exists

Why would the relationships between lawyers and firms be examined closely?

Lawyers advocate for their clients and will support them until it is blatantly obvious that fraud occurred.

What is the most common technique used to manipulate financial statements?

Misstatement of Revenue

Why is it important to be extra cautious when changing auditors?

On average, one out of four companies with fraud switched auditors during the fraud period or right before the fraud period.

Fraud Triangle

Opportunity, Rationalization, Pressure or Opportunity, Attitude, Incentive

Understating the Allowance for Doubtful Accounts allows fraudsters to

Overstate Receivables and Net Income

In evaluating "purchase inventory" transactions, which of the following fraud schemes is most applicable? 1. Overstate purchase returns and purchase discounts 2. Not recording warranty (service) liability 3. Borrowing from related parties 4. All of the above are fraud schemes involving the purchase of inventory

Overstate purchase returns and purchase discounts Not recording warranty (service) liability: This scheme relates to the selling of finished products, not the purchasing of raw inventory. Borrowing from related parties: This scheme relates to borrowing money transactions.

With asset-based financial statement frauds, assets are most often:

Overstated Assets are most often overstated in asset fraud. This normally decreases expenses and improves how profit looks (See topic 7 for more information).

SOX (Sarbanes-Oxley Act) created a private-sector, non-profit organization to help auditors concerning their responsibilities to detect fraud. What is the name of this organization?

PCAOB (Public Committee Accounting Oversight Board)

What are the three categories of Fixed Assets?

Property, Plant, and Equipment. (PP&E)

What is the Acid Test Ratio?

QA/CL

What is QA (Quick Assets)?

Quick Assets = Current Assets - Inventories

What is not believed to improve auditor independence

Requiring audit firm lead partner rotation every seven years instead of five. SOX requires audit firm lead partner rotation every five years instead of seven.

The Sales Return Percentage is a measure of the percentage of sales that are being returned by customers. What type of Fraud is it useful in detecting?

Revenue-Related Financial Statement Fraud

Which of the following are the two most commonly manipulated to perpetuate financial statement fraud?

Revenues and Accounts Receivable

Which SAS publication helped to close the Expectation Gap between auditors and the public?

SAS No. 99

In 2002, a landmark piece of legislation was signed into law to protect against and deter fraud, which also created a private sector organization called the PCAOB (Public Committee Accounting Oversight Board) to help. What was it?

Sarbanes-Oxley Act of 2002 (SOX)

Beyond internal controls design, implementation and effectiveness assessments, the Sarbanes Oxley act provided for

Section 302 of SOX requires that the company's "principal officers" (typically the Chief Executive Officer and Chief Financial Officer) certify and approve the integrity of their company financial reports.

Segregation of Duties

Segregation of duties means that incompatible or high risk duties are separated between two or more people. Independent checks involves someone checking on someone else's work; a system of authorizations usually implies dollar limits or events that individuals can participate in or authorize and physical safeguards involves safes, locks, key, fences, etc.

The impact of Sarbanes-Oxley on the accounting and auditing profession was:

Significant because of the creation of the PCAOB and its responsibilities provided oversight and regulation for the profession. The creation of the PCAOB and its responsibilities by the SOX act provided oversight and regulation for the accounting and auditing profession for the first time in over 100 years.

The ratio "income from operations less cash flow from operations divided by income from operations" should generally be:

Slightly negative This ratio should be slightly negative because depreciation is subtracted from "income from operations" but not from "cash flow from operations." For more information, see topic 8.

What are SAPs

Standard Audit Procedures

What is the purpose of the Current Ratio?

The Current Ratio is a liquidity ratio which is used to help assess whether a company has sufficient cash or cash-equivalent assets to be able to pay its debts as they are due.

Which type of Fraud Scheme is related to Not Recording Warranty (service) Liability?

The Selling of Finished Products

The frauds at Computer Systems (CEO was Robert Reed Rogers) and Lincoln Savings and Loan (Charles Keating) had what auditor failures in common?

The auditor's did not look into management's background.

The corporate governance fabric

The corporate governance fabric is generally thought to include: board of directors, audit committee, senior / executive management, internal audit, external (independent) audit and regulators and governing bodies.

The five COSO framework areas

The five COSO framework areas are Control Environment, Risk Assessment, Control Activities, Information and Communication and Monitoring.

Control Activities

The five types of control activities are segregation of duties, system of authorizations, physical controls, independent checks and documents and records.

Management's discussion and analysis section of the report

The management's discussion and analysis section of the annual report is where management communicates information that can be characterized as part of a Company's public relations efforts. The other options are not valid sections of an annual report.

The impetus for the Sarbanes-Oxley Act of 2002 was

The numerous and costly financial reporting frauds of the early 2000s such as WorldCom, Tyco, Adelphia, Enron and other paved the way for passage of the SOX Act of 2002.

Why has there been so much frustration between the general public and auditors regarding fraud detection?

The public wants all cases of fraud detected, while auditors felt they only needed to be "reasonably certain" of its absence.

What is the most significant "red-flag" or tell-tale sign of fraud?

The symptoms, or red-flags, cannot be ranked in order of their significance or extent.

Which type of symptom is Determining that the Notes Payable Balance is too low?

This is an Analytical Symptom.

When doing common size financials, the 100% benchmark for the balance sheet should be

Total assets or total liabilities & equity

Cost of goods sold can be understated by overstating ending inventory. (T/F)

True

Focusing on the changes in dollar amounts on the financial statements from period to period is the least effective method of comparisons. (T/F)

True

Looking at management's motivations for committing fraud is analyzing the incentive portion of the Fraud Triangle. (T/F)

True

Research shows that many fictitious entries occur through the override of management controls. SAS No. 99 now requires testing these types of entries for every public company that has them.

True

SAS 99 requires auditors to assume there are material misstatements in revenue, though realizing there are situational-specific methods to recognize revenue and interpret the associated rules. (T/F)

True

SAS No. 99 has the new requirements of auditors to ask management if they are committing, or are aware of, any instances of fraud. (T/F)

True

SAS No. 99 required audit teams to "think like fraudsters." (T/F)

True

Stuffing distribution channels with promises to take back excess inventory free of charge directly violates GAAP revenue recognition rules. (T/F)

True

A good ending question to an interview would be an open-ended, non-threatening and general question about potential issues of which they might be aware. (T/F)

True.

A higher Acid Test Ratio is better. (T/F)

True.

After the beginning of the 20th century, auditors began to deny that it was their responsibility to detect fraud. They even stopped counting inventories and "took the managers' word for it." (T/F)

True.

Changes in behavior can be an excellent indicator of a first-time offender of fraud. (T/F)

True.

Each account in the Financial Statements is subject to different Fraud Schemes, all of which could be separate and distinct from each other. (T/F)

True.

If the number of days to collect is increasing, then it could be due to fictitious receivables not ever getting collected. (T/F)

True.

In the beginning of the 20th century, auditors felt that their responsibility was to detect fraud. (T/F)

True.

Of all the types of fraud, inventory fraud is the most difficult to commit because the lie perpetuates from period to period (creating an offsetting error that must be maintained). (T/F)

True.

Revenue recognition is the most violated rule by fraudsters. (T/F)

True.

The public expects all fraud to be detected while auditors feel that only an "assurance" that no fraud has occurred can be expected. This difference in expectations is called the "Expectation Gap." (T/F)

True.

Understating Accounts Payable does affect the Gross Margin Ratio. (T/F)

True.

When offsetting /inflating ending inventory amounts to the fraud, the fraudster needs to continue inflating that amount from year to year to continue the farce. (T/F)

True.

Documentary symptoms provide the best opportunity to find contingent liabilities that should be recorded. (T/F)

True. Finding communications between the client and lawyers, or payments to lawyers (without an acknowledged litigation), mention of litigation in minutes, etc., are all excellent ways to detect missing balances.

Auditors are responsible for providing reasonable assurance that all material related party transactions have been properly disclosed. (T/F)

True. GAAP and GAAS require auditors to provide this assurance.

If an auditor finds photo-copied purchase-related records where originals should exists, the auditor should take that as a potential fraud symptom and act accordingly. (T/F)

True. This is an identified documentary symptom of fraud.

The Bre-X disclosure fraud involved promises that are conceptually similar to the promises made in investment scams and Ponzi schemes. (T/F)

True. Topic 8.4 briefly mentions the similarities between these two types of frauds.

Understating Accounts Payable does not affect Cost of Goods Sold Fraud. (T/F)

True. When Payables increase or decrease, Inventory, or some other asset, also increases or decreases. In order for COGS to be affected, the increase or decrease in Payables would have to result in a change to Sales. But, a change in Payables cannot be directly tied to Sales unless the change in Payables also tied to a change in Raw Materials or Inventory. And that is not always the case. Payables can change as a result of the purchase of any asset, but just Raw Materials or Inventory.

Which is the cause of Understatement of Liability Fraud? Does it under-record or over-record a future liability?

Under-record a future liability

If a business, for example, requires tenants to make deposits that could mistakenly be recorded as revenue, which liability account should get examined further for potential fraud?

Unearned Revenue

Analytical Fraud symptoms include:

Unexplained inventory shortages or adjustments Deviations from specifications Increased scrap Excess purchases Too many debit or credit memos Significant increases or decreases in account balances, ratios, or relationships

According to FASB ASC 450: Contingencies, when do contingent liabilities need to be recorded (versus simply disclosed or not even mentioned) on the financial statements?

When the likelihood of loss or repayment reasonably probable

With regard to deferred charges that are capitalized, the most important question to ask is:

Whether the costs are being incurred to generate future revenues or whether there is likelihood that sufficient future revenue will be generated against these costs.

An excellent way to actively search for analytical symptoms is to

compare internal trends with industry averages, trends of similar firms, or even company financial statement data with non-financial statement data.

Horizontal Changes

compare percentages

Control Environment

ex. Good Hiring practices

Autocratic Management

occurs when supervisors and managers do not listen to, or have a receptive attitude towards their subordinates' input or suggestions.

When examining whether a company has understated accounts payable, which ratio will be most helpful?

Accounts payable/cost of goods sold. Accounts payable/cost of goods sold is helpful in determining whether a company is understating its accounts payable (See topic 6 for more information). Note: The gross profit margin is useful to detect inventory and cost of goods sold as well as revenue-related financial statement fraud. Similarly, the sales return percentage provides a measure of the percentage of sales that are being returned by customers and is useful in detecting revenue-related financial statement fraud.

Control activities include:

Adequate segregation of duties, proper procedures for authorization, and adequate documents and records are all considered to be control activities. For more information, see topic 9.

Motivations for fraud change from case to case, though there tends to be a common theme. What is that common theme?

All of these: 1. Attempt to improve financial information to support high stock price. 2. To support a bond or stock offering. 3. To increase stock price

While not the most common tactic(s) of perpetrating fraud, which of the following are still considered "very common?"

All of these: 1. Improper capitalization of assets 2. Use of off balance sheet SPE's to hide debt and expenses. 3. Overstatement of existing assets

Which of the following were explicitly reiterated in SAS No. 99 from SAS No. 82?

All of these: 1. Maintain professional skepticism. 2. Making extensive inquiries of management whenever necessary. 3. Fraud detection has become an ongoing process, not just a piece in the planning process.

What is the purpose of the Acid Test Ratio?

Also known as the Quick Ratio, it measures how sufficient a company's short-term assets are to cover its current liabilities.