Fraud and

Financial
Shenanigans
Pertemuan ke 8

Fraud
Auditors responsibility for detecting fraud has
generated considerable controversy and it is
popularly believed that auditors are responsible for
detecting fraud. Detection of fraud and error was at
one time an important function of audit, but today
auditors concentrate on assessing the integrity and
competence of management, and the effectiveness
of internal control, using analytical procedures, and
largely restricting detailed audit work to high risk
areas.

Fraud
The auditing standard on fraud states that it is not
the auditors function to prevent fraud and error,
but that auditors plan, perform and evaluate their
audit work in order to have a reasonable
expectation of detecting material misstatements
arising from error or fraud.
Management has prime responsibility to prevent
and detect the occurrence of fraud through
appropriate systems of internal control and other
means.

Fraud
Board of directors responsibilities include
maintaining sound internal controls to safeguard
shareholders investment and company assets,
including prevention and detection of fraud and
error.

Fraud
Means to achieve these include:

developing an appropriate control environment;

establishing a strong and effective system of
internal control;
encouraging a strong ethical environment and
developing a code of conduct;
establishment of an audit committee;
reporting on the effectiveness of the companys
internal control system.

Fraud
Auditors do plan and conduct audit tests to limit
the possibility that material fraud and irregularities
go undetected.
This process starts at the planning phase when
auditors consider the company and its
environment and the risks facing it.

Fraud
Auditors argue they cannot guarantee detection of
all frauds and errors because of:
(1) inherent limitations in audit techniques and
tests;
(2) deceit, collusion and other means to conceal
fraud make detection difficult;
(3) audit evidence is that required to form an
opinion and not specifically to find fraud.

Fraud
Identification of motives and indicators of potential
significant fraud are important.
Pressure to misrepresent financial performance
may be high.
In such circumstances auditors might change their
audit approach to reflect higher risk.

Fraud
Reasons behind misrepresentation might be:
(a) the company has performed badly or is under
pressure from markets;
(b) directors wish to show continuing growth;
(c) where the company expands by acquisition,
directors may wish to inflate profits to show
success, and to sustain the share price;
(d) there are liquidity problems.

Fraud
Characteristics of personnel, the management team
and its structure may provide helpful indicators as to
when and where a fraud is likely:
(a) particular directors are autocratic and
authoritarian;
(b) staff are poorly qualified or lack motivation;
(c) individuals are paid by results;
(d) individuals are allowed too much authority or
power;
(e) turnover of staff is high.

Fraud
Weaknesses in systems may:
reduce the reliability of accounting information;
allow employees to commit fraud;
allow management to avoid or override controls.

Fraud
Once auditors have ascertained that fraud might
be taking place they decide on appropriate action:
(a) confirm understanding of facts, nature of fraud
and likely magnitude to aid determination of
additional audit tests;
(b) discuss the fraud or error with senior
management, directors or audit committee.

Fraud
If fraud has been discovered, auditors should:
(i) ask directors to consider changing financial
statements;
(ii) ask management to determine the extent of
fraud or error;
(iii) assess the impact on other audit work.

Fraud
If auditors suspect non-directors may be
implicated, they should discuss the matter with the
directors.
If directors may be involved, they should consider
reporting to the audit committee.
They might also seek legal advice and, in some
circumstances, report their suspicions to third
parties.

Fraud
If directors do not take appropriate action, it may
be difficult to determine the full extent of the fraud
or error, may have implications for the audit report,
and may cause the auditors to re-evaluate the
integrity of management and the control
environment.

Fraud
Auditors should document the process until it is
satisfactorily resolved, including:
(a) initial grounds for suspicion;
(b) additional audit work;
(c) details of what, when and to whom they
reported;
(d) managements response and any action;
(e) implications for audit work

Fraud
The Audit Agenda highlighted the difficulty of
detecting fraud where it is well planned, ingenious
or involving collusion or top management, but
noted that auditors can contribute to the
prevention of fraud by informing management of
weaknesses in the control systems.
It also referred to the limited nature of penalties
imposed on directors if they mislead auditors.

Fraud
Some auditing standards might be amended but
APB says that a significant increase in the likelihood
of detecting management fraud requires radical
change, including:
(a) increased emphasis on professional scepticism;
(b) tighter rules on acceptable audit evidence;
(c) reporting material matters in the financial
statements that are supported only by
managements representations.

Fraud
APB considers that expanding the auditors role
could be helpful in preventing and detecting fraud,
perhaps by:
(a) reporting to boards and audit committees on
controls to prevent and detect fraud;
(b) more reporting of suspected frauds.

What is Financial Shenanigans

Actions taken by managements that mislead investors about a companys

financial performance or economic health.

Investors are often tricked into believing that a companys earnings are
stronger, its cashflows more robust and its balance sheet position more
secure than are really the case.

Some shenanigans can be detected in the numbers presented by carefully

reading a companys financial statements.

Others might not be explicitly provided in the numbers and therefore

requires scrutinizing the narratives contained in footnotes

Classification of Financial Shenanigans

Earnings Manipulations Shenanigans

#1: Recording Revenue Too Soon

#2: Recording Bogus Revenue

#3: Boosting Income Using One-Time or Unsustainable Activities

#4: Shifting Current Expenses to a Later Period

#5: Employing Other Techniques to Hide Expenses or Losses

#6: Shifting Current Income to a Later Period

#7: Shifting Future Expenses to an Earlier Period

Classification of Financial Shenanigans

Cash Flows Shenanigans

#1: Shifting Financing Cash Inflows to the Operating Section

#2: Shifting Normal Operating Cash Outflows to the Investing Section

#3: Inflating Operating Cash Flow Using Acquisition or Disposal

#4: Boosting Operating Cash Flow Using

Key Matrics Shenanigans

#1: Showcasing Misleading Metrics That Overstate Performance

#2: Distorting Balance Sheet Metrics to Avoid Showing Deterioration

What Environment Breeds Shenanigans

Management Team Devoid of Check and Balances

Senior executives can freely criticize and disagree with one another

A single dictatorial leader runs roughshod over the others culture fear and
intimidations exists

Investors face great risks if that dictatorial leader is also bent on creating
misleading financial reports

An extended streak of meeting or beating expectations

Management who publicly boasts about its long consecutive streak of meeting
or exceeding expectations

Tough times emerges, such a management may feel pressured to use

accounting gimmicks and perhaps fraud to keep the streak alive

EM#1: Record Revenue Too Soon

1.

Recording Revenue Before Completing Any Obligation under the Contract

2.

Recording Revenue Far in Excess of Work Completed on the Contract

3.

Stretched out the last month of the quarter and both backdated and forged
sales contract

Revenue recognition in situations in which the seller has started to deliver

on the contract, however the management records a far greater amount
than is warranted large amounts of long-term receivables

Recording Revenue Before the Buyers Final Acceptance of the Product

Bill-and Hold Arrangements

Consignment Arrangements

EM#1: Record Revenue Too Soon

4.

Recording Revenue When the Buyers Payment Remains Uncertain or

Unnecessary

Accelerating revenue recognition if it records sales when buyer lacks the

ability to pay (uncertain) or when the seller agressively induces the sale by
not requiring the customer to pay until long after sale

The sale was contingent on the receipt of outside funding and no revenue
should have been recognized until such funding had been secured

Extended payment terms on new products

EM#2: Recording Bogus Revenue

1.

Recording Revenue from Transactions That Lack Economic Substance

2.

3.

Recording Revenue from Transactions That Lack a Reasonable Arms-Length

Process

Was a discount given to the relative..?

Were there any side agreements requiring the seller to provide..?

Recording Revenue on Receipts from Non-Revenue-Producing Transactions

4.

Legitimate Insurance Contracts Require a Transfer of Risk

Cash received in lending transactions and from vendors

Recording Revenue from Appropriate Transactions, but at Inflated Amounts

Principals and Agents Concept

EM#3: Boosting Income Using One-Time or

Sustainable Activities
1.

Turning the Sale of Business into a Recurring Revenue Stream

2.

Dispose a business unit to another company and at the same time enter
into an agreement to buy back product from that sold business unit

Boosting Income through Misleading Classifications

Improperly shift nonoperating income or gains to the operating section

EM#4: Shifting Current Expenses to A Later

Period
1.

Improperly Capitalizing Normal Operating Expenses

2.

Amortizing Costs Too Slowly

3.

Step-up Costs

Failing to Write Down Assets with Impaired Value

4.

Assets Under Construction

Obsolete Inventory and Impaired Plant Assets

Failing to Record Expenses for Uncollectible Receivables and Devalued

Investment

Long-overdue receivables and Impaired Investment

EM#5: Employing Other Techniques to Hide

Expenses or Losses
1.

Failing to Record an Expense from a Current Transaction

2.

Failing to Record Expense for a necessary Accrual or Reversing a Past

Expense

3.

Decline in Reserves for Warranties or Warranty Expense

Failing to Record or Reducing Expenses by Using Aggresisve Accounting

Assumptions

4.

Pretending no invoice from a vendor until after the quarter has ended

Assumptions on Pension or Employees Benefit Liabilities

Reduce Expenses by Releasing Reserves from Previous Charges

Create a bogus liability with a desirable credit balance and then, whenever
needed, make an accounting entry that moves the credit from the liability
and boosting profits

EM#6: Shifting Current Income to A Later

Period
1.

Creating Reserves and Releasing Them into Income in a Later Period

2.

Improperly Accounting for Derivatives in Order to Smooth Income

3.

Derivatives be marked to market each end of period and reported as gain

or loss in the current period, unless the derivatives is an effective hedge

Creating Reserves in Conjuction with an Acquisition and Releasing Them

into Income in a Later Period

4.

Saving Up for a Rainy Day

Instruct the target company to hold revenue until after the merger closes

Recording Current-Period Sales in a Later Period

Decide not to record the sale before the period closes, thereby hodling back
revenue until the later period

EM#7: Shifting Future Expenses to an

Earlier Period
1.

Improperly writing-off assets in the current period to avoid expenses in a

future period

2.

Improperly Recording Charges to Establish Reserves Used to Reduce

Future Expenses

Big Charges During Difficult Time or Building Up Reserves During Times of

Plenty

CF#1: Shifting Financing Cash Inflows to

the Operating Section
1.

Reporting Bogus CFFO from a Normal Bank Borrowing

2.

Boosting CFFO by Selling Receivables Before the Collection Date

3.

Inflating CFO by Faking the Sale of Receivables

CF#2: Shifting Normal Operating

Cashoutflows to the Investing Section
1.

Inflating CFFO with Boomerang Transaction

2.

Improperly Capitalizing Normal Operating Costs

3.

Company recorded cash received from customer as an Operating inflow,

however the cash paid to the same customer was recorded as an Investing
outflow

By classifying billion of dollars of normal operating costs as capital

equipment purchases, not artificially inflated its profits, but it also
overstated its CFFO

Recording the Purchase of Inventory as an Investing Outflows

CF#3: Inflating Operating Cash Flow Using

Acquisitions or Disposals
1.

Inheriting Operating Inflows in a Normal Business Acquisition

2.

Acquiring Contracts or Customers Rather Than Developing Them

Internally

3.

Inherited the receivables and inventory of the acquired business, will

generate CFFO benefits by rapidly liquidating these assets

Payment to external dealers accounted as normal business acquisitions

contract

Boosting CFFO by Creatively Structuring the Sale of a Business

Stripping out some assets (i.e. receivables) prior to the sale

lowers sale price (and investing inflow), however collecting cash
inflow on those assets

CF#4: Boosting Operating Cash Flow Using

Unsustainable Activities
1.

Boosting CFFO by Paying Vendors More Slowly

2.

Cash management techniques viewed as nonrecurring.

Boosting CFFO by Collecting from Customers More Quickly

Company cannot continue to collect at a faster and faster rate every quarter
perpetuity

3.

Boosting CFFO by Purchasing Less Inventory

4.

Boosting CFFO with One-Time Benefits

Non operating income are considered as a part of operating cash flow