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Financial Reporting Fraud

Forensic Accounting & Audit Investigative Workshop - 2013

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Topics
1. Fraudulent Financial Reporting
2. Exploring Fraudulent Financial Reporting
– Case Example
3. Exploring Fraudulent Financial Reporting:
– Why auditors fail to detect fradulent financial reporting
– Practical approaches to prevention, detection and response
4. Legal Dimension of Fraud:
– Financial fraud
– Fradulent financial reporting techniques
5. Legal Dimension of Fraud:
– Investigating financial fraud
– Key characteristics
– Investigative steps
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Section - 1:
Fraudulent Financial Reporting

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Background
• Broad definition of fund markets: all forums in which
consumers of fund contract with suppliers of fund to fulfill
their requirement.
• There’re many types of fund markets: debt & equity market
(incl Gov’t Bonds), credit market, money & exchange market.
They are called as financial industry
• All of these markets rely on financial info, incl. Gov’t as
supervisor & regulator them.
• According to ACFE survey: financial industry has significant
fraud exposures.
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Vulnerability of Financial Industry - 2006

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Vulnerability of Financial Industry - 2008

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Vulnerability of Financial Industry - 2010

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Vulnerability of Financial Industry - 2012

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Securities Investment Model

• Investors purchase equity securities in the expectation
that they will generate a satisfactory return through
dividend and/or appreciation in the market value.
• Value may be measured & predicted by historical
performance, current results of operation & financial,
projection the future.
• Investors use financial info to assess operating results,
make judgments about future, evaluate non accounting
factors as well.
• Investor meet risks. The most basic of risk is future
financial outcomes will not meet expectations. One of
the greatest risk is financial info risk (misstated FS)
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Targets of Fund Market Fraud

• Anyone in a position to lend, place or invest
money can be target of fund market fraud
• They may become victims in following ways:
– Attacked from within (inside)
– Attacked from outside
– Attacked from outside & inside
– Used as an unwitting participant to facilitate a
fraudulent scheme perpetrated on others
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Financial Statements Fraud - definition

• Financial statements 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.
• Fraudulent FS typically takes the form of material
misstatements. Such misstatements: overstatement assets/
revenues, understatement liabilities/expenses,
mischaracterization of or failure to disclose, transactions,
accounting events, or other material info. FS that are
intentionally misstated so they are misleading & don’t
conform to GAAP represent a fraud upon investors
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Type of Financial Statements Fraud

• Inclusive fraud: FS include transactions or amounts that are
incorrect (ex: recording fictitious asset, omission of liabilities,
early recording A/R & sales, overvaluation of assets)
• Exclusive fraud: transactions that should be included are not
(ex: exclusion of liabilities, delayed recognition of provision
expenses, understatement of expenses-expense record delay,
litigation, assets impairment, allowances, overstatement of
liquidity measures)
• Intentional mischaracterization of the nature of transactions
and misleading disclosure (ex: material changes in accounting
estimates, misclassification of operating expenses or losses as
nonrecurring, misstatement of or failure to include accounting
policies)
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Characteristics of Financial Statements Fraud

• Financial statements fraud is usually a means to an end rather
than an end in itself.
– When people cook the books, they may be doing it to buy more time
to quietly fix business problems that prevent their company from
achieving its expected earnings or complying with loan covenants.
– It may also be done to obtain or renew financing that would not be
granted, or would be smaller, if honest financial statements were
provided.
– People who are intent on profiting from crime may commit financial
statements fraud to obtain loans they can then siphon off for personal
gain or to inflate the price of the company s shares, allowing them to
sell their holdings or exercise stock options at a profit, or even obtain
bonus money calculated based on sales or profits.
– Most commonly, financial statements fraud is used to make a company
s earnings look better on paper. But It sometimes covers up the
embezzlement of company funds.
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Characteristics of Financial Statements Fraud

• Financial statements fraud is usually done by high-level persons in
an organization, because they can disobey rules and override
controls
• Instead the focus appears to have been preserving their status as
leaders of the organization a status that might have been lost had
the real financial results been published promptly.
• However, the overall objective of the manipulation may sometimes
require the opposite action, such as concealing over-budget results
in a good year in order to help the subsequent year, which is
expected to be tougher
• These more subtle types of fraud are often dismissed as either
mistakes or errors in judgment and estimation
• or these are more subtle fraud due to they can be corrected by
adjustment entries proposed by CPA
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Why commit Financial Statements Fraud

• 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 dispel 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
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Cause of Financial Statements Fraud

• Sometimes, the cause of fraudulent financial reporting is the
combination of situational pressures on either the company or
the manager and the opportunity to commit the fraud
without the perception of being detected.
• Examples of situational pressures include:
– Sudden decreases in revenue or market share experienced by a
company or an industry.
– Unrealistic budget pressures, particularly for short-term results (the
pressures become even greater with arbitrarily established budgets
that are without reference to current conditions).
– Financial pressures resulting from bonus plans that depend on short-
term economic performance (these pressures are particularly acute if
the bonus is a significant component of the individual s total
compensation)
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Cause of Financial Statements Fraud

• Opportunities to commit fraud most often arise gradually.

– Generally, these opportunities can stem from a lack of adequate
oversight functions either within the company itself & Gov’t.
– The existence of an oversight function does not, in and of itself,
guarantee the detection of fraudulent acts; the oversight function
must also run and respond effectively.
• The perception of detection, not internal control per se, is
arguably the strongest deterrent to fraud. If such perception
does not exist, it will be trigger to do FS fraud

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Section - 2:
Exploring Fraudulent Financial Reporting

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Other Example of FS Fraud Cases

• Multiple fraud schemes: Bally Total Fitness Holding Corp (Feb
2008), CPA : E&Y
• Revenue fabrication schems : Satyam Computer Services Ltd
(Jan 2009), CPA: PwC
• Liability/expense omissions: Adelphia Communications Corp
(July 2002), CPA : Deloitte & Touche
• Capitalised expenses.World.Com Inc. (Nov 2002), CPA: Arthur
Andersen
• Related-party transactions: Tyco International Ltd (Sept 2002),
CPA: PwC

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How Occupational Fraud is Committed

Occupational Frauds by Category — Frequency

©2012 Association of Certified Fraud Examiners, Inc. 26

How Occupational Fraud is Committed

Occupational Frauds by Category — Median Loss

©2012 Association of Certified Fraud Examiners, Inc. 27

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Why auditors fail to detect fraudulent

financial reporting
• Line of defenses concept
• Professional Standard protection
– CPA: ED SPA 240 or SA 316/317
• Reasonable assurance ; There is inherent limitation i.e probability of frauds never
detected eventhough the audit has been planned & performed very well
• Auditors obligation is assess whether FS has been free of materially misstatement
• Auditors rely on (fraud) risk identification and assessment in their planning
• Representation letter
– CIA: 1210.A2 – Internal auditors must have sufficient knowledge to
evaluate the risk of fraud and the manner in which it is managed by
the organization, but are not expected to have the expertise of a
person whose primary responsibility is detecting and investigating
fraud
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Why auditors fail to detect fraudulent

financial reporting
• Loose-thread theory & small stuff
• Independency contamination
• Most auditors in field work are junior auditors while they
have limited experiences and they are seldom to get adequate
knowledge
• Lack of knowledge about client business operation & industry
(competition, economic situation, regulation, etc)
• Most fraud schemes are rarely uncovered by traditional
approaches
– Think out of the book
– Think like a crook
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Why auditors fail to detect fraudulent

financial reporting
• Lack of knowledge about fraud risk or typical risks within the
client while CPAs rely on the management answer for fraud
risk checklist
• Lack of knowledge and skill to assess governance & control
quality, including assurance responsibility & quality
• Lack of knowledge about IT risk and fraud in heavy digital
working environment
• Lack of detection sense (investigative traits), ex: curiosity,
inquisitive, persistence to uncover concealment
• Reckless in understanding complex transaction, contracts
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Practical approaches to prevention,

detection and response
• Due to the perpetrator of FS fraud is management, as
regulator, the best approach to prevent is:
– Build Good Governance measures: Organization/Structures, Policy and
Procedures, Implementation Effectiveness (outcome)
– Build self assessment method, build assurance method and
responsibility, build clear sanction
– Build monitoring & enforcement
• As supervisor, do review control environment/governance &
monitoring quality & adequacy carefully (opportunity side).
• As supervisor, do review management contract &
performance measurement systems (pressure side)
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Practical approaches to prevention,

detection and response
• As supervisor, do review management style (behavior) and life
style, tone at the top & commitment realization, human caital
touch (pressure & rationalization side)
• As supervisor, do careful review of financial distress, economic
volatility, do financial analysis
• As supervisor, do proactive fraud auditing which include fraud
risk identification & fraud risk schenarion in every assignment
• As supervisor, know typical fraud schemes within your auditee
and industry, especially financial shenanigans
• As supervisor, build & manage whistleblowing system and
complaint
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Perpetrators
Position of Perpetrator — Frequency

©2012 Association of Certified Fraud Examiners, Inc. 33

Perpetrators
Position of Perpetrator — Median Loss

©2012 Association of Certified Fraud Examiners, Inc. 34

Perpetrators

©2012 Association of Certified Fraud Examiners, Inc. 35

Perpetrators
Behavioral Red Flags of Perpetrators Based on Scheme Type

©2012 Association of Certified Fraud Examiners, Inc. 36

Perpetrators
Behavioral Red Flags of Perpetrators Based on Position

©2012 Association of Certified Fraud Examiners, Inc. 37

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Section - 3:
Legal Dimension of Fraud

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Other terms of FS fraud

• Window dressing : “the act or an instance of making
something appear deceptively attractive or favorable atau
something used to create a deceptively favorable or attractive
impression”.
• Cooking the books
• Earning management
• Income smoothing
• Creative accounting / Financial numbers game
• Financial shenanigans

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Earnings management
• William J. Burns, Jr., dan Kenneth A. Merchant pada tahun 1990
melakukan penelitian dan ternyata praktisi akuntansi,
khususnya praktisi yang semakin berpengalaman, mentolerir
pengaturan operasional misalnya menunda pembelian aset
tetap atau menunda kontrak dan eksekusi penjualan ke tahun
beikutnya, dalam rangka manajemen laba, khususnya income
smoothing. Namun praktisi tersebut cenderung tidak setuju
manajemen laba dengan rekayasa akuntansi.

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Earnings management
• Riset Burns dan Merchant menunjukkan bahwa apabila suatu
praktik akuntansi tidak secara eksplisit dilarang atau hanya
deviasi kecil dari aturan, maka deviasi adalah perbuatan etis
terlepas dari siapa yang terkena dampak. Maka pengguna
laporan keuangan yang memakai informasi laba jangka pendek
rawan untuk salah interpretasi, dimanipulasi, atau dikelabui.
Tidak ada keraguan bahwa laba jangka pendek (short-term
earnings) dimainkan oleh banyak perusahaan. Beberapa praktik
manajemen laba dapat dianggap sebagai tidak bermoral dan
tidak etis.

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Earnings management
• Mengingat kecenderungan praktik manajemen laba adalah
untuk short-term earnings maka Michael D. Akers, Don E.
Giacomino, dan Jodi L. Bellovary mendefinisikan earnings
management sebagai “attempts by management to influence
or manipulate reported earnings by using specific accounting
methods (or changing methods), recognizing one-time non-
recurring items, deferring or accelerating expense or revenue
transactions, or using other methods designed to influence
short-term earnings

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Earnings management
• Mengingat kecenderungan praktik manajemen laba adalah
untuk short-term earnings maka Michael D. Akers, Don E.
Giacomino, dan Jodi L. Bellovary mendefinisikan earnings
management sebagai “attempts by management to influence
or manipulate reported earnings by using specific accounting
methods (or changing methods), recognizing one-time non-
recurring items, deferring or accelerating expense or revenue
transactions, or using other methods designed to influence
short-term earnings

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Earnings management
• Schipper (1989) mendefinisikan earnings management sebagai
“purposeful intervention in the external financial reporting
process, with the intent of obtaining some private gain”
• Healy dan Wahlen (1999) mendefinisikan earnings
management sebagai “managers use judgment in financial
reporting and in structuring transactions to alter financial
reports to either mislead some stakeholders about the
underlying economic performance of the company or to
influence contractual outcomes that depend on reported
accounting numbers

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Income smoothing
• Perataan laba (income smoothing) merupakan salah satu aspek
dalam manajemen laba. Pengertian awal mengenai income
smoothing ialah moderates year-to-year fluctuations in income
by shifting earnings from peak years to less successful periods
(Riahi-Belkaoui, 2004).
• Sedangkan pengertian yang lebih modern adalah the process of
manipulating the time profile of earnings or earning reports to
make the reported income less variable, while not increasing
reported earnings over the long run (Riahi-Belkaoui, 2004),
income smoothing is a form of earnings management in which
revenues and expenses are shifted between periods to reduce
fluctuations in earnings (Arens, et. al, 2005: 310)
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Income smoothing
• Definisi lainnya tentang perataan laba menurut Beidleman
(Riahi-Belkaoui, 2004): “The intentional dampening or
fluctuations about some level of earnings that is currently
considered to be normal for a firm., atau an attempt on the
part of the firm’s management to reduce abnormal variations
in earnings to extent allowed under sound accounting and
management principles.” Atau income smoothing is a form of
earnings management and is generally defined as the
dampening of fluctuations in reported earnings over time. In
other words, management is inclined to take actions to
increase earnings when earnings are relatively low and to
decrease earnings when earnings are relatively high
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Creative Accounting /
Financial numbers game
• Creative accounting diterapkan perusahaan karena beberapa
kondisi seperti bervariasinya prinsip akuntansi, dalam rangka
penerapan prinsip akuntansi yang agresif, dalam rangka
earnings management, pelaporan keuangan yang benar-benar
menyimpang (outright fraudulent financial reporting).
• Penerapan Prinsip Akuntansi yang Agresif: Terkadang bukannya
menggunakan PSAK yang fleksibel untuk menyajikan laporan
keuangan yang wajar, tetapi perusahaan menerapkan PSAK
secara agresif yang cenderung melanggar prinsip agar kinerja
laporan keuangannya terlihat lebih menarik dan bagus. Berikut
ini beberapa contoh triknya:

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Creative Accounting /
Financial numbers game
• Over-estimasi dalam biaya restrukturisasi perusahaan: Caranya
dengan menghapus sebagian persediaan dan aktiva tetap dan
biaya penghapusan tersebut dimasukkan sebagai biaya
restrukturisasi. Selain itu, cadangan biaya litigasi dan
lingkungan dimasukkan juga sebagai biaya restrukturisasi..
Akibatnya, biaya restrukturisasi pada tahun berjalan sangat
besar dan kinerja laporan keuangan pada tahun dilakukannya
restrukturisasi menjadi underestimate. Di samping itu, kinerja
laporan keuangan di tahun-tahun mendatang menjadi lebih
cantik karena tidak ada lagi biaya penyusutan, biaya persediaan
yang rusak, biaya litigasi atau biaya lingkungan.
• Memainkan tingkat prosentase penyelesaian pekerjaan.
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Creative Accounting /
Financial numbers game
• Menangguhkan biaya proyek dan menghapus utang usaha
• mempercepat atau memperlambat pengakuan pendapatan
(Recognizing Premature or Deferred Revenue) dan biaya
• Mencatat pendapatan fiktif (Fictitious Revenue)
• Kapitalisasi beban yang agresif dan kebijakan amortisasi yang
diperluas (Aggressive Capitalization & Extended Amortization
Policies).
• Penyajian yang salah pada aset dan liabilitas (Misreported
Assets & Liabilities).
• Kreatif pada masalah laporan laba rugi dengan laporan arus kas
(Getting Creative with the Income Statement Problems with
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Financial Shenanigans
• Mencatat penghasilan terlalu segera (recording revenue too
soon).
• Mencatat penghasilan palsu (recording bogus or fictitious
revenue).
• Memperbesar pendapatan dengan laba sesaat (boosting
income with one time gains).
• Menggeser beban tahun berjalan ke periode sesudah atau
sebelumnya (shifting current expenses to a later or earlier
period).
• Tidak mengungkapkan liabilitas secara cukup (failing to disclose
liabilities).
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Financial Shenanigans
• Menggeser pendapatan tahun berjalan ke periode sesudahnya
(shifting current income to a later period).
• Menggeser beban yang akan datang (beban yang
ditangguhkan) ke periode tahun berjalan (shifting future
expenses into the current period).
• penilaian aset yang tidak tepat (improper asset valuation)
including reserves (net realizable value concept)

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Other financial fraud techniques

• Cookie-jar reserves
• Bill & hold trx
• Channel Stuffing (Trade Loading)
• Round-tripping
• Up-front fees
• Side agreements
• Conditional sales
• Multiple deliverables
• Liberal return, refund & exchange

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Investigating financial reporting fraud

1. Fraud risk identification & assessment
a. Governance, control environment & monitoring weaknesses
b. Management contract & performance measurement systems
c. Management style (behavior) and life style, tone at the top &
commitment realization, human capital touch
d. Financial distress or failures
2. Estimate the risk over financial reporting & risk complexity
3. Design audit procedures & design investigative procedures
4. Perform audit & investigative procedures
a. Loose-thread theory
b. Know micro-level (transaction) fraud red flag
c. Substance over form is important
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Investigating financial reporting fraud

4. Perform audit & investigative procedures
d. Contracts & Complex or unusual transactions
e. Explore informed persons within organization
f. Shifting to “investigative skills“ when meet red flag
5. Use appropriate “investigative” interview techniques,
document examination, financial analysis, phyisical
inspection, and reperformance
6. Use data analytics & data mining – combined with benford
analysis
7. Always tries to thing outside the book & think like a crook to
uncover concealment & off the book recording
8. Move to investigation when predication is enough
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Micro level red flag

• Rapid growth or unusual profitability – compared to others
• Recuring negative cash flows from operations while reporting
earnings & earning growth
• Significant trx with related parties or SPE
• Significant, unusual, highly complex trx, especially those
close to the period end that pose difficult substance over
form questions
• Unusual growth in the day’s sales in receivables ratio
• Significant volume of sales to entities whose substance and
ownership is unknown or odd
• Unusual surge in sales by a minority of units within company
or sales recorded by HQ
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Micro level red flag

• Unusual increase in gross margin or compared to others
• Unusual decline in the days purchases in AP ratio
• Significant declines in customer demand and increasing
business failures in either the industry or overall economy
• Assets, liabilities, revenues, expenses based on significant
estimates that involve subjective judgment or uncertainties
that are difficult to support
• Non-financial management ‘s excessive participation in or
preoccupation with the selection of acctg principles or
determination of significant estimates
• Adding to assets while competitors are reducing capital
• Reduction (increasing) reserves/allowances
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Micro level red flag

• Reducing AP while competitors stretching out payment
• Significant bank accounts or subsidiary or branch operations
in tax-haven jurisdictions for which there appears to be no
clear business justifications
• Recurring attempts by management to justify marginal or
inappropriate accounting on the basis of materiality
• Formal or informal restrictions on the auditor that
inappropriately limit access to people or information, or limit
the ability of the auditor to communicate effectively with the
BoC or audit committee

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Legal aspect of financial reporting fraud

1. UU PT
2. KUHPer : Psl 1365 dan 1366
3. KUHP
a. Perbuatan curang dalam laporan keuangan: Pasal 392 dan 403
b. Pemalsuan: Pasal 263, 264, 266, 274, 275, dan 225
c. Penipuan: Pasal 378
4. KUP : Pasal 38 dan 39
5. UU PM : Pasal 107: Setiap Pihak yang dengan sengaja bertujuan menipu atau merugikan
Pihak lain atau menyesatkan Bapepam, menghilangkan, memusnahkan, menghapuskan,
mengubah, mengaburkan, menyembunyikan, atau memalsukan catatan dari Pihak yang
memperoleh izin, persetujuan, atau pendaftaran termasuk Emiten dan Perusahaan Publik

6. UU TIPIKOR: Psl 9: Pemalsuan buku, catatan, daftar

7. UU PERBANKAN: Pasal 49 ayat (1) memberi ancaman pidana terkait pembukuan,
catatan, dokumen dan laporan bank yang sengaja dipalsukan, diubah, dihapus, dihilangkan,
disembunyikan atau dirusak.

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Exercises
BALANCE SHEET
2011 2012 Change
Assets
Current assets
Cash 45.000 13,64% 15.000 3,53% (30.000) -66,67%
Account Receivables 150.000 45,45% 200.000 47,06% 50.000 33,33%
Inventory 75.000 22,73% 150.000 35,29% 75.000 100,00%
Fixed Assets (net) 60.000 18,18% 60.000 14,12% - 0,00%
Total 330.000 100,00% 425.000 100,00% 95.000 28,79%
Liabilities & Equities
Account Payables 95.000 28,79% 215.000 50,59% 120.000 126,32%
Long term debt 60.000 18,18% 60.000 14,12% - 0,00%
Stockholder's equity
Common stock 25.000 7,58% 25.000 5,88% - 0,00%
Paid in capital 75.000 22,73% 75.000 17,65% - 0,00%
Retained earnings 75.000 22,73% 50.000 11,76% (25.000) -33,33%
Total 330.000 100,00% 425.000 100,00% 95.000 28,79%
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Exercises
2011 2012 Change
INCOME STATEMENT
Net sales 250.000 100,00% 450000 100,00% 200.000 80,00%
COGS 125.000 50,00% 300000 66,67% 175.000 140,00%
Gross Margin 125.000 50,00% 150.000 33,33% 25.000 20,00%
Operating expenses
Selling expenses 50.000 20,00% 75.000 16,67% 25.000 50,00%
Administrative exp. 60.000 24,00% 100.000 22,22% 40.000 66,67%
Net income 15.000 6,00% (25.000) -5,56% (40.000) -266,67%

additional information
average net receivables 155.000 210.000
average invesntory 65.000 130.000
average assets 330.000 425.000
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End of Session
Financial Reporting Fraud

Forensic Accounting & Audit Investigative Workshop - 2013

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