Forensic Accounting Presentation to BA 124 San Jose State University March 16, 2004Topics CoveredFraudulent Financial ReportingSlide 4Slide 5Slide 6What is Fraudulent Financial Reporting?Why is it done?Fraud Risk Conditions Present when Fraud OccursConditions Present when Fraud OccursBut . . .Fraud Risk – Incentives/PressuresFraud Risk – OpportunitiesWhat is a Typical Pattern of Fraud?Where Can Fraud Occur?Slide 16Slide 17Case Study – X-Tech CorporationX-Tech CorpSlide 20Slide 21X-Tech Corp - Interference with InvestigationX-Tech Corp - Summary of Forensic FindingsExamples of X-Tech Behavior – Swing SheetsExamples of X-Tech Behavior – Intimidation and BullyingExamples of X-Tech Behavior – Round-Trip TransactionsExamples of X-Tech Behavior – Revenue AccelerationExamples of X-Tech Behavior – Channel StuffingExamples of X-Tech Behavior – Bowling for DollarsExamples of X-Tech Behavior – Premature or Excessive ShipmentsExamples of X-Tech Behavior – Manipulating ShipmentsExamples of X-Tech Behavior – Swapping ProductsExamples of X-Tech Behavior – Lifting Credit HoldsExamples of X-Tech Behavior – Side AgreementsExamples of X-Tech Behavior – Blackout Period for Credit ProcessingExamples of X-Tech Behavior – Bill and HoldExamples of X-Tech Behavior – Cut-off ProblemsExamples of X-Tech Behavior – Concurrent TransactionsExamples of X-Tech Behavior – Manipulating Ratios and DisclosuresExamples of X-Tech Behavior – Manipulating Journal EntriesConsideration of Fraud in a Financial Statement AuditConsideration of Fraud in a Financial Statement AuditSlide 43Asking Questions and Analyzing DataAsking Questions & Analyzing Data - Key PointsAsking QuestionsSlide 47Slide 48Asking Questions – Outside or Third PartiesAnalyzing DataSlide 51Slide 52Slide 53Slide 54Slide 55Slide 56Be Careful What You Say – E-mails Recovered by Forensic AccountantsLast Point – Examples of Bad E-mailsSlide 59Questions and Answers1Forensic AccountingPresentation to BA 124 San Jose State UniversityMarch 16, 2004Jaime Jue | KPMG LLP2Topics Covered1. Fraudulent Reporting – Numbers Can Lie2. Case Study3. Consideration of Fraud in a Financial Statement Audit4. Be Careful What You Say - Examples of Bad E-mails5. Questions and Answers3Fraudulent Financial ReportingNumbers Can Lie4Fraudulent Financial ReportingThe Auditor’s Role:The auditor has responsibility to plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether caused by error or fraud.AICPA, Statement on Auditing Standards (SAS) No. 1, Codification of Auditing Standards and Procedures5Fraudulent Financial ReportingManagement’s Role:Management is responsible for adopting sound accounting policies and for establishing and maintaining internal control that will, among other things, initiate, record, process and report transactions (as well as events and conditions) consistent with management’s assertions embodied in the financial statements.SAS No. 16Fraudulent Financial ReportingManagement’s Role Against Fraud:Management, along with those who have responsibility for oversight of the financial reporting process (such as the audit committee [or] board of directors…), should set the proper tone, create and maintain a culture of honesty and high ethical standards, and establish appropriate controls to prevent, deter, and detect fraud.SAS No. 17What is Fraudulent Financial Reporting?Fraudulent Financial Reporting may be accomplished by the following:•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•Intentional misapplication of accounting principles relating to amounts, classification, manner of presentation, or disclosureAICPA, Statement on Auditing Standards (SAS) No. 99, Consideration of Fraud in a Financial Statement.8Why is it done?•To report a smooth, regular, and increasing pattern of earnings•To enrich corporate insiders / management•To give investors / bankers / Wall Street what it wants9Fraud Risk Conditions Present when Fraud Occurs•Incentives / Pressures•Opportunities•Attitudes / Rationalizations10Conditions Present when Fraud OccursThree conditions are generally present when fraud occurs.1. First, employees have an incentive or are under pressure, which provides a reason.2. Second, circumstances exist – for example, when controls are ineffective or can be overridden – that provide an opportunity.3. Third, those involved are able to rationalize committing fraud.11But . . .•Even honest individuals can commit fraud if under enough pressure. •The greater the pressure, the more likely an individual will rationalize committing fraud.12Fraud Risk – Incentives/Pressures1. Profitability threatened by economic, industry, or entity operating conditions.2. Management pressured to meet third-party expectations.3. Management or board members’ personal finances threatened by the entity’s financial performance.4. Employees pressured by management to meet financial targets.13Fraud Risk – Opportunities1. Complex or unstable organizational structure.2. Deficient internal controls3. Poor accounting system4. Management override14What is a Typical Pattern of Fraud?•It does not start with dishonesty.•It starts with pressure.•It starts small.•Opportunities allow it to happen.•It is rationalized as appropriate.•The fraud grows over time.•There is no way out.Adapted from Michael R. Young, Accounting Regularities and Financial Fraud, 2d, Aspen Law & Business, p. 11-13.15Where Can Fraud Occur?Revenues•Premature recognition of revenue•Right of return, right of refund, or ability for customer to resell•Large, nonrecurring revenue sources•Concurrent transactionsExpenses•Capitalizing vs. expensing•Delaying expense recognition (deferral)•Acquisition and restructuring reserves used to generate income or cover period expenses16Where Can Fraud Occur?Assets•Fixed Assets (impairment or write-downs)•Change in method of capitalization or depreciation•InventoriesLiabilities•“Cookie Jar”, Acquisition, or Restructuring Reserves•Off-balance sheet financing•Contingent liabilities•Allowance for doubtful accounts•Miscellaneous Accruals17Where Can Fraud