Certified Forensic Accountant

Module 2 Topic 6
Analyzing Financial Statement Fraud
 FRAUDULENT FINANCIAL REPORTING
Most fraudulent financial reporting schemes involve “earnings
management”, which the Securities and Exchange Commission
(“SEC”) has defined as “the use of various forms of gimmickry to
distort a company’s true financial performance in order to
achieve a desired result.”
 
Earnings management, however, does not always involve
outright violations of Generally Accepted Accounting Principles
(“GAAP”) - - more often than not, entities manage earnings by
choosing accounting policies that bend GAAP to attain earnings
targets. Thus, it is important to distinguish between earnings
management techniques that are aggressive in nature but
otherwise permitted by GAAP, and those that clearly violate
GAAP.
 CATEGORIES OF FRAUD
• Fraudulent Financial Reporting Schemes;
• Misappropriation of Assets;
• Revenue and Assets Obtained By Fraud and
• Expenditures and Liabilities for an Improper Purpose
• Most auditors would consider only to the first two
categories (fraudulent financial reporting and
misappropriation of assets) to be financial statement
frauds.

The final two categories although financial in nature, are not

generally considered to be financial statement frauds, as they
do not impact upon the balances in the financial statements.
Earnings Management Techniques Permissible
Under GAAP:
The “Grey Zone”

GAAP frequently allows management alternative ways

to record the operations of an entity. For instance,
GAAP allows any depreciation method, so long as it
systemically and rationally allocates the cost of the
asset over its useful life. Similar instances in which
management is provided wide latitude include:
Earnings Management Techniques Permissible
Under GAAP: The “Grey Zone”
• Changing depreciation methods from an accelerated method
to the more conservative straight-line method or vice versa;
• Changing the useful lives or the estimates of salvage values of
assets;
• Determining the appropriate allowance required for
uncollectible accounts receivable;
• Determining whether/when assets have become impaired
and are required to be reserved against or written off;
• Choosing an appropriate method of inventory valuation
(LIFO, FIFO, specific identification etc.);
• Determining whether a decline in the market value of an
investment is temporary or permanent; and
• Estimating the write-downs required for investments.
 Earnings Management Methods Not
Permissible by GAAP
Some financial frauds have no grey; that is, earnings
management that are clearly not within the
parameters of GAAP. These techniques can inflate
earnings, create an improved financial picture, or
conversely, mask a deteriorating one. Examples cited
by the SEC include:
– “Big Bath” charges;
– Creative acquisition accounting;
– “Cookie jar” liability reserves;
– Use of materiality to record small but intentional
misstatements in the financial statements; and
– Revenue recognition irregularities.
 Big bath accounting
• Taking a one-time loss through a major cleaning-up
exercise (‘big bath’) of the balance sheet
– Identifying and adjusting over-valued assets and under-
valued liabilities
– Usually explained as an exceptional one-time operation
• Restructuring charges make room for future profit
enhancements
 Creative Accounting – Definition

• A term used to describe the practice of applying

inappropriate accounting policies or entering
into complex or “special purpose” transactions
with the objective of making a company’s
financial statements appear to disclose a more
favourable position, particularly in relation to
the calculation of certain ‘key’ ratios
• Undesirable as it is intended to mislead users of
financial statements
 Some common methods of accounting
manipulation (Rees 1995, p 60-61)

• Excessive provision (revised)

• Extraordinary items (not allowed anymore)
• Off balance sheet finance
• Capitalised cost
• Non-trading profits
• Etc.
 Creative accounting used to:

• Hide a particularly bad year for the company

• Force an exceptionally good year
• Continue the pressure to always be the best
• Smooth out results to give an impression of
stability or sustained improvement
• Boost assets to avoid take-over
NB. To distort in one year often increases the need to distort the next year too
 Cookie Jar Reserve Sample: Net Operating Losses

The U.S. income Tax code allows firms reporting operating losses to offset
those losses against past or future tax payments.
 Cookie Jar Accounting: Valuation Allowance

When a valuation allowance is recognized, there is a

corresponding increase in the income tax expense.
If it subsequently determined that the deferred tax
benefit will be realized, then the entry that established
the valuation allowance is reversed. This results in a
decrease in income tax expense and an increase in net
income. Some analysts call this cookie jar accounting.

Also reveals information about the long-term prospects of

a firm’s profitability. General Motors established a $38.6
billion valuation allowance in the 3rd quarter, 2007.
 OVERVIEW OF LARGEST FRAUDULENT
FINANCIAL REPORTING FRAUD CASES
Company Fraud Scheme Result
Misappropriation of firm assets Declared bankruptcy in January
by executives for personal use. 2002. CEO and family
Adelphia Communications Concealment of $2.3 billion in members charged with fraud.
loans to cover losses by
founder and family members

As a result of its merger of HFC Restated 1997 earnings

with CUC International, it was decreased by more than $161
revealed that CUC overstated million.
Cendant Corp. revenue by $500 million Former CFO, VP, and controller
between 1995 and 1997 using pled guilty to numerous other
assorted techniques such as charges.
recording fictitious revenues Company settled $3.2 billion
and understating liabilities. shareholder suit
Ernst & Young paid $335
million to settle shareholder
lawsuit.
OVERVIEW OF LARGEST FRAUDULENT
FINANCIAL REPORTING FRAUD CASES
Company Fraud Scheme Result
Overstated income by Declared bankruptcy in
Enron
intentionally understating December 2001.
liabilities and concealing debt Lost more than $80 billion in
through the creation of off market capitalization.
balance sheet entities. Former CFO among others
Inadequately disclosed Co.’s convicted of money
off balance sheet laundering and securities,
transactions. wire and mail fraud.
Possible tax evasion. Additional charges brought
against others.
Resulted in dissolution of
company and accountants
Arthur Anderson.

Charged with using "swap Declared bankruptcy January

Global Crossing
deals" with other telecom 2002.
carriers to inflate sales. SEC investigations pending.
 Company Fraud Scheme Result
Inflated revenue by improperly Declared bankruptcy, January
K-Mart
recognizing entire $42.3 2002.
million in revenue from a Two former VPs charged with
multiyear contract in 2 nd
earnings fraud.
quarter of 2001.
Improperly recognized Restated earnings for fiscal
revenue from sales of software years 1998 and 1999, which
MicroStrategy
as agreements were entered caused revenues to be reduced
into rather than as services by almost $66 million.
were provided. Former CEO, COO, and CFO
each fined $350,000.
Created $35 million in Restated 1997 income from
inappropriate restructuring $109 million to $38 million.
Sunbeam Corp.
reserves in 1996 that were CEO charged with violating
reversed in 1997 to inflate federal securities laws by
income thus creating the misrepresenting material
illusion of a rapid turn around. information about the
In 1997, reported over $70 company. CEO settled by
million of revenue from bill paying a piece of a $141 million
and hold sales, channel fine.
stuffing and other Former controller and chief
inappropriate accounting accounting officer each agreed
practices. to pay $100,000 in fines.
Former Arthur Anderson
partner also settled for
undisclosed amount.
 Company Fraud Scheme Result
Misappropriation of $600 Three former executives
million by CEO and CFO for including CEO and general
personal use through theft and counsel arrested for fraud.
the false sale of securities. CEO also charged with avoiding
Company also separately sued payment of over $1 million in
former CEO seeking the return sales taxes on $13 million of
of more than $100 million. Suit artwork
Tyco International alleges CEO gave himself
unauthorized bonuses totalling
$58 million and unauthorized
loans of more than $43 million,
and of taking personal credit for
more than $43 million in
charitable donations that
actually were made by Tyco.
Intentionally improperly Declared bankruptcy, July 2002.
capitalized billions of dollars of Former finance chief and
expenses as capital finance and accounting
expenditures. executives charged with
WorldCom Former CEO facing possible securities fraud.
charges for allegedly profiting
improperly from IPOs offered by
brokerages in return for
investment banking business.
Company Fraud Scheme Result
Overstated revenue for over 4 Co. agreed to pay $10 million in
years by accelerating the fines and restate its income for
recognition of $3 billion in the years 1997-2000.
revenue and inflating earnings SEC sued three current KPMG
by about $1.5 billion. Alleged partners and one former
scheme included the partner of securities fraud in the
Xerox recognition of revenue on its claiming the firm fraudulently
office copier leases too early in let the Co. manipulate its
their cycles. accounting practices to fill a $3
billion gap and make it appear
to be meeting market
expectations.
 IMPROPER REVENUE RECOGNITION

• Improper recognition of revenue - either prematurely

or of fictitious revenue – is the most common form of
fraudulent earnings management.
• Premature recognition should be distinguished from
recognition of fictitious revenue derived from false
sales or to false customers.
• The Report of the National Commission on Fraudulent
Financial Reporting (hereinafter, “ the COSO Report”)
found that improper revenue recognition was alleged
in 47% of the cases reviewed by the Commission from
1981 to 1986
Following are the most common techniques (IMPROPER REVENUE):
• Agreements or policies which grant liberal return, refund or
exchange rights;
• Side agreements;
• Channel stuffing;
• Early delivery of product
• Bill and hold transactions;
• Recording false sales to existing customers and false sales to
fictitious customers;
• Round tripping
• Other forms of improper recognition:
– Recognizing revenue on disputed claims against customers;
– Holding the books open past the end of a period;
– Recognizing income on consignment sales or on products shipped for
trial or evaluation purposes; and
– Improper accounting for construction contracts ; and
– Sham related party transactions.
 Forensic Auditing Techniques
  The auditor should perform the following techniques
when investigating revenue recognition allegations:
• Inquire of management and other relevant personnel as
to the existence factors causing the auditor to believe
the scheme exists
• Perform substantive analytics designed to detect the
fraud being investigated; and
• Perform substantive testing to determine whether there
is evidence to support the existence of a scheme or lack
of evidence to support the validity of a transaction.
Forensic Auditing Techniques
Such substantive procedures include but are not limited to:
•Request and review documents such as contracts and support for
invoices and deliveries;
•Confirmation with customers to the existence of accounts
receivable and the amount of consigned goods;
•Possible public records/background research/site visits conducted
on customers/third parties to verify existence of the entity being
billed;
•Analyzing journal entry activity and supporting documentation in
certain accounts, focusing on round dollar entries at the end of
periods;
•If entries are accruals, obtaining support for the reversal and
confirming the proper timing of the entries.
The following general indicators can often alert the auditor or
auditor as to the potential existence of premature revenue
recognition:

• Unexplained change in recognition policies;

• Unexplained improvements in gross margin;
• Increasing sales with no corresponding increase in cash from
operations;
• Reported sales, revenue or accounts receivable balances which
appear to be to high or are increasing too fast;
• Reported sales discount, sales returns or bad debts expenses which
appear to be too low;
• Large, numerous or unusual sales transactions occurring shortly
before the end of the period;
• Large amounts of returns or credits after the close of a period; or
• Inconsistent business activity
• Common side agreement fraud schemes involve:
– Liberal or unconditional rights of return granted to
customers;
– Rights to cancel orders at any time;

• Contingencies that nullify the sale, such as:

– Re-sale;
– Receipt of funding;
– Rights of continuing negotiations; and
– Extension of payment terms
Liberal Return, Refund, or Exchange Rights
Specifically, Statement of Financial Accounting Standard (“SFAS”)
No. 48, Revenue Recognition Where Right of Return Exists
provides that when customers are given a right of return,
revenue may be recognized at the time of sale if the:
– Sales price is substantially fixed or determinable at the date
of sale; Buyer has paid or is obligated to pay the seller;
– Obligation to pay is not contingent on resale of the product;
– Buyer's obligation to the seller does not change in the event
of theft or physical destruction or damage of the product;
– Buyer acquiring the product for resale is economically
separate from the seller;
– Seller does not have significant obligations for future
performance or to bring about resale of the product by the
buyer; and amount of future returns can be reasonably
estimated.
Channel Stuffing

Channel stuffing refers to the practice of offering deep discounts,

extended payment terms or other concessions to customers to
induce the sale of products in the current period, when they
would not have been otherwise sold, until later periods, if at all.
Early Delivery of Product
Companies can circumvent the SAB 101 delivery requirement in a
variety of ways including:

• Shipping unfinished or incomplete products to customers, or at a

time prior to when customers are ready to accept them;
• Engaging in “soft sales” (shipping of products to customers who
have not agreed to purchase);
• Recognizing the full amount of revenue on contracts where
services are still due to the client, and/or
• Recognizing the full amount of revenue on fees collected up
front.
Forensic Auditing Techniques

The auditor should also make broad inquiries of non-

financial personnel such as:

•Shipping department personnel

•Sales force personnel
•Warehouse personnel
•Additional audit procedures include
Partial Shipments
Many companies will prematurely recognize 100% of revenue on
partial or incomplete shipments of customer orders. The delivery
requirement is not met, if the unshipped portion constitutes a
substantial portion of the total deliverable.
Auditing for partial shipments is similar to auditing for early product
delivery. The auditor must consider:
• Numerous returns of incomplete products after the close of period
by customers seeking the full product;
• Large, numerous or unusual transactions occurring shortly before
the end of the period;
• Examining product details on the invoices;
• Is the invoice cut with all products ordered whether shipped or not?
• Reviewing customer complaints regarding lack of completeness in
shipments.
Contracts with Multiple Deliverables
Common customer acceptance provisions included in contracts
that, if not satisfied by the seller, would preclude recognition
include:
– Seller’s obligation to perform additional services subsequent
to the delivery, e.g., product installation and activation;
– Product testing prior to payment; and
– Training of personnel with respect to produce use

Up-Front Fees
Some firms will collect up-front fees for services provided over an
extended period, e.g., maintenance contracts. SAB 101 provides
that up-front fees should generally be recognized over the life of
the contract or the expected period of performance.
Bill and Hold Transactions
“Bill and Hold” schemes are another common method of
bypassing the delivery requirement. As its name implies, a
legitimate sales order is received, processed, and ready for
shipment. The seller however, recognizes revenue immediately
upon shipment.
The auditor must consider whether the seller has met (or is seeking
to circumvent) enumerated specific criteria established by the SEC,
including whether:

• Risk of ownership has passed to the buyer;

• Customer has made a fixed commitment to purchase the goods,
preferably in written documentation;
• Buyer must request that the transaction be on a bill and hold
basis; Buyer must have a substantial business purpose for
ordering the goods on a bill and hold basis;
• Delivery must be fixed and on a schedule that is reasonable and
consistent with the buyer's business purpose;
• Seller must not retain any specific performance obligations under
the agreement such that the earning process is not complete;
• Ordered goods must be segregated from the seller's inventory
and not be subject to being used to fill other orders; and Product
must be complete and ready for shipment.
Fictitious Revenue Schemes
Schemes to create fictitious revenues, as opposed to prematurely
recognize revenue, cross the line between the potentially defensible
and the completely indefensible.
 
Fictitious Sales to Existing or Non Existent Customers
 
A common technique to overstate revenues is to create fictitious
orders either for existing or fictitious customers.
Fictitious revenue schemes can and often will be detected by the
same methods used to detect premature revenue recognition
schemes. Auditors should consider:

• Discovery of significant revenue adjustments to revenue at the end

of the reporting period;
• Unexpected increases in sales by month at period end;
• Customers with unknown names or addresses or which have no
apparent business relation to the business;
• Increased sales accompanied by stagnant or decreasing cost of
sales and corresponding improvement in gross margins;
• Improvement in bad debts as a percentage of sales; and/or
• Decrease of shipping costs compared with sales.
 Round Tripping

Round tripping consists of recording transactions that occur

between companies for which there is no economic benefit to
either company.

• For example, a company that provides a loan to a customer so that

the customer can purchase the product engages in round tripping
if the loan was issued with no real prospect that the customer will
ever repay the loan.

• Round tripping recently has occurred extensively in the

telecommunications and oil and gas industries
Recognizing Revenue on Disputed Claims
against Customers
Reasonable assurance of payment is basic to revenue
recognition. Companies sometimes circumvent this
requirement by recognizing the full amount of revenue even
though the customer has for some reason disputed payment.
Auditors should inquire as to all receivables that are in dispute
and, if necessary, confer with legal counsel for the company to
assess whether collection of the revenue is sufficiently certain to
be able to be properly recognized
Holding the Books Open past the
End of a Period
Improperly holding open the books beyond the end of an
accounting period can enable companies to record additional
end of period sales that are invoiced and shipped after the end of
a reporting period. While standard cut-off testing will often
discloses these schemes, auditors should be cognizant and skilled
in detecting manipulation of information systems to achieve this
result.
 Common Issues: Improper Sales Reporting
o Written sales cut-off procedures

o Monitoring of sales volume by day, week, month

o Review of distributor inventory levels, DSO by customer, credit

notes (especially credit notes issued after the quarter ends), and
discounts/rebates

o If necessary, speak with distributors or customers

Recognizing Income on Consignment Sales or
Products Shipped for Trial/Evaluation
Purposes
The same criteria apply to products delivered for
demonstration purposes. The reason for this is that in a
typical consignment arrangement, neither title nor the
risks and rewards of ownership pass from the seller to
the buyer. Consignment sales and sales shipped under
trial or evaluation purposes are thus merely specific
examples of contingent events which must be satisfied
before revenue can be recognized.
Contract Accounting Schemes
The percentage of completion method applies
only if management can reliably estimate
progress toward the completion of a contract;
that is; management must be able to estimate
reliably the total costs required to complete
the contract. Conversely, GAAP requires the
"completed contract" method when
management cannot reliably estimate
progress toward completion.
Sham Related Party Transactions
Sham related party transactions are transactions between
related parties where either little or no consideration is
given for the product or service.

Accordingly, arms-length transactions cannot be achieved

in those situations where the parties are related or where
one party can exercise substantial control over the other.  

Related party transactions carry the presumption that one

or both parties have received a benefit that they would not
have otherwise received had the transactions been truly
arms length.
 ASSET OVERSTATEMENT/LIABILITY
UNDERSTATEMENT SCHEMES
Common asset overstatement fraud schemes include: 

• Creating fictitious assets;

• Manipulating balances of legitimate assets with the
intent to overstate value;
• Understating liabilities or expenses, including failing to
record (or deliberately under estimating) accrued
expenses, environmental litigation liabilities and other
business problems;
• Misstating inter-company expenses; and
• Manipulating foreign currency exchanges.
Inventory Schemes
Generally, when inventory is sold, the amounts are transferred to
cost of goods sold and included in the income statement as a
direct reduction of sales. An overvaluation of ending inventory
will understate cost of goods sold and in turn, overstate net
income.

Inventory schemes can generally fall into three categories:

– Artificially inflating the quantity of inventory on hand;

– Changing between inventory reporting methods (average
costing, last invoice price, LIFO, FIFO, etc.);
– Fraudulent or improper inventory capitalization.
Inflating Inventory Quantity
(Fictitious Inventory)
The simplest way to overstate inventory is to add fictitious items
to inventory. Companies can accomplish this by creating fake or
fictitious:

– Journal entries;
– Shipping and receiving reports;
– Purchase orders; and
– Quantities on cycle counts or physical counts.
Inflating Inventory Value
Inflating inventory value achieves the same impact on earnings
as manipulating the physical count. Management can
accomplish this simply by creating false journal entries designed
to increase the balance in the inventory account.

Few or no write-downs to market or no provisions for

obsolescence in industries where there have been changes in
product lines or technology or rapid declines in sales or markets
warrant further investigation as to why the company has not
accounted for such declines even when the inventory in question
may be relatively new.
Fraudulent or Improper Inventory
Capitalization

Improper capitalization of expenses is discussed in detail in

Improper Capitalization of Expenses. With respect to inventory
fraud however, companies will sometimes seek to inflate
inventory by capitalizing certain expenditures associated with
inventory, such as selling expenses and general and
administrative overhead.
Accounts Receivable Schemes
Companies can manipulate accounts receivable with the same
techniques that they can manipulate inventory; that is, by creating:
• Fictitious receivables; and
• Inflating the value of receivables.

Analytics that may assist in detecting overstated receivables include:

• A decrease in the company’s quick or current ratio;
• Unexplained decrease in accounts receivable turnover
• Unexplained increase in days sales outstanding; and
• An increase of the ratio of credit sales to cash sales.
Creating Fictitious Receivables
The indication of fictitious receivables are generally similar to
those in our discussion of fictitious earnings:
•Unexpected increases in sales and corresponding receivables
by month at period end;
•Large discounts, allowances, credits or returns after the close
of the accounting period;
•Large receivable balances from related parties or conversely
from customers with unknown names or addresses or which
have no apparent business relation to the business;
•Receivable balances increasing faster than sales;
•Organizations that pay commissions based on sales rather
than the collection of the receivable;
Inflating the Value of Receivables

Inflating the value of legitimate receivables has the

same impact as creating fictitious ones. GAAP
requires accounts receivable to be reported at net
realizable value. Net realizable value is the gross value
of the receivable less an estimated allowance for
uncollectible accounts.
Investment Schemes
Fraudulent investment schemes provide another
method for a company to overstate assets. Similar to
schemes relating to inventory and receivables,
management can create fictitious investments or
deliberately over-value existing ones.

The auditor should be also wary of losses on securities

held as available for sale that are accumulating in the
other comprehensive income account. The company
must eventually take a charge for these losses either
through a sale or through a permanent write-down.
Fictitious Investments
Fictitious investments are similar to the creation of other
fictitious assets. Indicator include:

• Missing supporting documentation;

• Missing brokerage statements; and
• Unusual investments (i.e., gold bullion) or ones held in
remote locations or with obscure third parties
Manipulating the Value of Investments
Companies can also manipulate their financial
statements by inflating the value of investments by
misclassifying them or failing to record unrealized
declines in market value for those investments

Investments may be classified as held to maturity only

if the holder has the positive intent and ability to hold
those securities to maturity.
 Improper Capitalization of Expenses
• This technique allows the company to capitalize and
amortize the expense over many periods rather than
recognize it in its entirety in the current period. Detecting
capitalization policies can often be achieved by considering
or reviewing the following items:
– Is there a heavy capitalization of fixed assets?
– Are capitalized costs that are increasing faster than revenue over lengthy
periods?
– Are repair and maintenance expenses (or other operating expense)
dropping out of line with operations (indicating these are possibly being
capitalized instead of expensed?
– With respect to construction contracts, does interest expense properly
increase when construction and capitalization of expenditures has ceased?
– Have prior accounting policies have been aggressive with respect to
capitalization?
Software Development
GAAP requires companies to treat costs associated
with developing new software as expenses until the
point of technological feasibility. Technological
feasibility is established upon completion of a detail
program design or, in its absence, completion of a
working model. Upon technological feasibility, all
software production costs must be capitalized and
subsequently reported at the lower of unamortized
cost or net realizable value.
 Research and Development (“R&D”)
The SEC has also been particularly concerned about
mergers and the acquirers who classify a large part of
the acquisition price as in process research and
development (“R&D”), thereby allowing the entity to
immediately expense the costs. This practice allows the
entity to write off the R&D in a single chunk in the year
of acquisition and not burdening future earnings with
amortized R&D charges. This type of practice also
involves the creation of liabilities for future operating
expenses.
 
Start Up Costs
Similar to R&D, GAAP requires all start-up costs to be
expensed in the year incurred. However, many entities
will label start up activities as other costs thereby
attempting to capitalize them.

Interest Costs
The interest cost capitalized is added to the cost of
acquiring the asset and then amortized over the useful
life of the asset. The total interest cost capitalized in a
period may not exceed the interest cost incurred during
that period. Capitalization is no longer allowed when
the cost of the asset exceeds its net realizable value.
 
Advertising Costs
SOP 93-7, Reporting on Advertising Costs , provides that all
advertising expenses must be expensed as incurred unless there
exists persuasive historic evidence that allow the entity to make a
reliable estimate of future revenue to be obtained as a result of
the advertising in which case the expenditures are allowed to be
capitalized.

Recording Fictitious Fixed Assets

Similar to the concept of recording fictitious sales or receivables,
entities will record fictitious assets to improve the balance sheet
which, as previously discussed, inflates earnings as well.

Depreciation & Amortization Schemes

Depreciation is another area in which management is given leeway
to choose any method so long is that method allocates the costs in
a “rational and systematic manner.”
 UNDERSTATEMENT OF LIABILITIES
AND EXPENSES
Auditors can use various analytical indicators to search for indicia
(signs) of these schemes, including:

• An increasing current ratio (current assets/current liabilities) or

quick ratio (cash + marketable securities + net receivables/current
liabilities) from one period to the next;
• Unexpected improvements in gross margins from one period to the
next;
• Change in inventory with no simultaneous increase in accounts
payable or accrued expenses between periods; and
• A comparison of the percent change in the accrued expense account
with revenues reveals that revenue is increasing faster than accrued
expense payable.
Establishing Off-Balance Sheet Entities
With an off-balance sheet transaction, a company’s “investment”
account on the income statement will reflect the relevant
proportion of net profit or loss that results from operation of the
underlying net assets. In other words, the effect of non-
consolidation should leave income the same as if the off-balance
sheet investment had been consolidated.

Off-Balance Sheet Treatment versus

Consolidation
Off-balance sheet transactions enable the company to avoid
showing the individual asset of the off-balance sheet vehicle in
the balance sheet, and more importantly, the associated debt
used to acquire the off-balance sheet vehicle’s assets.
IMPROPER OR INADEQUATE DISCLOSURES
Improper disclosures can take various forms notably,
misrepresentations, intentional inaccuracies, or
deliberate omissions in:

– Descriptions of the company or its products, in

news reports, interviews, annual reports, websites,
etc.;
– Management discussions and other non-financial
statement sections of annual reports, 10-Ks, 10-Qs,
and other reports; and
– Footnotes to the financial statements.
 MATERIALITY
Materiality is a mixed question of legal and accounting
principles. Guidance can be found from the Supreme
Court, SEC, FASB, and academia. The Supreme Court
has defined something as material if “…there is
substantial likelihood that the disclosure of the
omitted fact would have been viewed by the
reasonable investor as having significantly altered
the ‘total mix’ of information made available.”
 MISAPPROPRIATION OF ASSETS
The Association of Certified Fraud Examiners
estimates that up to 6% of organizational revenues are
lost to fraud. While most misappropriations are often
quantitatively immaterial when looked at in isolation,
often times they occur enough so that they rapidly
become material to an organization.

One common theme however, is the importance of

having and applying strong internal controls, which
cannot be circumvented or overridden.
Misappropriation of Cash
– Skimming of Cash
Unrecorded or Understated Sales or Receivables - (Failure
to record the full amount of sales or other items of income.)
Many asset misappropriation schemes start at the entry
point of the sale. An employee can embezzle monies by not
recording the sale or full amount of the monies received.

Fraudulent Disbursements
Fraudulent disbursement schemes generally fall into five main
categories:
-Billing schemes;
-Theft of company checks;
-Payroll schemes;
-Expense reimbursement schemes; and
-Register disbursement schemes.
 OTHER FRAUDULENT REVENUE AND
EXPENDITURES
Revenue and Assets Obtained By Fraud
Revenue obtained by fraud refers generally to the reverse
side of a transaction involving a misappropriation of assets.

Expenditures and Liabilities for an Improper Purpose

Bribery of a government official exemplifies an expenditure
made for an improper purpose. Committing to pay some
future expense of the same government official is assuming
a liability for an improper purpose.
Most auditors would conclude that illegal payments do not
constitute a misappropriation of asset.