Fraud Examination Albrecht, 2014 SH

Chapter 13:
Discussion Questions 2, 3 & 4
2. List the four methods used to perform analytical analyses to search for financial
statement fraud symptoms. Give an example of each method as it applies to searching for
symptoms related to underreporting of liabilities.
The four methods for analytical analysis of fraud symptoms in financial statements are:
comparing changes and trends in financial statement account balances, comparing changes and
trends in financial statement relationships, comparing financial statement balances with
nonfinancial information or other information, such as the number or quality of the assets they
represent, and comparing financial statement balances with those used by other similar
companies (Albrecht, 2014).
Comparing changes and trends in financial statement account balances from period to
period can be done using the horizontal analysis on liabilities accounts. When there is a
significant change or alteration in the trend such as sudden decrease of liabilities, then it might
be a sign of fraud. For example, company ABC provided its 5 period of financial statements.
When horizontal analysis is performed, a significant decrease on the accounts payable account in
the fourth period and fifth period are found, this can be a red flag of understatement of liabilities
that have to be checked upon further.
Comparing changes and trends in financial statement relationships from period to period
by preparing financial statements and perform vertical analysis. With this method, the percentage
of liability from the total assets or total liabilities and equities will be found. The changes in the
liabilities percentage over the years can be seen and identify easily when there is a big change or
an unusual one. The big change or the unusual one has to be investigate further whether it is a
sign of fraud or not. For example, from the second to third period, the percentage of liabilities
has gone down drastically, from 50% to 25%. This sudden big change has to be analyzed further
as it can be a sign of underreporting liabilities fraud.
Comparing financial statement amounts with assets they are supposed to represent or
with nonfinancial statement factors as comparing liabilities is hard and quite useless. Liabilities
do not represent specific assets except mortgage liabilities which is specific for an asset like
building or a liability used to buy a car or other transportation methods. This kind of liability can
be analyzed whether the company is underreporting its liability but only for this specific liability.
For example, when a company is writing off its mortgage liability whereas it actually is still
payable then the company is indeed underreporting its liabilities.
Comparing financial statement information with other companies can be done using the
vertical analysis or direct comparison. Commonly, comparing liabilities is not useful when a
company is being compared against another one as a company would have different ways of
financing its business. The common comparison between companies would be revenue,
inventory, accounts receivable and others. However, it can be a sign of undervaluing liability
when a company percentage of interest expense, in which it represents the liabilities, is only 3%
of the sales, when other companies in the same industry has interest expense that accounts 5-7%
of their sales.

3. Explain what is meant by cutoff problems as they relate to accounts payable.

Cutoff regards about whether a transaction is recorded in the correct accounting period or
not (Accounting Concern, n.d.). Cutoff problems happen when a firm does not record its
Fraud Examination Albrecht, 2014 SH

transactions in the appropriate accounting period, such as delaying the write-down of obsolete
inventory, recording returns in a later period, recording purchases from previous period, and so
forth (Albrecht, 2014). In the context of accounts payable, cutoff problems which often happened
are recording current liabilities in the next accounting period when the current period is deemed
to have not performed well so that it may look better than it actually is. A company usually
record the current inventory purchase payable in the next period or record return of goods in an
earlier period to have recorded lower accounts payable.

4. Why might liabilities be understated if proper adjusting entries are not made at the end
of an accounting period?
The purpose of each adjusting entry is to get both the income statement and the balance
sheet to be accurate (Averkamp, 2015). Usually the adjusting entries related to the liabilities are
used for reducing liability when the goods have been delivered to the customers or when the
companies had paid some of its liabilities to the creditors. Yet, there is a possibility that the
liabilities are underreported even though proper adjusting entries are not made when the
employee wages are not yet paid. When the employees services had been utilized by a company
and their wages have not yet been paid, the wages payable will not be recorded when there are
no proper adjusting entries. The same scenario also can be applied to tax payable. It is common
for a company to understate its liability as it is seen to be a burden and an obligation that will
reduce a companys wealth.

Case 7
Calculate all ratios needed to determine if XYZ is possibly underreporting accounts
payable. If you detect possible fraud, explain why you think it might exist.
Ratios 20x1 20x2 20x3
Acid-test ratio 1.11817 1.06681 0.73022
2 2
Current ratio 1.48990 1.37056 1.00180
5 9 3
Accounts payable/total liabilities 0.11461 0.11817 0.16980
and equity 6 1 1
Accounts payable/cost of goods sold 0.30784 0.22641 0.30884
9 1
Accounts payable/total liabilities 0.23132 0.19276 0.19113
8 2 8
Accounts payable/inventory 3.67650 3.69784 5.28666
9 2 7
There is a possible understating accounts payable in the second year of the reporting year as the
sign of fraud will show when the first two ratios are increasing and the rests are decreasing. It
can be seen that the fourth and fifth ratios, which are accounts payable/cost of goods sold ratio
and accounts payable/total liabilities ratio, are dropping from the first year to the second year (as
shown in the table with bold numbers). The decreasing value is most likely caused by the
significant decrease in accounts payable that can be a sign of underreporting accounts payable.
Fraud Examination Albrecht, 2014 SH

The accounts payable is the nominator in the calculation, so when it is decreasing then the results
of the calculation would also decrease assuming the denominator is held constant. The dropped
in value of the ratios are quite significant although it is still below 0.1. When the changes are
calculated in percentage, they become -26.44% and -16.66% respectively for the fourth and fifth
ratio, which shows that the changes are quite significant.

Case 9
1. Determine the red flags that exist in these financial statements. Describe the scenarios
that might contain these symptoms.
Vertical Analysis
20x1 Percent 20x2 Percent 20x3 Percent
age age age
Sales $ 100% $ 100% $ 100%
37,847,68 12,445,01 8,213,23
1 5 6
Cost of $ 58.00% $ 45.10% $ 44.93%
goods sold 15,895,74 6,832,927 4,523,18
1 6
Gross $ 42% $ 55% $ 55%
margin 21,951,94 5,612,088 3,690,05
0 0
Horizontal Analysis
20x1 20x2 Percent 20x2 20x3 Percent
age age
Sales $ $12,445, -67% $12,445, $ -34%
37,847,68 015 015 8,213,23
1 6
Cost of $ $ -57% $ $ -34%
goods sold 15,895,74 6,832,92 6,832,92 4,523,18
1 7 7 6
Gross $ $ -74% $ $ -34%
margin 21,951,94 5,612,08 5,612,08 3,690,05
0 8 8 0

There are some red flags that can be found in the financial statements, such as the
overstatement of the sales in 20x1, overstatement of the accounts receivables in 20x1, and
overstatement of the cost of goods sold in 20x1. The overstatement of sales in the first year can
be seen as the calculation from the horizontal analysis indicates a big drop from the first year
sales to the second year compared to the second year sales to the third year. The overstatement of
receivables in the first year is shown by the net of allowance for doubtful accounts that are
$148,300 and $139,200 respectively for the first and second year. It is odd that the net allowance
for doubtful accounts in the two years are not that difference, whereas the amount of the
receivables decrease significantly from $12,592,231 to $3,932,170. Commonly, the net of
allowance for doubtful accounts is held constant by a percentage of the accounts receivable. Yet,
it is not the case for ABCDE company. The overstatement of the cost of goods sold can be seen
Fraud Examination Albrecht, 2014 SH

in the vertical analysis calculation above, which shows that the cost of goods sold for the first
year is significantly higher than the second and third year.
Overstatement of sales can happen when the accountant is recording bogus sales from
both bogus and real customers. It can also be done by recording the sales when the goods have
not been received by the customers, which is supposed to be recorded as liability. Another way to
do it is to record sales when the goods are actually returned by the customers.
Overstatement of accounts receivable can be done in many ways. The accountant can
record accounts receivable even when the customers already paid or paid in cash. When the
goods are not yet been paid by the customers but returned because of the bad quality, but the
accountant still do not reduce the accounts receivable amount. Recorded bogus sales can also
lead to recording of bogus accounts receivable.
Overstatement of the cost of goods sold usually is done to minimize the margin or profit
so that the company will pay less tax. It can be done by accounting the cost of the unsold goods
or damaged goods. The inclusion of the work in process cost can also be used to overstate the
cost of goods sold. The company can increase the cost of goods sold by recording the expense as
one of the component of the cost of goods sold.

2. Based upon the red flags and scenarios you identified, determine what types of financial
statement fraud the company may be involved in. (Hint: Pay careful attention to cost of
goods sold, sales, and allowance for doubtful accounts.)
It is most likely that the company is doing the fictitious revenue and asset
misappropriation financial statements fraud. The overstatement of revenue indicates the fictitious
revenue fraud. The overstatement of cost of goods sold and the overstatement of accounts
receivable are the indications of the asset misappropriation fraud, in which includes the asset
overstatement fraud.

Case Study 2
1. Suppose you are an accountant for pre-fraud WorldCom. You have just been instructed
by the CFO to alter specific company accounts in order to boost the companys numbers
before fourth quarter disclosures. You know the actions are unethical, but you fear that
refusing to comply with executive orders may result in punishment and possible
termination of your job. What would you do?
I would try to give an explanation to the CFO regarding the action that is not ethical
while also describing the consequences when the fraud is found out by the public, such as losing
the trust of the stakeholders especially the shareholders, penalties and punishment that will be
given by regulators as by doing the fraud, it means that the company fails to comply with the
regulation and the accounting standards. When it does not work, I would blow the whistle by
notifying the internal auditor and the audit committee regarding the order from the CFO to alter
some accounts in the financial statement. If by any chance the report about the order is not
responded well, I would have to notify related external parties such as SEC or the public. I
believe that the truth and justice will have to be prioritized and that if I got any punishment or
fired, it will all be worth it at the end and that I will be fine as I am not the one in fault.
Fraud Examination Albrecht, 2014 SH

2. Although it usually doesnt involve physically stealing money, financial statement fraud
is commonly considered the most expensive type of fraud. Why is this true?
Financial statement is made to provide information regarding a companys condition and
its operation performance (Bragg, 2012). The financial statement is used by the stakeholders
especially the shareholder to make decision about their investment plan. As the shareholders
usually rely on a companys financial statement to make decision on where to invest their money,
when the information in the financial statement is not correct, it may mislead the investors to
make wrong decisions. Those wrong decisions will then make the investors lose their money or
at least choose the investment that does not give them the maximum return.
In the point of view of the company, it is quite costly to make financial statement. It is not
easy to manipulate the data in the financial statement. There are too many risks to be taken when
committing financial statement fraud. The company can lose its investors when the fraud is
revealed. The company will also have to pay big amount of money for the punishment of doing
such fraud. If the fraud is brought out to the public, the companys life is at stake. Hence, it is the
most expensive type of fraud.

3. The Sarbanes-Oxley Act of 2002 has, in many ways, changed the role of financial
statement auditors. In addition to ensuring financial statement accuracy, independent
auditors are now required to review a companys internal controls and report their
assessments in the companys annual report. How might these new policies help prevent
financial statement fraud from occurring?
The internal auditors have the obligation to create a good internal control and maintain it.
However, they cannot be fully trusted as they are not independent from the company itself.
Hence, it is the job of independent auditors to ensure the companys internal controls are good.
Reviewing, assessing, and reporting the condition of the internal controls in a company will help
improving and maintaining the internal controls in the company. When there are good internal
controls, supposedly there will be no fraud in the company. The internal controls will reduce the
opportunity for the fraudster to commit fraud or in the case of financial statement fraud, the
management will have no or little opportunity to conduct fraud in the financial statement.

References
Accounting Concern, n.d. Accounting Dictionary: Cutoff. [Online]
Available at: http://www.accountingconcern.com/accounting-dictionary/cutoff/
[Accessed 24 11 2016].
Albrecht, Albrecht, Albrecht and Zimbelman, 2014, Fraud Examination, 5ed, Cengage Learning
Averkamp, H., 2015. What are adjusting entries. [Online]
Available at: http://www.accountingcoach.com/blog/appreciating-adjusting-entries
[Accessed 27 11 2016].
Bragg, S., 2012. Accounting Tools: What is the purpose of financial statements?.
[Online]
Available at: http://www.accountingtools.com/questions-and-answers/what-is-the-
purpose-of-financial-statements.html
[Accessed 27 November 2016].
Fraud Examination Albrecht, 2014 SH