Assurance and Forensic Accounting

Topic 5 – Investigation of Fraud Offences

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Topic 5 – Investigation of Fraud Offences i

Contents

Contents ii

Introduction 1
Learning objectives 1

Financial Statement Fraud 2

Detecting Financial Statement Fraud 3

Beneish Ratios for Detecting Fraud 4

Summary 4

References 5

ii Assurance and Forensic Accounting

Introduction
Financial statements are sometimes prepared in ways that intentionally misstate the
financial position and performance of an organization. Such misstatements can result
from manipulating, falsifying, or altering accounting records. Misleading financial
statements cause serious problems in the market and the economy. They often result
in large losses for investors, a lack of trust in the financial markets, and litigation
and embarrassment for the individuals and organisations associated with the financial
statement fraud. During the years 2000-2002, numerous revaluations of corporate
wrongdoing, including financial statement fraud, created globally a crisis of
confidence in the capital markets. Examples of financial statement fraud include
Enron, WorldCom and Global Crossing. This topic examines why these problems
occurred and how accountants and auditors can detect financial statement fraud.

Learning objectives
At the end of this topic you should be able to:
 illustrate how to detect financial statement fraud
 Convey the nature of financial statement fraud, and why it occurs.

Recommended Text
Fraud Examination, 6th edition, Albrecht et al., (2019)
Chapter 11.

Financial statement fraud [Excerpt] pp. 387-395

Web resource
All Auditing and Assurance Standards are available from:
http://www.auasb.gov.au/

Financial Statement Fraud

Financial statement fraud represents some kind of ethical compromise.
People commit frauds when three elements come together to motivate the
fraud: (1) a perceived pressure, (2) a perceived opportunity, and (3) the

Topic 5 – Investigation of Fraud Offences iii

 ability to rationalize the fraud as acceptable. This concept is referred to as
the fraud triangle (see figure 11.1 Albrecht et al. 2016).
Financial statements are sometimes prepared in ways that intentionally
misstate the financial position and performance of an organization, hence
show a false economic picture.
 To make the company’s performance and stability to look better than
it actually is so that investors’ confidence is maintained or increased,
thus increasing market confidence and share price or bonus payments
to directors, executives and other persons, and/or
 To reduce the company’s profit to pay lower taxes or lower share price
if company directors want to cheaply acquire the firms shares.

Misstatement of financial statements can result from manipulating, falsifying,

or altering accounting records by persons within the company by:
 manipulating the timing of transactions and other amounts
 manipulating the actual amounts used in the recognition and reporting
revenues, expenses, assets and liabilities.

Examples:
 Enron inflated profits and hid debts (therefore expenses) totalling over
$1 billion by improperly using off-the-books partnerships in ‘special-
purpose’ entities.
 WorldCom overstated cash flow by treating $3.8 billion in operating
expenses as capital expenses and gave founder Bernard Ebbers $400
million in off-the-books loans.

Detecting Financial Statement Fraud

The ability to anticipate a fraud perpetrator’s likely method of
concealing a fraud. Questions to ask:

 What types of fraud schemes is management likely to use to

commit financial statement fraud?
 What typical tests are used to detect these schemes?
 How could management conceal the scheme of interest from
the typical test?

iv Assurance and Forensic Accounting

  How could the typical test be modified so as to detect the
concealed scheme?

Methods of detecting fraud include:

 Look for a discrepancy between the company’s financial and
nonfinancial performance.
 Investigate management (Managements’ backgrounds,
Managements’ motivations, Managements’ influence in making
decisions for the organization).
 Relationships should be examined to determine if they present
management fraud opportunities or exposures.
 Some industries are more risky than others. Attributes of fraud-
prone organizations:
 unduly complex organizational structure.
 without an internal audit department.
 board of directors with no or few outsiders on the board
or audit committee.

Beneish Ratios for Detecting Fraud

One of many econometric multivariate models to detect existence of
earnings management is the Beneish ratios, a symptom of financial
statement fraud. The model incorporates a series of index ratios to derive
M-score as an indicator of financial statement manipulation. The 8 ratio
model was subsequently revised into a 5 ratio model due to weakness in the
explanatory power of three ratios. The indexes can be used individually to
analyse data however explanatory power is significantly improved by the
use of a multivariate model. Some indexes are:
DSRI: Measures if sales are being manipulated. The ratio measures if
accounts receivable are growing faster than sales. If accounts receivable
are out of balance with sales, it is suspected that accounts receivable over
time are dubious.
GMI: Material gross profit declines from one accounting period to another
can motivate managers to engage in fraud to hide declining profitability by
artificially increasing profits or decrease losses. Serves as an alert to the
risk of earnings manipulation.
AQI: Measures if the company is capitalising costs (hence relative increases
in net fixed assets) to offset declining profitability.
SGI: Sales growth index attempts to measure if sales figures contain false
sales. An increase in the ratio may or may not be legitimate.
TATA: An increase in accruals over time may indicate that managers are
Topic 5 – Investigation of Fraud Offences v
 manipulating earnings by exercising discretion over how accruals are
booked. High accruals and decreasing cash can be a red flag but can also
mean that managers are trying to internally finance their costs. Future
research may need to modify to include impairment costs with depreciation
and amortization.

Summary
Much can be learned about the exposure to financial statement fraud by
closely examining management and the board of directors, relationships
with others, and the nature of the organizations. Looking at those three
elements usually involves the same procedures for all kinds of financial
statement frauds, whether the accounts manipulated are revenues, assets,
liabilities, expenses or equities. Fraud symptoms most often exhibit
themselves through changes in the financial statements. In addition to
changes in financial statement balances and amounts, understanding what
the notes to the financial statements say is very important. Many auditors
and forensic accountants struggle to detect such frauds, as they are
complex. The next topic further details fraud risks related to the
overstatement of assets, understatement of liabilities and issues
surrounding inventories.

Additional activities
Write a 500 word summary explaining the fraud triangle. Relate your
responses to the real life cases mentioned in the course videos.

References

Albrecht et al., (2019), Fraud Examination, 6th edition, Cengage.

vi Assurance and Forensic Accounting