Forensic Accounting

By Mary-Jo Kranacher, CPA/CFF, CFE

Chapter 14
Financial Statement Fraud
LEARNING OBJECTIVES
14-1 Identify some common reasons why senior management might overstate or understate
business performance.
14-2 Describe the ways in which financial statement fraud is committed.
14-3 Discuss the conceptual framework for financial reporting.
14-4 Identify and describe the five classifications of financial statement fraud.
14-5 Explain how fictitious revenue schemes are committed.
14-6 List the four criteria necessary for a sale to be complete.
14-7 Describe how understating liabilities and expenses can make a company appear more
profitable.
14-8 Identify the issues generally involved in improper disclosures.
14-9 Discuss how improper asset valuation may inflate the current ratio.
14-10 Explain how financial statement fraud may be deterred.

True/False
14-T/F #1. The premise of the economic entity assumption is that the activity of a business
enterprise should be kept separate and distinct from its owners and other business
entities
Answer: True

14-T/F #2. In valuing a firm’s assets for financial statement purposes, it is assumed that the
business is not one that will continue into the future
Answer: False

14-T/F #3. To measure and analyze financial transactions, a common standard is necessary.
In our society, that common denominator is money
Answer: True

14-T/F #4. This Periodicity assumption uses the principle of dividing economic activity into
specific time intervals, such as monthly, quarterly, and annually as well as a five
year time period.
Answer: False

Page 1 of 11
14-T/F #5. Generally accepted accounting principles require that assets be carried on the
financial statements at the price established by the exchange transaction. This
figure is referred to as historical or acquisition cost.
Answer: True

14-T/F #6. According to generally accepted accounting principles, the cash basis of
accounting should be used for financial reporting
Answer: False

14-T/F #7. The matching concept recommends but does not require that the books and
records and the resultant financial statements match revenue and expense in the
proper accounting period.
Answer: False

14-T/F #8. The principle behind full disclosure, once again, is that any material deviation
from generally accepted accounting principles must be explained to the reader of
the financial information..
Answer: True

14-T/F #9. If a misstatement on financial statements is so significant that reasonable, prudent

users of the financial statements would make a different decision than they would
if they had been given correct information, then the misstatement is material and
requires correction.
Answer: True

14-T/F #10. Reporting practices within certain industries may not deviate from generally
accepted accounting principles as a matter of fair and clear presentation..
Answer: False

14-T/F #11. The conservatism constraint requires that, when there is any doubt, one should
avoid understating assets and income.
Answer: False

14-T/F #12. Relevance implies that certain information will make a difference in arriving at a
decision
Answer: True

14-T/F #13. Accurate financial statements are the responsibility of company’s external
accountants.
Answer: False

Page 2 of 11
14-T/F #14. Financial statement frauds can be broken down into five distinct categories:
concealed liabilities and expenses, fictitious revenues, improper asset valuations,
improper disclosures, and timing differences.
Answer: True

14-T/F #15. Fictitious or fabricated revenue schemes involve the recording of sales of goods
or services that did not occur
Answer: True

14-T/F #16. Channel stuffing, which is compliant with GAAP, 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.
Answer: False

14-T/F #17. If expenditures are capitalized as assets and not recognized during the current
period, income will be understated.
Answer: False

14-T/F #18. In warranty liability fraud, the warranty liability is usually either omitted or
substantially understated.
Answer: True

14-T/F #19. Management has an obligation to disclose to the shareholders any acts of fraud
committed by officers, executives, and others in positions of trust.
Answer: True

14-T/F #20. 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
Answer: False

Multiple Choice
14-M/C #1. Which of the following is NOT a valid reason for a senior manager to issue
fraudulent financial statements?
A. To conceal true business performance
B. To preserve personal status/control
C. To maximize tax liability
D. To maintain personal income/wealth flowing from salary, bonus, stock
and stock options.

Page 3 of 11
Answer: C

14-M/C #2. Which of the following is NOT one of the more common reasons senior
management overstate business performance?
A. To meet or exceed the earning or revenue growth expectations of stock
market analysts
B. To impress union officials prior to labor negotiations
C. To increase the amount of financing available from asset-based loans
D. To trigger performance-related compensation or earn-out payments
Answer: B

14-M/C #3. Which of the following is NOT one of the more common reasons senior
management understate business performance?
A. To defer “surplus” earnings to the next accounting period.
B. To take all possible write-offs in one “big bath” now so future earning will
be consistently higher.
C. To preserve a trend of consistent growth and avoid volatile results.
D. To enhance the earnings per share.
Answer: D

14-M/C #4. All of the following methods indicate how people commit financial statement
fraud EXCEPT:
A. Bribe the SEC to accept fraudulent financial statements
B. Playing the accounting system
C. Beating the accounting system
D. Going outside the accounting system
Answer: A

14-M/C #5. Improper asset valuations usually fall into one of the following EXCEPT:
A. Inventory valuation
B. Accounts receivable
C. Cash
D. Fixed assets
Answer: C

14-M/C #6. Fixed assets are subject to manipulation through several different schemes. Which
scheme is NOT commonly used?
A. Booking fictitious assets
B. Misrepresenting asset valuation
C. Improperly capitalizing inventory and startup costs

Page 4 of 11
 D. Depreciating an asset to an amount less than zero
Answer: D

14-M/C #7. Financial statement analysis includes all of the following EXCEPT:
A. Stratified analysis
B. Vertical analysis
C. Horizontal analysis
D. Ration analysis
Answer: A

14-M/C #8. Current ratio is computed by:

A. Current liabilities / current assets
B. Current assets / current liabilities
C. Total assets / total liabilities
D. Total liabilities / total assets
Answer: B

14-M/C #9. Receivable turnover is computed by:

A. Net credit sales / average net receivables
B. Average net receivables / net credit sales
C. Average net receivables / 365
D. Net credit sales / 365
Answer: A

14-M/C #10. Which of the following is NOT a step to reduce financial statement fraud?
A. Establish effective board oversight of the “tone at the top” created by
management
B. Avoid setting unachievable or unreasonable financial goals
C. Eliminate all bonus systems bases on financial performance
D. Avoid applying excessive pressure on employees to achieve goals
Answer: C

14-M/C #11. One of the most popular methods of overstating inventory is through:
A. Understating cost of goods sold
B. “Phantom” inventory
C. Overstating sales revenue
D. Overstating inventory obsolescence
Answer: B

14-M/C #12. Which of the following is NOT a red flag associated with improper disclosures?

Page 5 of 11
 A. A strong, independent audit committee
B. Domination of management by a single person or small group
C. Rapid growth or unusual profitability, especially compared to other
companies in the same industry
D. Significant related-party transactions not in the ordinary course of
business
Answer: A

14-M/C #13. Events occurring or becoming known after the close of the period may have a
significant effect on the financial statements and should be disclosed are called:
A. Reportable events
B. Subsequent events
C. Proximate events
D. Known events
Answer: B

14-M/C #14. ________ 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.
A. Related-party transactions
B. Illicit transactions
C. Family transactions
D. Adversarial transactions
Answer: A

14-M/C #15. Improper capitalization of expenses was one of the key methods financial
statement fraud allegedly used by:
A. Enron
B. Tyco
C. Raptor
D. WorldCom
Answer: D

14-M/C #16. Which of the following is NOT a red flag of improper financial disclosure?
A. Domination of management by a single person or small group (in a non-
owner-managed business) with no compensating controls
B. Used by the company of a non-Big Four accounting firm
C. Ineffective board of directors or audit committee oversight of the financial
reporting process and internal control

Page 6 of 11
 D. Ineffective communication, implementation, support, or enforcement of
the entity’s values or ethical standards by management
Answer: B

14-M/C #17. The most common fraud scheme(s) involving accounts receivable are:
A. Fictitious receivables
B. Failure to write-off accounts receivable as bad debts
C. Both A and B
D. Neither A nor B
Answer: C

14-M/C #18. Fixed assets are subject to manipulation through several schemes. Which of the
following is NOT such a scheme?
A. Booking fictitious assets
B. Misrepresenting asset valuation
C. Improperly capitalizing inventory and startup costs
D. Booking at historical cost
Answer: D

14-M/C #19. Which of the following is NOT a red flag associate with improper asset
valuation?
A. Using lower-of-cost or market inventory valuation
B. Recurring negative cash flows from operations or an inability to generate
cash flows from operations while reporting earnings and earnings growth
C. Significant declines in customer demand and increasing business failures
in either the industry or the overall economy
D. Unusual increase in gross margin or margin in excess of industry peers
Answer: A

14-M/C #20. Which is NOT a measure to reduce the opportunity to commit financial statement
fraud?
A. Maintain accurate and complete internal accounting records
B. Maintain a security guard at each company location
C. Divide important functions among employees, sharing control of one area
D. Maintain accurate personnel records, including background checks on new
employees
Answer: B

14-M/C #21. Which is NOT a step to reduce grounds for rationalizing fraud?
A. Promote strong values, based on integrity, throughout the organization

Page 7 of 11
 B. Provide regular training to all employees, communication prohibited
behavior
C. Provide job opportunities to friends and relatives
D. Clearly define the consequences of violating the rules.
Answer: C

Short Answer Essay

14-SAE #1. List four steps to reduce the opportunity to commit financial statement fraud.
Answer: 1. Maintain accurate and complete internal accounting records
2. Carefully monitor the business transactions and interpersonal relationships of
suppliers, buyers, purchasing agents, sales representatives, and others who
participate in the transactions between financial units
3. Establish a physical security system to secure company assets, including
finished goods, cash, capital equipment, tools, and other valuable items
4. Divide important functions among employees, sharing control of one area
5. Maintain accurate personnel records, including background checks on new
employees
6. Encourage strong supervisory relationships and leadership within groups to
promote enforcement of accounting procedures
7. Establish clear and uniform accounting procedures with no exception clauses

14-SAE #2. List four red flags associated with improper disclosure.
Answer: 1. Domination of management by a single person or small group (in a non-
owner-managed business) with no compensating controls
2. Ineffective board of directors or audit committee oversight of the financial
reporting process and internal control
3. Ineffective communication, implementation, support, or enforcement of the
entity’s values or ethical standards by management or the communication of
inappropriate values or ethical standards
4. Rapid growth or unusual profitability, especially compared to other companies
in the same industry
5. Significant, unusual, or highly complex transactions, especially those close to
period end that pose difficult “substance over form” questions
6. Significant related-party transactions not in the ordinary course of business or
with related entities not audited or audited by another firm
7. Significant bank accounts or subsidiary or branch operations in tax-haven
jurisdictions for which there appears to be no clear business justification
8. Overly complex organizational structure involving unusual legal entities or
managerial lines of authority
9. Known history of violations of securities laws or other laws and regulations,
or claims against the entity, its senior management, or board members
alleging fraud or violations of laws and regulations
10. Recurring attempts by management to justify marginal or inappropriate
accounting on the basis of materiality

Page 8 of 11
 11. Formal or informal restrictions on the auditor that inappropriately limit access
to people or information or the ability to communicate effectively with the
board of directors or the audit committee

Critical Thinking Exercise

A woman shoots her husband. Then she holds him underwater for over five minutes. Finally, she
hangs him. But five minutes later they both go out together and enjoy a wonderful dinner
together. How can this be?

Answer: The woman was a photographer. She shot a picture of her husband, developed it,
and hung it up to dry.

Text Review Questions

14-TRQ #1. Why might senior management overstate or understate business performance?
Answer: Senior managers (CEOs, CFOs, etc.) and business owners may “cook the books”
for any of several key reasons:
 To conceal true business performance. The objective may be to overstate or
understate results
 To preserve personal status/control. Senior managers with strong egos may be
unwilling to admit that their strategy has failed and that business performance
is bad, since it may lead to their termination
 To maintain personal income/wealth flowing from salary, bonus, stock, and
stock options

14-TRQ #2. What are some of the ways in which financial statement fraud is committed?
Answer: 1. Playing the accounting system. In this approach, the fraudster uses the
accounting system as a tool to generate the desired results.
2. Beating the accounting system. In this approach, the fraudster feeds false
and fictitious information into the accounting system to manipulate reported
results by an amount greater than can be achieved by simply “playing the
accounting system.”
3. Going outside the accounting system. In this approach, the fraudster
produces whatever financial statements he or she wishes, perhaps using just
a typewriter or a personal computer.

14-TRQ #3. What is the conceptual framework for financial reporting?

Answer: The Financial Accounting Standards Board (FASB), an independent public
watchdog organization responsible for standard setting, has codified most historic
accounting principles. Statement on Auditing Standards (SAS) No. 69, “The
Meaning of Present Fairly in Conformity with Generally Accepted Accounting
Principles,” indicates the primary sources of generally accepted accounting
principles—FASB Standards and Interpretations, APB Opinions, and American
Institute of Certified Public Accountants (AICPA) Accounting Research
Bulletins.

Page 9 of 11
14-TRQ #4. What are the four classifications of financial statement fraud?
Answer: Financial statement fraud may involve the following schemes:
1. Falsification, alteration, or manipulation of material financial records,
supporting documents, or business transactions
2. Material intentional omissions or misrepresentations of events, transactions,
accounts, or other significant information from which financial statements are
prepared
3. Deliberate misapplication of accounting principles, policies, and procedures
used to measure, recognize, report, and disclose economic events and business
transactions
4. Intentional omissions of disclosures or presentation of inadequate disclosures
regarding accounting principles and policies and related financial amounts

14-TRQ #5. How are fictitious revenue schemes committed?

Answer: Fictitious or fabricated revenue schemes involve the recording of sales of goods
or services that did not occur. Fictitious sales most often involve 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 or the services not rendered. At the beginning of the next
accounting period, the sale might be reversed to help conceal the fraud, but this
may lead to a revenue shortfall in the new period, creating the need for more
fictitious sales. Another method is to use legitimate customers and artificially
inflate or alter invoices to reflect higher amounts or quantities than were actually
sold

14-TRQ #6. What are the four criteria necessary for a sale to be complete?
Answer: Generally speaking, revenue is recognized when it is (1) realized or realizable and
(2) earned. In December 2003 the Securities and Exchange Commission issued
Staff Accounting Bulletin No. 104, “Revenue Recognition” (SAB 104), to update
existing guidance on revenue recognition criteria. SAB 104 states that revenue is
typically considered realized or realizable and earned when all of the following
criteria are met:
 Persuasive evidence of an arrangement exists
 Delivery has occurred or services have been rendered
 The seller’s price to the buyer is fixed or determinable
 Collectability is reasonably assured

14-TRQ #7. How can understating liabilities and expenses make a company appear more
profitable?
Answer: The preferred and easiest method of concealing liabilities/expenses is simply to
fail to record them. Multimillion-dollar judgments against the company from a
recent court decision might be conveniently ignored. Rather than being posted
into the accounts payable system, vendor invoices might be thrown away (they’ll
send another later) or stuffed into drawers, increasing reported earnings by the full
amount of the invoices. In a retail environment, debit memos might be created for

Page 10 of 11
 charge-backs to vendors, supposedly to claim permitted rebates or allowances, but
sometimes just to create additional income.

14-TRQ #8. What issues are generally involved in improper disclosures?

Answer: Improper disclosures relating to financial statement fraud usually involve the
following:
 Liability omissions
 Subsequent events
 Management fraud
 Related-party transactions
 Accounting changes

14-TRQ #9. How may improper asset valuation inflate the current ratio?
Answer: In detecting fraud, this ratio can be a prime indicator of manipulation of accounts.
Embezzlement will cause the ratio to decrease. Liability concealment will cause
the ratio to appear more favorable.

14-TRQ #10. How can financial statement fraud be deterred?

Answer: Following the principles of the fraud triangle, introduced in the first chapter of
this book, a general approach to reducing financial statement fraud is the
following:
 Reduce pressures to commit financial statement fraud
 Reduce the opportunity to commit financial statement fraud
 Reduce grounds for rationalizing of financial statement fraud

Page 11 of 11