ITS 4450 - Fraud Risk Assessment Tools and Investigation


Chapter 11, Financial Statement Fraud

This lesson presents material from chapter 11. Objectives important to this lesson:

  1. Financial statements
  2. Financial statement fraud
  3. Fraud statistics
  4. Concealment of financial statement fraud
  5. Detecting financial statement fraud
Concepts:
Chapter 11

The chapter begins with two illustrative stories about two major enterprises that were found guilty of filing false financial statements. Importantly, they were both audited by the same independent auditing firm who did not report any irregularities.

The text explains that the false financial statements were the basis of unwarranted increases in the stock prices of the two companies. Investors bought stock at those prices, and became victims when the stock became worthless. Financial statements are best indicators of the value of a company, but they mean nothing when they are untrustworthy. Some examples are given of each of these subtypes of fraud:

  • misstated financial statements - lies
  • inappropriate executive loans and looting - theft
  • insider trading - buying or selling stock based on information that is not available to the public
  • IPO tricks - spinning means we buy your stock and you buy ours to jack up the apparent values; laddering means chosen investors are allowed to buy at a low price if they agree to buy again at a higher price
  • huge benefits for executives - executives leaving the company are given golden parachutes that look like corporate looting, and current executives are treated similarly
  • loans from banks for favors - banks have given executive favored status for loan terms in return for the company paying extra fees to the bank

Not all of the items above are obviously linked to financial statements, but they all relate to improper statements and actions for profit. The text goes on several real world examples of this sort of behavior. The author then presents a number of theories about motivations, reasons for ethical compromises, and enterprise features (like weak controls and ineffective watchdogs) that may lead to financial statement fraud.

The text points out that this kind of fraud may be very difficult to prove, primarily because it is committed at very high levels in an organization. It is not, however, never punished. We are referred to the Accounting and Auditing Enforcement Releases of the SEC. The link provided in the last sentence goes to a web page where you can open a report on each AAER enforcement action in a given period.

The text provides some statistics on financial statement fraud, compiled by COSO. A list of ten observations about available data begins on page 370. Key observations are that such a fraud typically goes on for two or more years, and it usually include false statements about assets and expenses. Pressure is often felt by high level executives who believe that the company will not perform as expected. Pressure, opportunity, and rationalization combine as we have seen in other cases.

In the following video, you will see a report on a financial fraud committed by a man who called himself Crazy Eddie:


Most videos about this subject are pretty dry. This one is presented by an insider who knew the details of the scam.


Assignments

  1. Continue the reading assignments for the course.
  2. Complete the assignments and class discussion made in this module.