Frank-Common Financial Fraud Schemes 7May 03v1

8/3/2019 Frank-Common Financial Fraud Schemes 7May 03v1

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\\ COMMON FINANCIAL STATEMENT STATEMENT FRAUD SCHEMES

Jamal Ahmad, JD., C.P.A.David Jansen, C.A.

Jonny J. Frank, J.D., LL.M.

Contents

1 Introduction

2 Categories ofFinancial Statement Fraud

3 Fraudulent Financial Reporting3.1Earnings Management Methods Permissible by GAAP; The Grey Zone3.2Earnings Management Methods Not Permissible by GAAP

4 Overview of Largest Fraudulent Financial Reporting Cases(1997 2002)

5 Improper Revenue Recognition5.1 Reviewing for and Investigating Allegations of Improper RevenueRecognition

5.1.1 Accounting Policies and Customer Contracts5.1.2 Forensic Auditing Techniques5.2 Side Agreements5.3Liberal Return, Refund Or Exchange Rights5.4Channel Stuffing

5.5Early Delivery Of Products5.5.1 Partial Shipments5.5.2 Soft Sales5.5.3 Contracts With Multiple Deliverables5.5.4 Up-Front Fees5.6Bill and Hold Transactions5.7Fictitious Revenue Schemes5.7.1 Fictitious Sales5.7.2 Round Tripping5.8Other Improper Recognition Schemes5.8.1 Recognizing Revenue On Disputed Claims Against Customers

5.8.2 Holding The Books Open Past The End Of A Period5.8.3 Recognizing Income On Consignment Sales Or On ProductsShipped For Trial Or Evaluation Purposes

5.8.4 Construction Accounting Schemes5.8.5 Sham Related Party Transactions

6 Asset Overstatement/Liability Understatement Schemes


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6.1Inventory Schemes6.1.1 Inflating Inventory Quantity (Fictitious Inventory)6.1.2 Inflating Inventory Value6.1.3 Fraudulent Or Improper Inventory Capitalization6.2 Accounts Receivable Schemes

6.2.1 Creating Fictitious Receivables6.2.2 Artificially Inflating The Value Of Receivables6.3 Investment Schemes6.3.1 Fictitious Investments6.3.2 Manipulating The Value Of Investments

Misclassification of Investments Recording Unrealized

Declines in Fair Market Value/Overvaluation6.4 Improper Capitalization of Expenses6.4.1 Software Development6.4.2 Research and Development6.4.3 Start Up Costs

6.4.4 Interest Costs6.4.5 Advertising Costs6.5 Recording Fictitious Fixed Assets6.6 g Depreciation and Amortization Schemes

7 Understatement of Liabilities7.1General7.2Off Balance Sheet Entity Schemes7.2.1 Off Balance Sheet Treatment versus Consolidation7.2.2 The Old Rules7.2.3 The New Rules7.3Overstatement of Liability Reserves (Cookie Jar Reserves)

8. Improper or Inadequate Disclosures

9. Materiality

10 Misappropriation of Assets10.1 Misappropriation of Cash

10.1.1 Skimming of Cash

Unrecorded or Understated Sales or Receivables

Lapping10.1.2Fraudulent Disbursements

Billing Schemes - Creation of Fictitious Vendors or ShellCompanies to Convert Monies

Billing Schemes - False Credits, Rebates, Refunds andKickbacks

Billing Schemes - Over billing

Billing Schemes - Pay and Return Schemes

Theft of Company Checks

Payroll Fraud - Ghost Employees

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Payroll Fraud - Falsified Hours10.2 Misappropriation of Inventory Conversion of Inventory

10.2.1Conversion of Inventory10.2.2False Write-Offs and Other Debits to Inventory10.2.3False Sales of Inventory

11. Other Fraudulent Revenue and Expenditures11.1 Revenue And Assets Obtained By Fraud11.2 Expenditures and Liabilities For An Improper Purpose

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1. Introduction

Statement on Auditing Standards No. 991 (SAS 99) requires auditors to focus

on two broad areas of fraud: (i) fraudulent financial reporting and (ii)

misappropriation of assets. Each of these has a multitude of fraud schemes.

This chapter provides an overview of the most common financial statement fraud

schemes, indicators of their occurrence, and methods of detection.

The focus is to familiarize the reader with certain fraud schemes, the various

indicators which evidence that these schemes may be or are being perpetrated

and how an auditor might detect those schemes. While this chapter discusses

numerous fraud schemes, it does not contain a comprehensive list of all possible

schemes. Similarly, with respect to the listed schemes, space constraints

prevent discussion of all possible detection procedures the auditor can perform to

determine whether the particular scheme exists.

2. 2. Categories ofFinancial Statement Fraud

Fraud schemes can be grouped in various categories. For example, from a legal

perspective, frauds can be distinguished between: frauds bythe corporation and

frauds against the corporation. Frauds committed by the corporation carry legal

risk, that is, potential civil, regulatory, and criminal liability. Frauds committed

against the corporation carry financial risk, that is, the loss of income or assets.

External and internal misappropriations of assets are by far the most common

fraud against the corporation.

This chapter groups, Ffinancial frauds generally falinto three four broad

categories:

Fraudulent Financial Reporting Schemes;

Misappropriation Of Assets;

Revenue And Assets Obtained By Fraud and

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Expenditures and Liabilities For An Improper Purpose Other economic

frauds and misconduct.

Most auditors would consideronly 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.

Alternatively, frauds can be distinguished between: frauds bythe corporation and

frauds against the corporation. Frauds committed by the corporation carry legal

risk, that is, potential civil, regulatory, and criminal liability. According to the SEC,

the most common schemes involve earnings management - - improper revenue

recognition schemes, and schemes to overstate assets or understate liabilities.

Frauds committed against the corporation carry financial risk, that is, the loss of

income or assets because of fraud. External and internal misappropriations of

assets are by far the most common fraud against the corporation.

3. 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 companys true financial performance in

order to achieve a desired result.2

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

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management techniques that are aggressive in nature but otherwise permitted by

GAAP, and those that clearly violate GAAP.

Accountants working with public companies, however, take note. The SEC takes

the position that compliance with GAAP will not necessarily protect an entity from

an SEC enforcement action, if financial performance is distorted.3

3.1 Earnings Management Techniques Permissible Under GAAP:The Grey Zone

GAAP frequently allows management alternative ways to record the operations

of an entity. For instance, GAAPallows any depreciation method, so long as it

systemically and rationally allocates the cost of the asset over its useful life. 4

Similar instances in which management is provided wide latitude include:

Changing depreciation methods from an accelerated method to the moreconservative 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 accountsreceivable;

Determining whether/when assets have become impaired and arerequired 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 istemporary or permanent; and

Estimating the write-downs required for investments.

Thus, in certain instances, GAAP allows a company to manage earnings by

simply altering its accounting policy to select those accounting principles that

benefit it most. The SEC itself has noted that accounting principles are not

meant to be a straightjacket and that flexibility of accounting is essential to

innovation.5 Abuses occur, however, when this flexibility is exploited to distort

the true picture of the corporation.6

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Entities have a host of reasons for selecting those principles that will paint the

rosiest financial picture. Some would argue that the market demands it, as

reflected by the stock price punishment for companies that differ by as little as

one penny per share from prior estimates. External market pressures to meet

the numbers conflicts with market pressure for transparency in financial

reporting.

Often, it is difficult to distinguish between aggressive, but allowable accounting

and that which is abusive and prohibited. How, for example, does one determine

whether managements reserve for uncollectible accounts is or is not

reasonable?

The line between aggressive and fraudulent behavior hinges on management s

intent. Fraud rarely occurs if managements intent is transparent and clearly

understandable. What, however, if management selects a GAAP permissive

policy to conceal a fraud or error? Does the selection of the otherwise allowed

policy demonstrate intent to commit fraud? Consider also whether management

selects a policy that it knows will have both a positive and negative effect on the

financial picture. If management selects the policy but refuses to recognize the

negative effect, does that demonstrate fraud in the selection of the policy?

Whether a fraud has been committed is fact-specific. For purposes of this

chapter, we have assumed that management has acted with malicious intent.

The case examples cited also involve instances where the company and/or its

management was charged and most often found guilty of wilfully engaging in the

alleged misconduct.

3.2 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

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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 thefinancial statements; and

Revenue recognition irregularities.7

4. Overview of Largest Fraudulent Financial Reporting Fraud Cases(1997 2002)

To demonstrate the breadth of recent fraud cases, the table below outlines some

of the larger and more publicized frauds and accounting scandals detected over

the period 1997 2002. The schemes involved an array of industries and

included both frauds by and against the entity as well as corporate

misconduct.

Company Fraud Scheme Result

AdelphiaCommunications

Misappropriation of firm assetsby executives for personal use.Concealment of $2.3 billion inloans to cover losses by founderand family members.

Declared bankruptcy inJanuary 2002. CEO andfamily members charged withfraud.

Cendant Corp. As a result of its merger of HFCwith CUC International, it wasrevealed that CUC overstatedrevenue by $500 million between1995 and 1997 using assortedtechniques such as recording

fictitious revenues andunderstating liabilities.

Restated 1997 earningsdecreased by more than $161million.Former CFO, VP, andcontroller pled guilty tonumerous other charges.

Company settled $3.2 billionshareholder suitErnst & Young paid $335million to settle shareholderlawsuit.

Enron Overstated income byintentionally understatingliabilities and concealing debt

Declared bankruptcy inDecember 2001.Lost more than $80 billion in

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Company Fraud Scheme Resultthrough the creation of offbalance sheet entities.Inadequately disclosed Co.s offbalance sheet transactions.

Possible tax evasion.

market capitalization.Former CFO among othersconvicted of moneylaundering and securities,

wire and mail fraud.Additional charges broughtagainst others.Resulted in dissolution ofcompany and accountantsArthur Anderson.

Global Crossing Charged with using "swap deals"with other telecom carriers toinflate sales.

Declared bankruptcy January2002.SEC investigations pending.

K-Mart Inflated revenue by improperlyrecognizing entire $42.3 million in

revenue from a multiyearcontract in 2nd quarter of 2001.

Declared bankruptcy, January2002.

Two former VPs charged withearnings fraud.MicroStrategy Improperly recognized revenue

from sales of software asagreements were entered intorather than as services wereprovided.

Restated earnings for fiscalyears 1998 and 1999, whichcaused revenues to bereduced by almost $66million.Former CEO, COO, and CFOeach fined $350,000.

Sunbeam Corp. Created $35 million ininappropriate restructuring

reserves in 1996 that werereversed in 1997 to inflateincome thus creating the illusionof a rapid turn around.In 1997, reported over $70million of revenue from bill andhold sales, channel stuffing andother inappropriate accountingpractices.

Restated 1997 income from$109 million to $38 million.

CEO charged with violatingfederal securities laws bymisrepresenting materialinformation about thecompany. CEO settled bypaying a piece of a $141million fine.Former controller and chiefaccounting officer eachagreed to pay $100,000 infines.

Former Arthur Andersonpartner also settled forundisclosed amount.

TycoInternational

Misappropriation of $600 millionby CEO and CFO for personaluse through theft and the falsesale of securities.Company also separately sued

Three former executivesincluding CEO and generalcounsel arrested for fraud.CEO also charged withavoiding payment of over $1

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Company Fraud Scheme Resultformer CEO seeking the return ofmore than $100 million. Suitalleges CEO gave himselfunauthorized bonuses totalling

$58 million and unauthorizedloans of more than $43 million,and of taking personal credit formore than $43 million incharitable donations that actuallywere made by Tyco.

million in sales taxes on $13million of artwork

WorldCom Intentionally improperlycapitalized billions of dollars ofexpenses as capitalexpenditures.Former CEO facing possible

charges for allegedly profitingimproperly from IPOs offered bybrokerages in return for investment banking business.

Declared bankruptcy, July2002. Former finance chiefand finance and accountingexecutives charged withsecurities fraud.

Xerox Overstated revenue for over 4years by accelerating therecognition of $3 billion inrevenue and inflating earnings byabout $1.5 billion. Allegedscheme included the recognitionof revenue on its office copier

leases too early in their cycles.

Co. agreed to pay $10 millionin fines and restate its incomefor the years 1997-2000.

SEC sued three currentKPMG partners and oneformer partner of securities

fraud in the claiming the firmfraudulently let the Co.manipulate its accountingpractices to fill a $3 billion gapand make it appear to bemeeting market expectations.

5. Improper Revenue Recognition

Improper recognition of revenue - either prematurely or of fictitious revenue is

the most common form of fraudulent earnings management. Premature

recognition of revenue involves the recording of revenue generated through

legitimate means, at any time prior than would be allowed under GAAP.

Premature recognition should be distinguished from recognition of fictitious

revenue derived from false sales or to false customers.

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The Report of the National Commission on Fraudulent Financial Reporting

(hereinafter, the COSO Report)8 found that improper revenue recognition was

alleged in 47% of the cases reviewed by the Commission from 1981 to 1986. A

second COSO Report found that the number of revenue recognition alleged

matters accounted for 50% of all matters enforced by the SEC from 1987-1997. 9

According to SEC figures, 32 of the 90 actions bought by the Commission in

1999 involved improper revenue recognition using such techniques as side

letters, rights of return, consignment sales, and the shipping of unfinished

products. Another 12 cases involved the booking of fictitious sales.10

A PricewaterhouseCoopers study revealed that in the year 2000, 66% of the

shareholder actions filed alleged revenue recognition violations.11 In 2001, the

number of revenue recognition actions jumped to 69% of all actions filed.12

Finally, of the approximately 140 earnings management/accounting cases

brought by the SEC in 2002, more than half related to revenue recognition. 13

With respect to premature recognition, SEC Staff Accounting Bulleting 101,

Revenue Recognition in Financial Statements, (SAB 101) 14 spells out four

basic criteria that must be met before a public company may recognize revenue.

Specifically, these criteria require:

Persuasive evidence that an arrangement exists; Evidence that delivery has occurred or that services have been rendered; A showing that the seller's price to the buyer is fixed or determinable; and Ability to collect payment must be reasonably assured.

SAB 101 echoes the recognition requirements originally listed in AICPA

Statement of Position (SOP) 97-2, Software Revenue Recognition15, which

governs the software industry. Accountants should also refer to industry specific

literature depending upon the client and circumstances.16 In fact, SAB 101

explains that where it exists, companies should apply industry specific authority

over SAB 101.

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Many of the schemes described in this chapter violate more than one of the SAB

101 recognition criteria. The indicia for each listed scheme are not mutually

exclusive; that is; factors indicating the potential existence of one scheme can

often be used to detect others.

Companies can use numerous methods to engage in premature or fictitious

revenue recognition. Following are the most common techniques:

Agreements or policies which grant liberal return, refund orexchange rights;

Side agreements;

Channel stuffing;

Early delivery of product

Contracts with multiple deliverables; Soft sales;

Partial shipments; and

Up-front fees;

Bill and hold transactions;

Recording false sales to existing customers and false sales tofictitious 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.

5.1 Reviewing For and Investigating Allegations of Improper RevenueRecognition

5.1.1 Accounting Polices and Customer Contracts

Inquiries into alleged improper revenue recognition usually begin with a review of

the entitys revenue recognition policies and customer contracts. The auditor

considers the reasonableness of the companys normal recognition practice and

whether the company has done everything necessary to comply. For example, if

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the company customarily obtains a written sale agreement, the absence of a

written agreement becomes a red flag.

The review should begin with a detailed reading of the contract terms and

provisions. Particular attention should be focused upon terms governing (i)

payment and shipment, (ii) delivery and acceptance, (iii) risk of loss, (iv) terms

requiring future performance on the part of the seller before payment, (v)

payment of up-front fees, and (vi) other contingencies. The auditor must consider

timing particularly as it relates to the companys quarter and year-end periods.

In which periods were the sales agreements obtained? When was the product or

equipment delivered to the buyers site? When did the buyer become obligated

to pay? What additional service(s) was required of the seller?

In the absence of a written agreement, the auditor should consider other

evidence of the transaction, e.g. purchase orders, shipping documents, payment

records, etc. He or she should also consider SAB 101 as well pronouncements

specific to the particular business, as accounting literature often contains relevant

examples and issues. For example, companies engaged in business over the

internet face unique revenue recognition issues. The Emerging Issues Task

Force Abstract (EITF) 99-19, Reporting Revenue Gross as a Principal versus

Net as an Agent, 17 attempts to solve this problem by listing factors which are

considered by the SEC in determining whether revenue should be reported on a

gross or net basis. Similarly EITF 01-9,Accounting for Consideration Given by a

Vendor to a Customer (Including a Reseller of the Vendors Products),18

addresses the issue of sales incentives, such as discounts, coupons, rebates,

and "free" products or services offered by manufacturers to customers of retailers

or other distributors. Being aware of the applicable authority governing the facts

and circumstances can assist the auditor in his determination of recognition

violations.

5.1.2 Forensic Auditing Techniques

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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 exists19; Perform substantive analytics designed to detect the fraud being

investigated; and

Perform substantive testing to determine whether there is evidence tosupport the existence of a scheme or lack of evidence to support thevalidity of a transaction. Such substantive procedures include but are notlimited to:

- Request and review documents such as contracts and supportfor invoices and deliveries;

- Confirmation with customers to the existence of accountsreceivable and the amount of consigned goods;

- Possible public records/background research/site visitsconducted on customers/third parties to verify existence of theentity being billed;

- Analyzing journal entry activity and supporting documentation incertain accounts, focusing on round dollar entries at the end ofperiods;

- If entries are accruals, obtaining support for the reversal andconfirming the proper timing of the entries.

The following general indicators can often alert the auditor or auditor as to thepotential 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 tobe to high or are increasing too fast;

Reported sales discount, sales returns or bad debts expenses whichappear 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 - Increased revenues with no corresponding increase in distribution

costs or- Increased revenues with no offsetting increase in accounts receivable.

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The use of analytics should also not be overlooked as a means of detecting

fraud. Analytical procedures and relationships the auditor can perform or review

to determine whether revenue is being recognized prematurely include:

Comparing current period financial statement line item amounts with

amounts from prior periods and inquiring as to significant changes inaccounts between periods (Horizontal Testing, See Chapter );

Reviewing balances in revenue related accounts for unusual changes;

Calculating the percent of sales and receivables to the total balance sheetin the current period, comparing it with prior periods and inquiring of anyunusual changes (Vertical Testing, See Chapter ) ;

Reviewing the statement of cash flows to determine if cash collected is inproportion to reported revenues;

Reviewing sales activity for the period and note any unusual trends orincreases such as increases towards the end of the period;

Significant or unusual or unexplained changes in the following particularratios (See Chapter XX for a detailed explanation of ratios):o Increases in Net Profit Margin (Net Income/Total Sales);

o Increases in Gross Profit Margin (Gross Profit/Net Sales);

o Increases in the Current Ratio (Current Assets/Current Liabilities);

o Increases in the Quick ratio (Cash and Receivables and Marketable

Securities/Current Liabilities);o Increases in the Accounts Receivable Turnover (Net Sales/A/R);

o Increases to Days Sales Outstanding (A/R Turnover/365);

o Increases in Sales Return Percentages (Sales Returns/TotalSales);

o Increase in Asset Turnover (Total Sales/Average Total Assets);o Increases in Working Capital Turnover (Sales/Average Working

Capital);o Decrease in A/R Allowance as a % of A/R (Allowance/Total A/R);

ando Decreases in the bad debt expense or allowance accounts.

Of course, good interviewing and sound analytics will not substitute for having a

good understanding of the clients business. Even seasoned auditors have been

misled and thought revenue to be appropriate because they did not fully

understand the business. Thus, after all the analytics and interviews, the auditor

must ask him or herself whether the information and results obtained make

sense in light of the clients industry and business. The auditor should also to the

extent applicable, benchmark performance results against other companies in

the same industry.

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5.2Side Agreements

While SAB 101 requires a definitive sales or service agreement, agreements can

and often are legitimately amended. Problems arise however when a companyenters into such an arrangement and subsequently modifies, supplements,

revokes, or otherwise amends the original agreement with a written or oral side

agreement prepared and agreed to outside the normal reporting channels of the

business.

Management often employ side arrangements or letters to boost sales figures.

Sales force members also use them to meet sales targets or to obtain

undeserved commissions. Side agreements created outside of the normal and

proper recording channels are often used to perpetrate many of the schemes

listed in this chapter.

The existence of numerous side agreements should raise red flags to the auditor

and require further detailed inquiry as to the facts and circumstances surrounding

how, when and why the agreements were entered into. Additional investigation

is warranted if the inquiry points to preparation outside the normal reporting

channels.

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:o Re-sale;

o Receipt of funding;

Rights of continuing negotiations; and

Extension of payment terms.

Case Illustration

The case of Informix Corp illustrates the improper use of side-agreements. 20

Informix sold licensed software to companies, which, in turn, would resell the

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licenses to third parties. Consistent with then current GAAP for revenue

recognition with respect to software21, the companys written policy was to

recognize revenue from the sale of licenses only upon receipt of a signed and

dated license agreement. However, to meet the earnings expectations of the

company and financial analysts, management entered into numerous written and

oral side agreements containing different provisions, which caused them to

violate GAAP revenue recognition principles. These provisions included:

Allowing resellers to return and to receive a refund or credit for unsoldlicenses;

Committing the company to use its own sales force to find customers forresellers;

Offering to assign future end-user orders to resellers;

Extending payment dates beyond twelve months;

Committing the company to purchase computer hardware or services fromcustomers under terms that effectively refunded all, or a substantialportion, of the license fees paid by the customer;

Offering to pay for customer storage costs;

Diverting the company's own future service revenues to customers as ameans of refunding their license fees; and

Paying fictitious consulting or other fees to customers to be repaid to thecompany as license fees.

Auditors should perform inquiries of management, accounting and sales

personnel as to whether they are made aware of all side agreements entered into

by the other party that modify sales in any one of the methods mentioned or in

any other fashion. The auditor should also inquire of sales people whether they

are allowed or encouraged to use side letters or agreements to complete a sale

and whether these agreements are made using proper reporting channels.

In addition to inquires, the auditor should review the companys right of return

policy and understand its rationale. The auditor should satisfy him or herself byreviewing a sample of contracts for side agreements and confirm with a sample

of customers the major contract terms of their contracts, including the existence

or absence of any side agreements.

5.3 Liberal Return, Refund, Or Exchange Rights

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In the case of Midisoft Corporation, 24 the SEC charged the company with

overstating revenue on in the amount of $458,000 on transactions for which

products were shipped, but for which, at the time of shipment, the company had

no reasonable expectation that the customer would accept and pay for the

products. The company eventually accepted back most of the product as sales

returns during the first quarter of the subsequent period.

The SEC noted that Midisofts written distribution agreements generally allowed

the distributor wide latitude to return product to Midisoft for credit whenever the

product was, in the distributor's opinion, damaged, obsolete, or otherwise unable

to be sold. In preparing Midisoft's financial statements for fiscal 1994, company

personnel submitted a proposed allowance for future product returns that was

unreasonably low in light of the large levels of returns Midisoft received in the first

several months of 1995. Furthermore, various officers and employees in the

companys Accounting and Sales Departments knew the exact amount of returns

the company had received prior to the end of March 1995, when the companys

independent auditors finished their field work on the 1994 audit. Had Midisoft

revised the allowance for sales returns to reflect the returns information, it would

have had to reduce accordingly the amount of net revenue reported for fiscal

1994. Instead, several Midisoft officers and employees devised schemes to

prevent the auditors from discovering the true amount of the returns including

preventing the auditors from touring that portion of the Midisoft headquarters

where the returned goods were stored. In addition, Midisoft accounting

personnel altered records contained in the computer accounting system to

reduce falsely the level of returns.

Midisoft teaches that the auditor should carefully review the terms of the

contracts and any side or extension agreements to determine what rights are

afforded the customer with respect to returning and exchanging the delivered

product. Only in those cases where the customer has limited or no right to return

the product should revenue be recognized. The auditor should also inquire into

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the companys refund and exchange policy: how it was derived, whether it is

subject to override, by whom and how often it is overridden. Other relevant

inquiries include sales personnel as to whether the company has offered

customers price concessions, refunds, or new products.

Auditors should also inquire of accounting staff and financial personnel as to the

returns policy and confirm with warehouse personnel who process returns that

the policy is being followed. In addition to the inquiries, the auditor may also

choose to perform the following analytics:

Compare returns in current period to prior periods and inquire as to anyunusual increases;

Determine whether returns are processed timely (this may require a visitan inquiry with warehouse personnel, an inquiry can also be made ofcustomers on confirmations)

o Companies may slow down the return processing process to avoid

reducing sales in the current period.

Perform sales return percentage (Sales Returns/Total Sales) and inquireas to any unusual increase; and

Compare returns subsequent to reporting period to both the return reserveand the monthly returns for reasonableness.

5.4 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 not been otherwise sold until

later periods, if at all.

Case Illustration

The case against Sunbeam Corporation25 is illustrative. In December 1997,

Sunbeam established a program offering discounts, favourable payment terms,

guaranteed mark-ups and the right of return or exchange on unsold products to

any distributor willing to accept the companys products before year-end. The

company failed to disclose this practice in its quarterly 10Q. As a result, the SEC

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charged that the companys 10Q statement was misleading and that the

company had eroded future sales and profit margins by pulling them into the

current period.

Channel stuffing often is indicated by an increase in shipments, which is usually

accompanied by an increase in shipping costs, at or near the end of period.

Where these circumstances occur, the auditor or auditor should (i) inquire

whether the goods were sold at steep discounts and (ii) review customer

contracts and side agreements for unusual discounts in exchange for sales and

rights of return provisions. The auditor should also inquire of sales personnel and

shipping personnel regarding management influence to alter normal sales

channel requirements.

In addition, customers offered deep discounts often purchase inventory in excess

of required needs to take advantage of the reduced prices. This excess,

inventory is often returned by the customer after the close of the period as it

cannot be resold. The auditor thus should consider the amount of returns shortly

after the close of a period as compared to prior periods and margins on sales

recorded immediately before the end of a reporting period.

5.5 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 priorto 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.

Based on the provisions of SAB 101, income should not be recognized under

these circumstances because delivery has not actually occurred.

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Customers on the other side of early delivery schemes often return the

unfinished product or demand more completion before payment is rendered.

Analytics that may reveal the existence of an early delivery scheme include:

Comparing returns in the current period and prior periods;

Comparing shipping costs in current period and prior periods; and

Comparing shipping costs as a percentage of revenue in the currentperiod and prior periods.

Careful scrutiny of the sales contract will also assist to detect these schemes.

When must payment be made in relation to delivery? Which party bears the risk

of loss on shipment? The audit or investigative team should then compare these

contract terms with the requirements of SAB 101 and other accounting literature.

The auditor should also make broad inquiries of non-financial personnel such as:

Shipping department personnel:Were shipments earlier than normal for customers?Is inventory stored in the warehouse documented as shipped?Was there inventory shipped to addresses other than customer sites?Were there any adjustments to shipping dates?Whether there exists consigned goods and their location.

Sales force personnel:Are shipments of any products designed to arrive ahead of thecustomers required delivery date?Do sales personnel pick up product and deliver to customers?Are there sales personnel with excessive samples?Do sales personnel have free reign in access to the warehouse?

Warehouse personnel:

- Are there any misstatements in the amount of merchandise thecompany ships or receives?

- Has there been destruction, concealment, predating, or postdating of

shipping and/or inventory documents?- Has there been an acceleration of shipments prior to month or year-

end?

- Have there been shipments to a temporary or holding warehousesprior to final shipment to the customers premises?

- Are there any other unusual, questionable, or improper practices?

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Additional audit procedures include:

Comparing the purchase order date with the shipment date;

Determine whether sales personnel are paid commissions based onthe sale of product or upon collection;

Inquiring of outside related business interests of key/sales personnelthat may be suspected in an improper revenue recognition scheme;

Performing public records searches on certain entities and individuals;

Determining whether shipments have been made to these outsidebusiness interests;

Reviewing amounts and trends of shipping costs at or near the end ofa period even to legitimate customers;

Reviewing rate of returns;

Inspecting shipping documents for missing, altered or incorrectinformation; and

Reviewing customer complaint logs or e-mail correspondence for

complaints of shipments of goods prior to the customers readiness toaccept.

5.5.1 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.

Case Illustration

The SECs enforcement action against FastComm Communications Corp is

illustrative.26 In 1999, the SEC charged FastComm with recognizing revenue on

the sale of products that were not fully assembled or functional. The SEC

charged that it was improper because delivery had not yet occurred.

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 bycustomers seeking the full product;

Large, numerous or unusual transactions occurring shortly before the endof the period;

Examining product details on the invoices;

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Is the invoice cut with all products ordered whether shipped or not?

Obtain understanding of drop shipments to customers; if a dropshipment is partial, is the invoice to the customer also partial?

How does the company ensure all drop shipped products areproperly accounted for in the sales invoice process and also in

paying for the goods to the supplier? Reviewing customer complaints regarding lack of completeness in

shipments.

In addition, the auditor will want to inquire of management and sales personnel

regarding the policy and process for billing partially filled orders. A review of the

shipping documents and comparison to the sales journal will also often reveal

what was booked as sales and what was actually shipped. The auditor may also

consider talking to customers or reviewing correspondence from customers to

see if there are numerous complaints from customers regarding partial

shipments.

5.5.2 Soft Sales

Case Illustration

In 1996, the SEC charged Advanced Medical Products employees with

recognizing revenues on soft sales or sales for which the customer had

expressed interest but not actually committed to purchasing. The company

shipped the products to its field representatives, who held them while the

customer decided whether to purchase the product.

The company however, recognized the revenue as of the date of the shipment to

the field representative. Employees withheld sending invoices and monthly

statements to prevent customer complaints resulting from being invoiced forequipment that they had not agreed to purchase.

To detect this scheme, the auditor may wish to review customer complaint logs

and correspondence for complaints of goods shipped prior to the customers

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readiness to accept or when the customer was merely making inquiry into the

goods.

5.5.3 Contracts With Multiple Deliverables

Another common scheme occurs when companies ship product or equipment to

customers who are not obligated to pay for such equipment until it is accepted.

Acceptance typically requires a seller to substantially complete or fulfil all the

terms of an arrangement before delivery is deemed to have occurred. Common

customer acceptance provisions included in contracts that, if not satisfied by the

seller, would preclude recognition include:

Sellers obligation to perform additional services subsequent to thedelivery, e.g., product installation and activation;

Product testing prior to payment; and

Training of personnel with respect to produce use.

If a contract requires the seller to provide multiple deliverables or elements, the

delivery is not deemed complete unless substantially all elements or deliverables

are delivered. The sales revenue should be recognized only if inconsequential

elements remain to be delivered.

When assessing whether revenue can be recognized prior to delivery of all

required elements or deliverables, the criteria under GAAP is whether the

undelivered portion is essential to the functionality of the total deliverable.27

SAB 101 enumerates several factors that should be considered in determining

whether remaining performance obligations are substantial or inconsequential.28

Case Illustration

The SEC action against Advanced Medical Products is a classic example of

improperly recognizing revenue on contracts with multiple deliverables.29 Rather

than shipping the product to the customer, Advanced Medical Products shipped

products to companys field representatives, who were responsible for installing

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the product and training the customers employees. The SEC charged that the

company incorrectly recognized revenue upon shipment to the field

representatives. This policy contravened GAAP as there was no economic

exchange and risk of loss had not passed to the customer because the products

were still in the control of the company.

In addition to the general indicators listed above, this scheme, which has been

prevalent in the software industry, can possibly be uncovered by confirming with

major customers whether all services have been performed with respect to the

products purchased and received. For companies that deal with distributors of

their product, auditors should obtain an understanding as to whether the

company forces a pre-determined listing of SKUs to its distributors, without an

order from the distributors. If this is the case, there may be a culture of forcing

product out to distributors to meet the numbers. A rash of returns from the

distributors in subsequent months might also reveal this practice. Further

manipulation of the books and records can occur by the entity when these

returns are not processed in a timely fashion.

5.5.4 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.

5.6 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 customer however, for whatever

reason, may not be ready, willing, or able to accept delivery of the product at that

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particular point in time. The seller holds the goods in its facility or ships them to a

different location, such as a third party warehouse for storage until the customer

is ready to accept 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 SEC30, 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 ona bill and hold basis;

Delivery must be fixed and on a schedule that is reasonable andconsistent with the buyer's business purpose;

Seller must not retain any specific performance obligations under theagreement such that the earning process is not complete;

Ordered goods must be segregated from the seller's inventory and not besubject to being used to fill other orders; and

Product must be complete and ready for shipment.

In addition to the above factors, the SEC also recommends preparers of financialstatements to consider:

The date by which the seller expects payment, and whether the seller hasmodified its normal billing and credit terms for this buyer;

The seller's past experiences with and pattern of bill and hold transactions;

Whether the buyer has the expected risk of loss in the event of a declinein the market value of goods;

Whether the seller's custodial risks are insurable and insured; and

Whether extended procedures are necessary in order to assure that thereare no exceptions to the buyer's commitment to accept and pay for thegoods sold (i.e., that the business reasons for the bill and hold have notintroduced a contingency to the buyer's commitment).31

Auditors coming across agreements that do not meet the above criteria should

be wary of potential bill and hold schemes. Auditors should consider whether:

Bills of lading are signed by a company employee rather than shippingcompany;

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Review of shipping documents indicates excessive shipments made towarehouses rather than to a customer's regular address (which couldmean that shipments are made to the sellers warehouses rather thancustomer locations);

Shipping information is missing on invoices;

High shipping costs incurred near the end of the accounting period; Large, numerous or unusual sales transactions occurring shortly before

the end of the period; or

Decrease in current year monthly sales from the prior year that mayindicate the reversal of fraudulent bill and hold transactions in asubsequent period.

When confronted with the above indicators, the auditor should first inquire of

management regarding any bill and hold policies and any customers with bill and

hold arrangements. The auditor should also make inquiry of warehouse

personnel regarding customer inventory being held on the premises in a third

party warehouse, or shipped to another company facility. Finally, the auditor

should inquire of shipping department or finance personnel if they have ever

been asked to falsify or alter shipping documents.

If additional investigation is warranted, the auditor should review the customer

contracts to determine whether they meet the requirements of SAB 101

enumerated above. The auditor should also:

Review underlying shipping documents for accuracy and verify existenceof transactions;

Compare shipping costs to prior periods for reasonableness.

Review warehouse costs and understand the business purpose of allwarehouses owned/used by the company;

Confirm special bill and hold terms with customers directly includingtransfer of risk of loss and liability to pay for the bill and hold goods;

Test reconciliation of goods shipped to goods billed for accuracy;

Select a sample of sales transactions from the sales journal, obtain the

supporting documentation and- Inspect the sales order for approved credit terms;

- Compare the details among the sales orders, shipping documents andsales invoices for inconsistencies;

- Compare the prices on sales invoices against published prices; and

- Re-compute any extensions on sales invoices; and

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In conjunction with the physical inventory, tour the facility orwarehouse and inquire of warehouse personnel about any held customerproducts.

Case Illustration

In 2003, the SEC charged Anika Therapeutics with improperly recognizing

approximately $1.5 million in revenue form a bill and hold transaction. A

distributor placed orders with Anika for a total of approximately 15,000 units of a

particular product in April and July 1998. As part of the agreement with the

distributor, Anika invoiced the distributor for the total 15,000 units for over

$500,000 in September 1998 but held the product at Anikas refrigerated facility

until the distributor requested the product, which did not occur until March 1999.However, Anika recorded the revenue for this sale in the quarter ended

September 30, 1998. 32

5.7 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.

5.7.1 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. These schemes involve the preparation of false

supporting documentation to provide backup to non-existing sales or services

never rendered.

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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 apparentbusiness relation to the business;

Increased sales accompanied by stagnant or decreasing cost of sales andcorresponding improvement in gross margins;

Improvement in bad debts as a percentage of sales; and/or

Decrease of shipping costs compared with sales.

Fictitious revenue schemes are relatively easy to investigate, once detected.The audit or investigative team should focus on accounting personnel and inquire

whether:

Revenues are recorded outside of the normal invoicing process, orstandard monthly journal entries;

Journal entries have adequate, proper and bona fide supportingdocumentation;

Accounting personnel have been pressured to make or adjust journalentries; and

Accounting or sales personnel have been pressured to create falseinvoices for existing or fictitious customers.

The auditor should also inquire whether sales or shipping personnel have noted

any unusually high sales or shipments to customers with no reasonable

explanation or noted any significant sales or shipments to unfamiliar new

customers.

Auditors should also consider the following detection procedures:

Send confirmations to customers who may be associated with suspicioustransactions;

Perform alternative procedures for confirmations not returned or returnedwith material exceptions such as:

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- Including other matters on the confirmations such as anyconsigned inventories held at the customer location or held for thecustomer; and

- Including amount of pending returns on the confirmation as a blankline for the customer to complete.

Review journal entries and supporting documentation, and verify theiraccuracy;

Identify amount of returns in subsequent period;

Look for sales which reverse in the subsequent period; and

Conduct research of publicly available information (e.g., on-line database,manual record and Internet) to verify existence and legitimacy ofcustomers. Follow up physical visits may also be prudent.

Case Illustration

Consider the case of medical device supplier, Boston Japan33, which during fiscal

years 1997-1998 recognized over $75 million dollars of revenue from fraudulentsales. Company sales managers leased commercial warehouses, recorded false

sales to distributors, and shipped the goods to the leased warehouses. The

company masked the fact that the distributors never paid for the goods by issuing

credits to the distributors and then recording false sales of the same goods to

other distributors, without ever moving the goods out of the leased warehouses.

Company employees even recorded sales to distributors that were not involved

in the medical device business, but that had agreed with company sales

managers to collude in the fraud. Some of the false sales were made to

distributors that never resold any of the goods and never paid Boston Japan for

any purported sales. The sales managers and cooperating independent

distributors further colluded to cover up false sales by falsely confirming the

legitimacy of the sales to the companys auditors.

5.7.2 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

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that the customer will ever repay the loan. These transactions are deemed

completed for the sole purpose of inflating revenue and creating the appearance

of strong sales.

Round tripping recently has occurred extensively in the telecommunications and

oil and gas industries. For example, numerous telecommunication companies

boosted their sales volume by exchanging the indefeasible rights of use on their

fiber-optic networks to other telecommunications companies (this practice was

known in the industry as capacity swaps.) These transactions were sometimes

booked as income even though the swaps generated no net cash for either

company.

Case Illustration

In 2002, the SEC began investigating the way telecom giant Qwest

Communications International Inc. and some of its competitors, such as Global

Crossing accounted for sales of fiber-optic capacity and whether it was proper for

the company to recognize the revenue right away immediately.

Qwest sold capacity on their fiber-optic network to carriers and also purchased

capacity from them. Both companies recognized revenue from capacity swaps

and indefeasible rights of use (IRU) that allowed another carrier or company the

unfettered use of the capacity over a long period of time. In some cases, the

amount of the sale and purchase were almost identical. Qwest booked the

revenue from these sales all at one time instead of deferring part of it over many

years. GAAP however, requires companies to record the revenue generated by

an IRU over the time of the contract.

The effect was to boost Qwest's revenue by $1 billion in 2001 and $465 million in

2000.

Since most roundtrip transactions involve counterparties in the same line of

business, an auditor should review a list of the companys significant customers.

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If there is a customer in the same line of business, the auditor should scrutinize

the transactions for evidence of any round tripping. The auditor should also

review the vendor list and compare it to the customer list. The same company

appearing on both lists might indicate round tripping. There is always the

possibility of an intermediary being involved in the transaction, so an auditor

should be aware of companies that appear on the two lists but would not be valid

customers or vendors. Round tripping often takes place with related parties so

the auditor should be aware of related party transactions and follow the steps

outlined in Section 5.9.5

5.8 Other Improper Recognition Schemes

5.8.1 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.

5.8.2 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. Direct

inquiry of accounting personnel, billing clerks and warehouse personnel may

assist in determining whether the books are held open past the end of the period.

Computer forensics can also be used to ferret out these schemes.

Case Illustration

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In 1993, the management of Platinum Software Corp., was concerned about the

companys "days sales outstanding" ("DSO") the measure of the time a

company takes to collect its receivables. The companys DSO had increased

throughout 1993, in part because it had improperly recognized revenue on

contingent or cancelled license agreements. One of the companys responses to

the increasing DSO was to hold open the companys open for cash received after

period-end. Management recorded checks received by the company in July

1993, on the companys balance sheet as an increase in cash and a reduction in

receivables as of June 30. Holding the books open resulted in a cash

overstatement and associated receivable understatement. Similarly, for the

quarter ending September 1993, management included cash that the company

received for about a week into October, resulting in a cash overstatement and

accounts receivable understatement of $724,000. The same pattern continued

through December 1993, resulting in a cash overstatement and accounts

receivable understatement of $3,463,000. The company was ultimately ordered

to cease and desist in this practice by the SEC.

5.8.3 Recognizing Income on Consignment Sales or Products Shipped forTrial/Evaluation Purposes

SAB 101 prohibits revenue recognition from consignment arrangements until

completion of actual sale. The same criteria apply to products delivered for

demonstration purposes. 34 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. Particular attention

must be paid to the terms, facts and circumstances of any agreement in which:

The buyer has the right to return the product and

- Buyer does not pay the seller at the time of sale, and the buyer isnot obligated to pay the seller at a specified date or dates;

- Buyer does not pay the seller at the time of sale but rather isobligated to pay at a specified date or dates, and the buyers

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obligation to pay is contractually or implicitly excused until the buyerresells the product or subsequently consumes or uses the product;

- Buyers obligation to the seller would be changed (e.g., the sellerwould forgive the obligation or grant a refund) in the event of theftor physical destruction or damage of the product;

-

Buyer acquiring the product for resale does not have economicsubstance apart from that provided by the seller; or

- Seller has significant obligations for future performance to directlybring about resale of the product by the buyer; and

- The product is delivered for demonstration purposes.35

Case Illustration

In the second quarter of 1998, FLIR Systems inappropriately recognized

$225,000 in revenue relating to a consignment sale. The purchase order

submitted by the FLIRs customers stated payment for each system to bemade when a system is sold by [the customer] to an outside customer. Despite

these words, FLIR recognized revenue from this sale, even though no end-user

was ever identified at the time of the purchase order.36

5.8.4 Contract Accounting Schemes

GAAP provides for contract revenue to be recognized using either the

percentage of completion or completed contract method. The percentage ofcompletion 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. 37 Conversely,

GAAP requires the "completed contract" method when management cannot

reliably estimate progress toward completion. The completed contract method

requires the company to postpone recognizing revenue until the contractual

obligations have been met.38

The percentage of completion is the method that is most often subject to abuse.

Some companies will use the percentage of completion method notwithstanding

that they do not qualify for that method. Companies can artificially inflate

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revenue by increasing the costs incurred toward completion, underestimating the

costs of completion, or overestimating the percentage completed.

The auditor should perform the following procedures when performing an audit or

investigation of contracts:

Select a sample of contracts and confirm:o Original contract price;

o Total approved change orders;

o Total billings and payments;

o Details of claims;

o Back charges or disputes; and

o Estimated completion date.

Ensure that all incurred costs are supported with adequate documentation

detailing the nature and amount of expense; Audit estimated costs to complete by reviewing estimates and comparing

with actual costs incurred after the balance sheet date;

Ensure that all estimated costs to complete the contract should besupported by reasonable assumptions;

Ensure that all contracts are approved by appropriate personnel;

Review unapproved change orders;

Identify unique contracts and retest the estimates of cost and progress onthe contract;

Test contract costs to ensure costs are matched with appropriatecontracts and costs are not shifted from unprofitable contracts to profitable

ones; Ensure that losses are recorded as incurred;

Review all disputes and claims;

Visit the construction contract site to view the progress of a contract;and/or

Interview project managers, subcontractors, engineering and technicalpersonnel to get additional information on the progress of an engagementand the assumptions behind the contract.

Case Illustration

In 1996, the SEC charged 3Net Systems with improperly recognizing over $1

million of revenue in both 1991 and 1992, by misrepresenting to its outside

auditors the degree to which certain work had been completed under certain

contracts with existing customers. In fact, 3Net had not completed any of the

contracts, and in addition, had not even determined the costs to complete.

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Further, 3Net had no other means of reliably estimating progress toward

completion for these contracts, as it lacked the systems necessary to estimate

and track progress on their development. Because 3Net could not reliably

estimate progress toward completion, the contracts in question did not qualify for

the percentage of completion method. The SEC charged 3Net should have used

the completed contract method for the contracts. Had it done so, 3Net would not

have reported revenue in fiscal 1991 because it completed none of these

contracts by the end of fiscal 1991.39

5.8.5 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. The existence

of related party transactions cuts to the very first criteria of SAB 101 that there be

persuasive evidence of an arms length arrangement. Sales transactions should

stem from express or implied contracts and represent exchanges between

independent parties at arms-length prices and terms. 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. Related party schemes can take place in

the context of any of the schemes listed in this chapter.

Transactions between related parties are often difficult to audit as these

transactions are not always accounted for in a manner that communicates their

substance and effect with transparency. The possibility of collusion always exists

given that the parties are, by definition, related. Internal controls, moreover,

might not identify the transactions as involving related parties.

An auditor may encounter related parties that are known by some members of

the company; however, the relationships are not properly disclosed in the books

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and records. The auditor should inquire as to outside business interests and

then try to determine whether they are properly disclosed, and the volume of

transactions, if any, that are occurring between the entities.

Auditors should also focus on the relationship and identity of the other party to

the transaction and whether the transaction emphasizes form over substance.

Common indicators of such related party, sham transactions include but are not

limited to:

Borrowing or lending on an interest-free basis or at a rate of interestsignificantly above or below market rates;

Selling real estate at prices that differ significantly from appraised value;

Exchanging property for similar property in a non-monetary transaction;

Loans with no scheduled terms for when or how the funds will be repaid. 40

Loans with accruing interest differing significantly from market rates;

Loans to parties lacking the capacity to repay;

Loans advanced for valid business purpose and later written off asuncollectible;41

Non-recourse loans to shareholders;

Agreements requiring one party to pay the expenses on the others behalf;

Round tripping sales arrangements (seller has concurrent obligation topurchase from the buyer);

Business arrangements where the entity pays or receives payments of

amounts at other than market values; Failure to adequately disclose the nature and amounts of related party

relationships and transactions as required by GAAP42;

Consulting arrangements with directors, officers or other members ofmanagement;

Land sales and other transactions with buyers of marginal credit risk;

Monies transferred to or from the company from a related party for goodsor services that were never rendered;

Goods purchased or sent to another party at less than cost;

Material receivables or payables from to or from related parties such asofficers, directors and other employees;43

Discovery of a previously undisclosed related party;

Large, unusual transactions with one or a few other parties on or at periodend; and

Sales to high-risk jurisdictions or jurisdictions where the entity would notbe expected to conduct business.

.

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If related party transactions are detected or suspected, the auditor should

consider further inquiry, including:

Conducting public records searches/background investigations oncustomers, suppliers and other individuals to identify related parties and

confirm legitimacy of business; Performing data mining to determine whether transactions appear on

computerized files;

Performing document review of identified transactions to obtain additionalinformation for further inquiry;

Searching for unusual or complex transactions occurring close to the endof a reporting period;

Searching for significant bank accounting or operations for which there isno apparent business purpose;

Reviewing the nature and extent of business transacted with majorsuppliers, customers, borrowers and lenders to look for previously

undisclosed relationships; Reviewing confirmations of loans receivable and payable for indications of

guarantees;

Performing alternative procedures if confirmations are not returned orreturned with material exceptions;

Reviewing material cash disbursements, advances and investments todetermine if the company is funding a related entity;

Testing related party sales to supporting documentation (i.e., contract andsales order) to ensure appropriately recorded;

Discussing with counsel, prior auditors and other service providers theextent of their knowledge of parties to material transactions; and

Inquiring about side agreements with related parties for right of return orcontract cancellation without recourse

6. Asset Overstatement/Liability Understatement Schemes

Improper reporting of assets is another way for companies to overstate earnings.

A direct relationship exists between overstatement of assets/understatement of

liabilities on the balance sheet and the inflation of earnings. The WorldCom

scandal for example, exemplifies how expenses improperly capitalized as assets

on the balance sheet can serve to inflate income. In many cases, perpetrators

are looking for a place on the balance sheet to place the debit. Overstating an

asset or understating a liability usually occurs with this scheme. Accounts such

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as inter-company and foreign currency exchange gain/loss should not be

overlooked as potential places to hide the debit.

Common asset overstatement fraud schemes include:

Creating fictitious assets;

Manipulating balances of legitimate assets with the intent to overstatevalue;

Understating liabilities or expenses, including failing to record (ordeliberately under estimating) accrued expenses, environmental litigationliabilities and other business problems;

Misstating inter-company expenses; and

Manipulating foreign currency exchanges.

An auditor can often become alert to the possibility of fictitious or over inflated

assets by inquiring as to whether the entity intends to secure financing. If the

answer is yes and if that financing is contingent on the value of particular assets

such as receivables or inventory, that should lead the auditor to ask more

questions and perform additional procedures to verify the existence, and location

and value of these assets. As with certain other schemes, the auditor can most

often detect these schemes by observing the companys operations and inquiring

as to unusual items.

6.1 Inventory Schemes

The original COSO Report found that fraudulent asset valuations comprised

nearly half of the cases of financial fraud statements. Misstatements of

inventory, in turn, comprised the majority of asset valuation frauds.

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:

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Artificially inflating the quantity of inventory on hand;

Inflating the value of inventory by- Postponing write-downs for obsolescence);- Manipulating unit of measurement to inflate value;- Under-reporting reserves for obsolete inventory, especially in

industries where products are being updated or have a short shelflife; and

- Changing between inventory reporting methods (average costing,last invoice price, LIFO, FIFO, etc.);

Fraudulent or improper inventory capitalization.

Following are indicators an auditor can look for to detect possible inventory

manipulation:

A gross profit margin which is higher than expected;

Inventory that increases faster than sales;

Inventory turnover that decreases from one period to the next;

Shipping costs that decrease as a percentage of inventory;

Inventory as a percentage of total assets that rise faster than expected;

Decreasing cost of sales as a percentage of sales;

Cost of goods sold per the books that do not agree with the company's taxreturn;

Falling shipping costs while total inventory or cost of sales have increased;and

Monthly trend analyses that indicate spikes in inventory balances nearyear-end.

6.1.1 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.

Some companies even go as far as maintaining empty boxes in a warehouse.

The most effective way for the auditor or auditor to confirm the inventory balance

is physically to observe the clients inventory, particularly at times when an

inventory count is being performed. In fact, Generally Accepted Auditing

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Standards (GAAS) require auditors to physically observe, test, and inquire as to

the amount of inventory on hand and to satisfy themselves with respect to the

methods of inventory taking and the measure of reliance placed upon the clients

representations about the quantities and physical condition of inventories.44

When the auditor cannot be satisfied as to the inventories he or she must

physically count the inventory and test transactions in that account.45 Where

inventory is stored outside the company site, such as public warehouses,

auditors should conduct additional procedures to confirm balance.

Case Illustration

Fraud history is filled with names of companies made famous or infamous by

fictitious inventory schemes including McKesson and Robbins, ZZZ Best and

Crazy Eddie. The most famous bogus inventory fraud perhaps is the Salad Oil

Swindle of the 1960s. In that case, management of the company rented

petroleum tanks and filled them with seawater. The company was able to

convince the auditors that the tanks contained over $100 million in vegetable oil

because the oil rose to the top of banks. In fact, the little oil that was present was

pumped from one tank to the next depending on the companys advance

knowledge of the auditors inventory observation plan.46

The auditor should look for the following operational factors may arouse

suspicions of fictitious inventory:

Inventory that cannot be easily physically inspected;

Unsupported inventory, cost of sales or accounts payable journal entries;

Unusual or suspicious shipping and receiving reports;

Unusual or suspicious purchase orders;

Large test count differences;

Inventory that does not appear to have been used for some time or that isstored in unusual locations;

Large quantities of high cost items in summarized inventory;

Unclear or ineffective cut-off procedures or inclusions in inventory ofmerchandise already sold or for which purchases are not recorded;

Adjusting entries which have increased inventory over time;

Material reversing entries to the inventory account after the close of theaccounting period;

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Inventory that is not subject to a physical count at year end;

Improper or accidental sales that are reversed and included in inventorybut not counted in physical observation (for example a companyaccidentally delivers a specifics product to a customer, tells the customerit was a mistake and requests the customer to send the product back);

and Excessive inter-company and interplant movement of inventory with little

or no related controls or documentation.

Even physical observation however, is not fail-proof. Even when an auditor can

observe inventory, a company can still perpetrate fraud by:

Following the auditor during the course of the count and adding fictitiousinventory to the items not tested;

Obtaining advance notice of the timing and location of the inventorycounts thereby permitting the company to conceal shortages at locations

not visited; Stacking empty containers at the warehouse which are not checked during

the count;

Entering additional quantities on count sheets, cards, scanners, etc. thatdo not exist or adding a digit in front of the actual count;

Falsifying shipping documents to show that inventory is in transit from onecompany location to another;

Falsifying documents to show that inventory is located at a publicwarehouse or other location not controlled by the company;

Including consigned items as part of the inventory count; and

Including items being held for customers as part of the inventory count.

To deter management from inflating inventory during physical counts, the auditor

should consider:

Reviewing company policy for inventory counts (frequency andprocedures);

Inquiring of management and internal audit as to the dollar adjustment ofthe book to physical counts and the reasons for the significant differences;

Inquiring as to whether all inventory shrinkages have been reported;

Inquiring and observe inventory at third-party locations/off-site storage

locations; Observing a physical inventory unannounced; and

Conducting physical inventories for multi locations all on the same date.

6.1.2 Inflating Inventory Value

GAAP requires that inventory be reported at the lower of replacement cost or

market value (i.e., current replacement cost.)47 Companies inflate inventory value

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for a variety of reasons other than to boost earnings. For instance, a common

reason to inflate the value of inventory is to obtain some form of financing using

the inventory as collateral. The higher the value of the inventory, the more the

company will be able to obtain in the form of financing.

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.

Another common way to inflate inventory value is to delay the write-down of

obsolete or slow moving inventory, since a write down would require a charge

against earnings.

Auditors thus should be fully aware of the items comprising inventory and their

life cycles, particularly as it relates to that industry. In addition, during the

physical observation of the inventory, the auditor must look for and inquire about

older items that appear to be obsolete. 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.

When a potential inventory valuation problem is detected or suspected, the

auditor should consider:

Inquiring of accounting personnel as to the companys inventory pricingpolicy and how they identify net realizable value mark-downs;

Inquiring of management, accounting and finance personnel as towhether the company has shown historical patterns in the past of over

valuation (i.e., prior year write down which became value impaired); Inquiring of accounting personnel as to whether they have ever been

requested to delay inventory write downs due to obsolescence etc.;

Touring the warehouse looking for items which appear to be old orobsolete and asking warehouse personnel if stock is slow moving,damaged or obsolete;

Inquiring of accounting personnel if they are aware of any items beingsold below cost; an

Frank-Common Financial Fraud Schemes 7May 03v1

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