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Chapter 10 Corruption Review Questions 10-1 What are the four categories of corruption? Answer: The four categories of corruption schemes are bribery, ¬illegal gratuities, economic extortion, and conflict of interest. 10-2 How are bribery, extortion, and illegal gratuities different? Answer: While bribery seeks to influence a decision, an ¬illegal gratuity rewards such decision, after the fact. Extortion schemes use coercion by demanding payment from another to prevent harm or loss of business. 10-3 What are the two classifications of bribery schemes? Answer: Bribery schemes fall into two broad categories: kickbacks and bid-rigging schemes. 10-4 What are some of the ¬different types of kickback schemes? Answer: Kickback schemes may take the form of diverting extra business to a certain vendor, approving inflated or ¬fictitious invoices for payment, or allowing the acceptance of substandard product. 10-5 What is a bid-rigging scheme? Answer: Bid-rigging occurs when an employee of a purchasing company illegally assists a certain vendor to win a contract by compromising the competitive bidding process. 10-6 How are bid-rigging schemes categorized? Answer: Generally, bid-rigging schemes are categorized ¬accord¬ing to the stage of bidding at which the fraud occurs. This may be at the pre-solicitation phase, the solicitation phase, or the submission phase in the competitive bidding process. 10-7 How might competition be eliminated in the solicitation phase of a bid-rigging scheme? Answer: A corrupt contractor may pay an employee of the purchasing company to ensure that one or more of the ¬contractor’s competitors are not allowed to bid on the contract. This might occur by requiring bidders to be represented by ¬certain sales or manufacturing representatives. Other ways of limiting or eliminating competition may include bid pooling or soliciting bids from fictitious suppliers. 10-8 What types of abuses may be found in the submission phase of a bid-rigging scheme? Answer: Some types of abuses found in the submission phase include compromising the confidentiality of the sealed-bid process, giving information to certain vendors on how to prepare their bid, or falsifying the bid log. 10-9 What is a conflict of interest? Answer: A conflict of interest occurs when an employee, manager, or executive has an undisclosed economic or personal interest in a transaction that adversely affects the company. The key word in this definition is undisclosed. The crux of a conflict case is that the fraudster takes advantage of his employer; the victim organization is unaware that its employee has divided loyalties. 10-10 What is meant by the term “turnaround sale”? Answer: In this type of purchasing scheme, an employee is aware that his company plans to purchase a specific asset, such as land, so the employee then takes advantage of his knowledge by purchasing the asset himself. The asset is then sold to the company by the employee at an increased rate. 10-11 How are under billings ¬usually accomplished? Answer: In this type of sales scheme, an employee undercharges a vendor in which he has a hidden interest. The victim company then ends up selling its goods or services at less than fair market value, resulting in a diminished profit margin or even a loss on the sale. 10-12 What is the difference ¬between business diversions and resource diversions? Answer: While both are considered conflicts of interest in which “favors” may be performed, business diversions tend to involve cases in which the employee undercuts his own employer through activities such as steering potential clients toward the employee’s business and away from the company’s business, resulting in unfair competition and a loss to the ¬victim company. Comparatively, resource diversions consist of the actual manipulation of a company’s funds or monetary resources to the benefit of the employee. Discussion Issues 10-1 Offering a payment can constitute a bribe, even if the illegal payment is never actually made. Why? Answer: Because the purpose of a bribe is “to influence,” the mere offering of a bribe may serve that end. 10-2 What is the common ingredient shared by the four classifications of corruption? Answer: Bribery, illegal gratuities, economic extortion, and conflicts of interest each involve the exertion of an official’s or ¬employee’s influence to the detriment of his constituency or company. 10-3 What is the difference ¬between official bribery and commercial bribery? Answer: While official bribery seeks to influence an official act, that is, the decisions of government agents or employees, commercial bribery attempts to influence a business decision. 10-4 If you suspected someone of being involved in a kickback scheme, what would you look for? Answer: Kickback schemes often involve diverting business to a certain vendor, overbilling for goods or services, or paying for ¬fictitious goods or services. Therefore, some of the indications of a kickback scheme may include goods being ordered repeatedly from the same vendor, established bidding policies not being followed, and higher costs of materials than normal. 10-5 An employee can implement a kickback scheme regardless of whether she has approval ¬authority over the purchasing function. How might this be ¬accomplished? Answer: An employee might be able to circumvent accounts payable controls by filing a false purchase requisition. If the person with the authority to approve this requisition relies on the corrupt employee and does not exercise proper judgment and responsibility, this type of scheme may be accomplished without the fraudster having purchasing approval authority. 10-6 What are some clues that might alert you to possible fraudulent activity at the different stages of a bid-rigging scheme? Answer: Suspicions of a bid-rigging scheme might arise when seemingly unnecessary restrictions that artificially limit competition are placed in the ¬solicitation documents. At the pre-solicitation phase, this includes: •Tailoring specifications of a contract to fit the capabilities of a single contractor •Providing confidential information about the contract on a preferential basis •Splitting the contract into several smaller parts in order to circumvent mandatory bidding thresholds At the solicitation phase, this includes: •Allowing only companies that are represented by a certain sales representative to submit bids •Bid pooling, whereby several bidders conspire to split the contract up and ensure that each gets a certain piece •Soliciting bids from fictitious suppliers At the submission phase, this includes: •Abuse of the sealed-bid process •Providing information to certain vendors on how to prepare their bid •Falsifying the bid log •Extending the bid opening date 10-7 How do conflicts of interest differ from bribery? Answer: Conflicts of interest and bribery are both distinct forms of corruption. A typical bribery case involves a fraudster who ¬approves an invoice and receives a kickback in return, whereas a conflict case generally involves a fraudster who approves an invoice because of his own hidden interest in the vendor. Although the two schemes are very similar, the fraudsters have different motives. In the bribery case, the fraudster approves the invoice because he receives some form of payment from a third party. In the conflict case, the fraudster approves the invoice because of his secret interest in the vendor; in a sense, the fraudster is the third party. 10-8 Compare the characteristics of purchasing schemes to sales schemes. Answer: Purchasing schemes are the most common type of conflict of interest. In purchasing schemes, the victim company unwittingly buys something at a high price from another company in which one of its employees has a hidden interest. Comparatively, sales schemes take place when a victim ¬company sells something at a low price to a company in which one of its employees has a secret hidden interest. 10-9 Assume an ¬employee is responsible for purchasing an apartment complex on behalf of his company. The employee owns stock in the management company that operates the apartment complex. The employee does not let his company know about his stock ownership, and proceeds to make the purchase. Why does this example represent a conflict of interest? Answer: This case is an example of a purchasing scheme. ¬Because the employee owns stock in the management company that operates the apartment complex and will profit from the sale of the complex, the employee may not negotiate to get the best price for his employer. This is a -conflict of interest ¬because it violates the employee’s duty of good faith to his company. 10-10 What are some of the ways organizations can determine whether a particular vendor is being favored? Answer: Companies can review tips and complaints from competing vendors. Companies can also compare the addresses of their vendors to the addresses of their employees to determine whether a match exists, indicating a possible conflict of interest. Vendor ownership information should also be kept on file and updated whenever an ownership change takes place. Purchasing personnel can also be interviewed and asked whether any vendors are receiving favorable treatment. Chapter 11 Accounting Principles and Fraud Review Questions 11-1 Why are the fraudulent statement methods under discussion referred to as “financial statement fraud”? Answer: They are referred to as financial statement fraud because the fraudster participates in falsification of a company’s financial statements, typically either by overstatement of ¬revenue/assets or understatement of expenses/liabilities. 11-2 There are three main groups of people who commit financial statement fraud. Who are they? Answer: The three main groups of people who commit financial statement fraud are organized criminals, mid- and lower-level employees, and senior management. 11-3 What are the three primary reasons people commit financial statement fraud? Answer: The three main reasons people commit financial fraud are to conceal True business performance, to preserve personal status/control, and to maintain personal income/wealth. 11-4 What are the three general methods commonly used to commit financial statement fraud? Answer: The three general methods commonly used to commit financial statement fraud are playing the accounting system, beating the accounting system, and going outside the accounting system. 11-5 What is meant by the term “overstatement”? Answer: “Overstatement” refers to a financial statement fraud in which the perpetrator purposely inflates a company’s financial information ¬(assets or revenues) to provide a false picture of the company’s performance. 11-6 What is meant by the term “understatement”? Answer: “Understatement” refers to a financial statement fraud in which the perpetrator provides a lowered value of a company’s financial information (liabilities or expenses). 11-7 What are the components of the conceptual framework for financial reporting? Answer: The components of the conceptual framework for ¬financial reporting include recognition and measurement ¬concepts—the economic entity, going concern, monetary unit, and periodicity assumptions; the historical cost, revenue recognition, matching, and full disclosure principles; and the cost-benefit, materiality, industry practice, and conservatism constraints—as well as the qualitative characteristics of relevance, reliability, comparability, and consistency. 11-8 Define the term “financial statement” and provide examples of types of financial ¬statements used in companies. Answer: The term financial statement refers to almost any ¬financial data presentation that is prepared in accordance with generally accepted accounting principles. Some common types of financial statements include balance sheets, statements of cash flows, summaries of operations, proxy statements, and ¬registration statement disclosures. Discussion Issues 11-1 Why is financial statement fraud commonly referred to as “cooking the books”? Answer: Financial statement fraud is commonly referred to as “cooking the books” because it involves the false presentation of a ¬company’s financial data. Records (or books) are manipulated by the fraudster to overstate or understate a company’s ¬financial information. 11-2 Compare the three main groups of people who may commit financial statement fraud, and describe their potential reasons for the fraud. Answer: Financial statement fraud may be committed by ¬organized criminals, who may engage in the fraud as part of a scheme to obtain fraudulent loans from a financial institution. A second group that may commit financial statement fraud is mid- and lower-level employees, who may falsify financial statements for their own area of responsibility for purposes of concealing their True business performance. The third group that may commit financial statement fraud is senior management. This group may have varied motives, but some common reasons include to maintain their own personal wealth or salary, or to preserve their status and control. 11-3 Although three general methods of producing fraudulent statements have been identified, one of these methods is typically used first. Which method is this, and why is it more likely to be selected first as opposed to the other two? Answer: In producing fraudulent statements, the method referred to as “playing the accounting system” is usually committed first. In this method, the fraudster uses the company’s accounting system to produce desired results (e.g., to increase or decrease earnings to a desired dollar amount), taking advantage of regular practices such as reporting of genuine sales. The other two methods (beating the ¬accounting system and going outside the accounting system) -require more direct manipulation to achieve desired results. 11-4 What is the generally ¬accepted accounting principle known as matching? Describe how a company may be involved in fraud that violates this ¬principle. Answer: The concept of matching refers to the standard that books and records from a given time period must coincide with the revenue and expenses in the same time period. Fraud can take place when a company purposely counts revenue from the subsequent year in the current year, or when it records the ¬current year’s expenses in the following year. 11-5 Management of a cellular phone company learns that a new technological advance will occur within the next year that will make the company’s current phones and related products obsolete. As a result, there is a strong chance that the company will close. When financial statements appear for auditors, management does not reveal its knowledge of the new technology. In this case, what accounting concepts are involved? Answer: In this example, management has reason to question the “going concern” assumption with regard to this business. This concept assumes that a business can continue indefinitely; however, when evidence reveals otherwise, management has a duty to report negative information that will affect a company’s future ability to earn revenue. Therefore, the principle of “full disclosure” has been violated. 11-6 In an organization, who is generally responsible for the financial statements, and how can those responsible help to deter financial statement fraud? Answer: Financial statements are the responsibility of a ¬company’s management, which means that financial statement fraud is rarely committed without the knowledge of members of management. In the instances in which management is not ¬responsible for investigating suspected frauds, it is critical that a code of conduct is in place. This will provide an ethical -standard for all employees to follow, which in turn will ¬decrease the likelihood of financial statement fraud. Chapter 12 Fraudulent Financial Statement Schemes Review Questions 12-1 What is financial statement fraud? Answer: Financial statement fraud is the deliberate misstatement or omission of amounts or disclosures in the financial statements to deceive financial statement users. 12-2 List five different ways in which financial statement fraud can be committed. Answer: Five ways in which financial statement fraud can be committed are (1) fictitious revenues, (2) timing differences, (3) concealed liabilities and expenses, (4) improper disclosures, and (5) improper asset valuation. 12-3 What are the two methods of engaging in fictitious revenues? Answer: Fictitious revenues schemes can involve making fictitious sales, which involves the use of fake or phantom customers and/or legitimate customers. The second method of recording fictitious revenues is to utilize legitimate customers and artificially inflate or alter invoices reflecting higher amounts or quantities than actually sold. 12-4 What are the two most ¬common pressures and motivations to commit financial statement fraud? Answer: Owners may feel pressured by bankers, stockholders, and even family and community to exceed financial analysts’ earnings forecasts. Additionally, departmental budget requirements may place pressures on managers to meet income and profit goals. 12-5 List three methods of engaging in timing differences. Answer: Schemes involving timing differences usually take the form of one of three methods: (1) failing to match revenues with expenses, (2) early ¬revenue recognition, or (3) recording expenses in the wrong ¬period. 12-6 What is the motivation for -violating the generally accepted accounting principle of matching ¬revenues with expenses? What is the result of ¬committing this fraud? Answer: Typically, the motivation for this type of timing difference scheme is to boost net income for the current year. The result is the overstatement of net income of the company in the period in which the sales were recorded. However, it also has the effect of understating net income in the subsequent year when the corresponding expenses finally are reported. 12-7 What is the motivation of early revenue recognition? What is the result of engaging in this type of fraud? Answer: The motivation for early revenue recognition is to show additional profit. This fraud leads to earnings misrepresentation and frequently serves as a ¬catalyst to further fraud. 12-8 List the three common ¬methods for concealing liabilities and expenses. Answer: The three common methods for concealing liabilities and expenses are (1) omitting liabilities/expenses, (2) capitalizing expenses, and (3) failing to disclose warranty costs and ¬liabilities. 12-9 What is the motivation for concealing liabilities and expenses? Answer: The motivation for concealing liabilities and expenses is to report inflated financial results. Concealing liabilities improves the company’s balance sheet, and concealing expenses results in a higher reported net income. 12-10 List five common categories of improper disclosures. Answer: Five common categories of improper disclosures are liability omissions, significant events, management fraud, related-party transactions, and accounting changes. 12-11 What are the four common forms of improper asset valuation? Answer: Improper asset valuations usually take of one of the following forms: inventory valuation, business combinations, accounts receivable, and fixed assets. 12-12 What is the likely result of committing an improper asset valuation? Answer: This type of fraud tends to inflate the current assets at the expense of long-term assets, and thus falsely improves financial ratios, such as the current ratio and quick ratio. 12-13 What is the difference ¬between fraudulent financial reporting and misappropriation of assets? Answer: Fraudulent financial reporting frequently involves a pressure or incentive to commit fraud and a perceived opportunity to do so. In general, fraudulent reporting occurs through intentional fraudulent omissions or inclusions in the financial statements. Asset misappropriation involves the theft or misuse of company assets. 12-14 Describe three analytical techniques for financial statement analysis. Answer: Horizontal analysis is a technique for analyzing the percentage change in individual financial statement items from one year to the next. Vertical analysis is the expression of the relationship or percentage of financial statement components to a ¬specific base item. Ratio analysis is a means of ¬measuring the relationship between two different financial statement amounts. Discussion Issues 12-1 What is the most effective way to prevent fictitious revenue from being fraudulently ¬reported in the financial statements? Answer: FASB Concepts Statement No. 6 defines revenue as “inflows or other enhancements of assets of an entity or settlements of its liabilities (or a combination of both) from delivering or producing goods, rendering services, or other activities that constitute the entity’s ongoing major or central operations.” Implementing controls to ensure that the criteria inherent in this definition are met prior to recording revenue will assist in mitigating the problem of fictitious revenue. 12-2 How can fictitious revenue be created through the use of false sales to shell companies? Discuss the method and result of committing this fraud. Answer: A company’s management can utilize several shell companies as customers in a number of favorable sales transactions. The sales transactions are fictitious, as are the supposed customers. An example entry from this type of case is ¬detailed below. A fictional entry is made to record a purchase of fixed assets: Date Description Debit Credit 12-01-X1 Fixed Assets 300,000 Cash 300,000 A fictitious sales entry is then made for the same amount as the false purchase: Date Description Debit Credit 12-01-X1 Accounts Receivable 300,000 Sales 300,000 12-01-X1 Cash 300,000 Accounts Receivable 300,000 From the above journal entry, we can see that the cash outflow that supposedly covered the purchase of assets is returned as payment on the receivable account to cover the fictitious sale. The result of the completely fabricated sequence of events is an increase in both company assets and yearly revenue. 12-3 How might a company utilize timing differences to boost revenues for the current year? Discuss and analyze the method and result of committing the fraud. Answer: Suppose at the end of the year, the following journal entry was made: Date Description Debit Credit 12-01-X1 Accounts Receivable 20,000 Sales—Project A 20,000 In January of next year, the project is started and completed. The entries below show accurate recording of the 15,000 of costs associated with the sale: Date Description Debit Credit 1-31-X2 Cost of Sales—Project A 12,000 Inventory 12,000 1-31-X2 Labor Costs—Project A 3,000 Cash 3,000 From the above journal entries we can see that a company may accurately record sales that occurred in the month of ¬December, but fail to fully record expenses associated with those sales. This error overstates the net income of the company in the period in which the sales were recorded, and also understates net income when the ¬expenses are reported. 12-4 In the case study, “The ¬Importance of Timing,” what kind of fraud did the accountant commit? How could this fraud have been discovered? Answer: He committed a fraud involving a timing difference. In this fraud, he made payment for materials and supplies in one year, even though they were not received until the next year. He also recognized the ¬repair in the year that the actual repair occurred. Division management asked Isbell to conduct an examination. He found $150,000 in repair invoices without proper documentation. The records for materials and supplies, which were paid for in one year and received in the next year, totaled $250,000. A check of later records and an inspection showed that everything paid for had, in fact, been received, just some days later than promised. 12-5 Liability/expense omission is the preferred and easiest method of concealing liabilities/expenses. Why? Discuss how to detect this type of fraud. Answer: Failing to record liabilities/expenses is very easy to conceal and very difficult to detect. The perpetrators of liability and expense omissions believe they can conceal their fraud in future periods. They often plan to compensate for their omitted liabilities with visions of other income sources such as profits from future price hikes. For example, the perpetrators may have planned to conceal the fraud by increasing the sales price in future periods when the expense would actually be recorded. These frauds can be discovered through a thorough review of all post-financial-statement-date transactions, such as accounts payable increases and decreases. 12-6 What internal control ¬activities and related test procedures can detect or deter ¬overstated inventory? Answer: When an overstated inventory scheme is suspected, the use of analytical procedures can help uncover suspicious activity. Red flags of overstated inventory include unusual growth in the number of days’ purchases in inventory and an allowance for excess and obsolete inventory that is shrinking in percentage terms or that is otherwise out of line with industry peers. Additionally, a review of the accounts receivable (A/R) aging ¬report and bills of lading can help detect this fraud. For example, in one case described in this chapter, an A/R aging report indicated sales of approximately $1.2 million to a particular customer in prior months. The aging showed that cash receipts had been applied against those receivables. An analysis of ending inventory failed to reveal any improprieties because the relief of inventory had been properly recorded with cost of sales. Copies of all sales documents to this particular customer were then requested. The product was repeatedly sold FOB shipping point, and title had passed. But bills of lading indicated that only $200,000 of ¬inventory had been shipped to the original purchaser. There should have been $1 million of finished product on hand for the food processor. However, there was nothing behind the facade of finished products. An additional comparison of bin numbers on the bill of lading with the sales documents ¬revealed that the same product had been sold twice. 12-7 What financial reporting analysis techniques can help to detect fraudulent financial statement schemes? Answer: Three primary financial statement analysis techniques are available to the fraud examiner. The first is vertical analysis, which is a technique for ¬analyzing the relationships between the items on an income statement, balance sheet, or statement of cash flows by ¬expressing components as percentages. This method is often referred to as “common sizing” financial statements. In the vertical analysis of an income statement, net sales are assigned 100 percent; for a balance sheet, total assets are assigned 100 percent, and so are total liabilities plus owner’s equity. All other items in each of the statements are ¬expressed as a percentage of these numbers. It is the expression of the relationship or percentage of component items to a specific base item. Vertical analysis emphasizes the relationship of statement items within each accounting period. These relationships can be used with historical averages to ¬determine statement anomalies. The second financial statement analysis technique is horizontal analysis, also known as trend analysis. This technique is used to determine changes (i.e., increases or decreases) in a series of financial data over a period of time. The first period in the analysis is considered the base, and the changes in the subsequent period are computed as a percentage of the base period. If more than two periods are presented, each period’s changes are computed as a percentage of the preceding period. The third financial reporting analysis technique is ratio analysis. It is a means of measuring the relationship between two different financial statement amounts. The relationship and comparison are the keys to the analysis. Traditionally, financial statement ratios are used in comparisons to an entity’s industry average. They can be very useful in detecting red flags for a fraud examination. 12-8 In the case study, “That Way Lies Madness,” what kind of fraud did Eddie Antar commit? How was the fraud committed? How could the fraud be discovered? Answer: Eddie Antar committed fictitious revenues, ¬concealed liabilities and expenses, and improper asset ¬valuation frauds. The schemes used by Crazy Eddie include the following: •Listing smuggled money from foreign banks as sales. Through these fictitious sales, he generated fictitious revenues. This fraud resulted in the increase of assets and yearly revenue. •Making false entries to accounts payable. •Overstating Crazy Eddie, Inc.’s inventory by breaking into and altering audit records. •Taking credit for merchandise as “returned,” while also counting it as inventory. •“Sharing inventory” from one store to boost other stores’ audit counts. •Arranging for vendors to ship merchandise and defer the billing, besides claiming discounts and advertising credits. •Selling large lots of merchandise to wholesalers, then spreading the money to individual stores as retail receipts. There were many clues: Stores were alarmingly understocked, shareholders were suing, and suppliers were shutting down credit lines because they were paid either late or not at all. An initial review showed that the company’s inventory had been overstated by $65 million—a number later increased to over $80 million. 12-9 During the audit of ¬financial statements, an auditor discovers that the financial statements might be materially misstated due to the existence of fraud. Describe (1) the auditor’s responsibility according to SAS No. 99 (AU 316) for discovering financial statement fraud; (2) what the auditor should do if he or she is precluded from applying necessary audit procedures to discover the suspected fraud; and (3) what the auditor should do if he or she finds that the fraud materially affects the integrity of the financial ¬statements. Answer: According to SAS No. 99 (AU 316), 1. The auditor should (a) exercise professional skepticism in conducting the audit by discussing among the audit team members the risks of material misstatement due to fraud; (b) consider the implications for other aspects of the audit and discuss the matter with an appropriate level of management; and (c) obtain sufficient and competent ¬evidential matter to determine whether material fraud exists and what its impact is on the fair presentation of financial statements. 2. If the auditor is precluded from applying necessary audit procedures to find out about the existence of fraud, the ¬auditor should (a) discuss the matter with the legal counsel; (b) disclaim or qualify an opinion on the financial statements; and (c) communicate audit findings to the audit committee or the board of directors. 3. If the auditor concludes that financial statements are ¬materially affected by discovered frauds, the auditor should (a) require that financial statements be revised to correct the fraud; (b) issue a qualified or an adverse opinion if management refuses to revise the fraudulent financial statements; (c) consider withdrawing from the audit engagement and ¬inform the audit committee, the board of directors, or the authorities about the fraud. Solution Manual for Principles of Fraud Examination 9780470646298, 9781118922347 Joseph T. Wells
