Chapter 1 -
The Problem of
Financial Statement Fraud
Learning Objectives
• Understand the role financial statements play in U.S. business.
• Understand the nature of financial statement fraud.
• Become familiar with financial statement fraud statistics.
• Through an example, see how financial statement frauds occur and are concealed.
Importance of Accurate Financial Information
In late 2001 and during 2002, the Enron financial statement fraud received considerable attention
in the media. Enron’s officers were alleged to have manipulated Enron’s financial statements in
several ways, including hiding liabilities in off-balance sheet partnerships (Variable Interest
Entities – VIEs, formally called Special Purpose Entities – SPEs), hiding losses in these VIEs,
and artificially inflating revenue by entering into buy-and-sell (wash sale or round trip)
transactions with other trading companies that allowed Enron to substantially overstate its
revenues and income.
1 Enron’s auditor, Andersen LLP, was “tried and convicted” in the media
and was charged with obstruction of justice (for supposedly shredding documents) by the U.S.
Government. The criminal trial and negative press led to the demise of Andersen, one of the
most respected and largest CPA firms in the world.
2
Certainly, Enron (and its fallout effect on Andersen, several law firms, financial institutions, and
others) has raised awareness among the public about financial statement fraud. However, Enron
is only one of over 600 financial statement frauds that have been investigated by the SEC alone.
Even with Enron and the other financial statement frauds, America’s capital markets are the envy
of the world,
3 known for their efficiency, liquidity, and resiliency. Financial statements prepared
by organizations play a very important role in keeping America’s markets efficient. They
provide meaningful disclosures of where a company has been, where it is currently, and where it
is going. Most financial statements are prepared with integrity and present a fair picture of the
financial position and results of operations of the organization issuing them. These financial
statements are based on generally accepted accounting principles (GAAP)
4 that guide how
transactions are to be accounted for. While GAAP is a set standard for accounting, it is not
meant to be a straitjacket. GAAP allows for flexibility to account for innovative transactions and
changing circumstances, within this flexibility, standards of objectivity, integrity, and judgment
must always prevail.
Unfortunately, once in a while financial statements are prepared in ways that misrepresent the
financial position and financial results of an organization. Misstatement of financial statements
can result from such acts as manipulation, falsification, or alteration of accounting records or
supporting documents from which financial statements are prepared; misrepresentation in, or
intentional omission from, the financial statements of events, transactions, or other significant
information; or intentional misapplication of accounting principles relating to amounts,
classification, manner of presentation, or disclosure. Misleading financial statements cause
serious problems in the markets and the economy. They often result in large losses by investors,
lack of trust in the market and accounting systems, or litigation and embarrassment for
individuals and organizations associated with the financial statements.
It is the Securities and Exchange Commission’s (SEC) position that auditors are the “public’s
watchdogs” in the financial reporting process. According to past Chairman Leavitt, “the SEC
and others rely on auditors to issue audit opinions which put something like the Good
Housekeeping Seal of Approval on the financial information investors receive” (Leavitt,
September 28, 1998).
Because of this “watchdog” role, and because accountants often provide investment and other
financial advice to their clients,
5 it is very important that accountants understand as much as
possible about financial statements and financial statement fraud. By improving their
knowledge, accountants can be more discriminating in the kinds of audit engagements they
accept, can better advise their clients, and can save themselves considerable grief and litigation
exposure.
Nature of Financial Statement Fraud
Financial statement fraud, like all other types of fraud, involves intentional deceit and
concealment, often through falsified documentation, forgery, and collusion among management,
employees, or third parties. For these reasons, fraud is rarely seen. Rather, fraud symptoms,
indicators, or red flags are usually observed. Because these symptoms can also be caused by
other, legitimate factors, the presence of fraud symptoms does not always indicate that fraud
exists. For example, a document may be missing, a general ledger may be out of balance, or an
analytical relationship may not make sense. However, these conditions may be the result of
circumstances other than fraud. Documents may have been legitimately lost. The general ledger
may be out of balance because of an unintentional accounting error; and unexpected analytical
relationships may be the result of unrecognized changes in underlying economic factors.
Caution must be exercised even when reports of alleged fraud are received, because the person
providing the tip or complaint may be mistaken or may be motivated to make false allegations.
Fraud symptoms also cannot easily be ranked in order of importance or combined into effective
predictive models. The significance of red flags varies widely. Some of these factors will be
present when no fraud exists; alternatively, a smaller number may exist where fraud is being
perpetrated. It can even be hard to prove fraud once it is suspected. Without a confession, a
number of repeated, similar fraudulent acts (so fraud can be inferred from a pattern), or
obviously forged documents, it is very difficult to convict someone of fraudulent behavior.
Because of the difficulty of detecting and proving fraud, accountants and auditors must exercise
extreme care when conducting audits, performing fraud examinations, trying to quantify fraud,
or performing other types of fraud-related engagements.
Financial statement fraud is just one of the many problems that have been plaguing corporate
America during the past couple of years. In addition to misstated financial statements, here are
other problems that have caused embarrassment for firms and a lack of trust in corporations:
• Executive Loans and Corporate Looting: Examples include John Rigas of Adelphia and
Dennis Kozlowski of Tyco.
• Insider Trading: Examples include Martha Stewart and Sam Waksal of ImClone.
• IPO Favoritism: For example, Bernie Ebbers of WorldCom.
• CEO Retirement Perks: Examples of companies which suffered negative press because of
excessive CEO retirement perks were Delta, PepsiCo, AOL Time Warner, Ford, GE, and
IBM. (The perks included such things as consulting contracts, use of corporate planes,
executive apartments with meals, maids, etc.)
• Exorbitant Stock Options for Executives. (Bernie Ebbers, for example, in one year made
significantly more (up to 40 times more) in exercising stock options than in cash and
other compensation.)
1 In May, 2006, former Enron CEOs Jeffrey Skilling and Ken Lay were convicted of a combined 25 criminal counts.
2 The conviction of Andersen was subsequently overturned. Unfortunately, by that time, it was too late to put the
firm back together again.
3 As this course was going to press, the financial markets in the U.S. were having significant problems stemming
mostly from sub-prime mortgage loans. Lehman Brothers declared Chapter 11 bankruptcy, Bear Sterns was sold to
J.P. Morgan with funding provided by the U.S. Government, Bank of America bought Merrill Lynch at fire sale
prices, and AIG was near bankruptcy. Over a period of a week, the Dow Jones Industrial average fell approximately
3,000 points. What the long-term effects of these problems would be in the financial markets was not clear.
4 At the time this course was going to press, the SEC had just issued a proposed timetable for U.S. Companies to
convert from GAAP to International Fraud Reporting Standards (IFRS). The FASB and Industrial Accounting
Standards Board (IASB) were working together closely to converge their standards. While GAAP will probably
continue to be used in the U.S. through approximately 2015, more principles-based IFRS will almost certainly
become the financial reporting standards of the future. What effect their transition from GAAP to IFRS will have on
fraudulent financial reporting remains to be seen.
5 The services auditors can provide to clients have been severely limited by the Sarbanes-Oxley Act of 2002. This
act identified eight “unlawful” services that cannot be performed by a company’s auditors, called for the
establishment of an independent oversight board (The Public Companies Accounting Oversight Board – PCAOB)
over the accounting profession, and made several other requirements affecting auditors and accountants. (See
chapter 2 for an overview of the effect of the Sarbanes-Oxley Act on accountants.)
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