FORENSIC ACCOUNTING &

FRAUD EXAMINATION
Financial Statement Fraud II
Temu 9 – PPAk

Dian Kartika Rahajeng, M.Sc., Ph.D.

[email protected]
 Ways to Manipulate Liabilities
• Reserves have been fraudulently used by companies to
manage earnings.
• These companies typically create excess reserves (by
initially overaccruing a liability) in one accounting period
and then reduce the excess reserve in later accounting
periods.
• After its creation in one period, the reserve is used in
future periods to inflate profits and to make it appear that
the company is turning around or to meet or exceed
earnings expectations.
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Liability Transactions

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 Understating Accounts Payable
• Accounts payable can be understated by a combination of the
following:
– Not recording purchases or recording the purchases after year-end
– Overstating purchase returns or purchase discounts
– Making it appear as if liabilities have been paid off or forgiven when
they have not
• When purchases are understated, net income is normally
overstated.

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 Understating Accrued Liabilities
• Some common accrued liabilities are salaries
payable, payroll taxes payable, rent payable, utilities
payable, interest payable, and so forth.
• When these liabilities are not recorded or are
understated, net income is usually overstated
because the other (debit) side of an accrual entry is
usually an expense account.

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 Underrecording Future Obligations
• Underrecording future obligations such as warranty or service
obligations is a type of fraud that is easy to perpetrate and
results in overstated net income and understated liabilities.
• The expense and liability that is expected to be incurred to
service these warranties must be recorded in the period in
which revenue is recognized for the automobiles that are sold.
• A company can understate this liability by not recording any
amount or by recording an amount that is too low.

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 Not Recording or Underrecording Various Types of
Debt (Notes, Mortgages, etc.)
• Ways to underrecord debt and similar liabilities include:
– Unauthorized borrowing against the equity in a company’s
assets
– Either not reporting or underrecording debt to related parties
– Borrowing but not disclosing debt incurred on existing lines of
credit
– Not recording loans incurred
– Claiming that existing debt has been forgiven by creditors
– Claiming that debt on the company’s books is personal debt of
the owners or principals, rather than debt of the business

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 Omission of Contingent Liabilities
• Contingent liabilities can be used to
fraudulently misstate financial statements by
underestimating the probability of occurrence
and not recording or disclosing contingent
liabilities in the financial statements.

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 Analytical Symptoms—Accounts
Payable
• Balances appear too low
• Purchase or cost of goods sold numbers are
low
• Purchase returns or discounts numbers are
high

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 Analytical Symptoms—Recognition of
Unearned Revenues
• Unearned liability balances appear too low
and revenue accounts appear too high

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 Analytical Symptoms—Underrecording
or Nonrecording of Service Warranties
• Balances in warranty, repurchases, or deposits
accounts appear too low

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 Analytical Symptoms—Unrecorded
Notes/Mortgages
• Unreasonable relationship between interest expense
and recorded liabilities
• Significant purchases of assets with no recorded debt
• Significant decreases in recorded debt
• Recorded amounts of notes payable, mortgages
payable, lease liabilities, pension liabilities and other
debts are too low
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 Accounting or Documentary Symptoms
• Documentary symptoms that relate to all kinds of understatement of
liability fraud include the following:
– Photocopied purchase-related records where originals should exist
– Unusual discrepancies between the entity’s records and confirmation replies
– Transactions not recorded in a complete or timely manner or improperly
recorded as to amount
– Balances or transactions that lack supporting documents, including
adjustments by the entity that significantly affect financial results
– Missing documents
– Unexplained items on reconciliations
– Denied access to records, facilities, certain employees, customers, vendors, or
others from whom audit evidence might be sought

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 Proactively Searching for Symptoms Related
to the Underreporting of Liabilities
• Proactive searching for analytical symptoms means
that we are searching for accounts that are unusual
in some way (e.g., too high, too low, etc.).

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Types Of Financial Statement Analysis

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 Focusing on Changes in Recorded
Balances from Period to Period
• Look for unusual changes in liability balances from period to
period (trends) by:
– Focusing on changes in the actual financial statement numbers
– Studying the statement of cash flows
– Using horizontal analysis

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 Some
Ratios
Used in
Detecting
Fraud

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 Comparing Financial Statement
Information with Other Companies
• Compare financial results and trends of the company with
those of similar firms in the same industry
– Relationships between interest expense and debt, the amount of
warranty expense as a percentage of sales, and other similar
relationships can be compared across firms

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 Actively Searching for “Accounting and
Documentary” Symptoms
• Documentary symptoms can be very helpful in detecting
understatement of liability frauds.
– The specific documentary symptoms you search for vary according to
the liability that is understated.
– Table 13.4 summarizes some of the most common kinds of
documentary symptoms by type of liability.

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Documentary
Symptoms of
Fraud

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Common Types of Asset Overstatement

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Frauds Involving Overstatement of Assets

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 Identifying and Actively Searching for Asset
Overstatement Fraud Symptoms
• In some ways, asset overstatements are easier to detect than other types
of financial statement fraud because the overstated assets are included on
the balance sheet.
• Fraud investigators can start their detection process by examining the
assets that make up the reported amounts, determining whether they
really exist and whether they are listed in the appropriate amounts and
periods.

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 Inappropriately Capitalizing Costs That
Should Be Expensed
• In identifying symptoms, the first thing you should ask is
whether these types of deferred charges exist on the balance
sheet.
– In many companies, they do not.
– When they do exist, you should always consider them candidates for
fraud and then convince yourself that their capitalization is
appropriate.
• This more skeptical approach is often justified because these assets are
often intangible and can easily be abused.

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Overstating Assets through Mergers, Acquisitions, or
Restructurings or Manipulating Intercompany
Accounts or Transactions
• As with improper capitalization, understanding the
general context of a merger or an intercompany
transaction may be more important in determining
whether fraud exists than trying to identify specific
analytical or documentary symptoms.

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 Overstatement of Cash and Short-Term
Investments (Including Marketable Securities)
• It is rare for a company to significantly overstate cash such
that the financial statements are materially misstated.
• There are two reasons for this:
– First, verifying recorded amounts of cash usually is easily done with
confirmations from financial institutions.
– Second, the amount of cash that a company has usually is small
relative to the amounts of receivables, inventory, or fixed assets.

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Overstatement of Receivables and/or Inventory (Not
Revenue- or Cost of Goods Sold-Related)
• Almost always, when accounts receivable are overstated,
revenues are overstated.
• Similarly, when inventory is overstated, cost of goods sold is
usually understated.
• Once in a while, however, inventory or accounts receivable (or
other assets) are overstated to conceal large thefts of cash or
other assets.

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 Disclosure Fraud Related to Financial Reports
and Financial Statement Footnotes
• Several fraud examination techniques can be used to detect
inadequate disclosures
– Look for inconsistencies between disclosures and information in
the financial statements and other information available
– Make inquiries of management and other personnel concerning
related-party transactions, contingent liabilities, and contractual
obligations
– Review the company’s files and records with the SEC and other
regulatory agencies concerning names of officers and directors
who occupy management or directorship positions in other
companies
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Other Types of Financial Statement Fraud
• Inappropriate accounting for nonmonetary transactions
• Inappropriate accounting for roundtrip transactions
• Improper accounting for foreign payments in violation of the
Foreign Corrupt Practices Act (FCPA)
• Improper use of non-GAAP financial measures
• Improper use of off-balance-sheet arrangements

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