Financial Statement Fraud
Talking about financial statement fraud is a great way to build students’ interest in accounting and auditing. Charles Keating, Barry Minkow, “Crazy Eddie” Antar, and “Chainsaw Al” Dunlap are fascinating characters, and my students love learning how they outwitted their auditors. To make the fraud stories educational, I require the students to identify the internal control weaknesses that allowed the frauds to occur and the audit procedures that should have detected the frauds. I like to spend at least 10 minutes discussing the three proposals to reduce fraudulent financial reporting described in David Reilly’s 11/8/06 Wall Street Journal article.
Called to Account describes 14 infamous financial statement frauds and their influence on the American accounting profession. It makes a good supplement to a traditional auditing text.
Articles:
“SAS 99 – Consideration of Fraud in a Financial Statement Audit,” Patrick Casabona & Michael Grego, Review of Business (2000): 16-20. This article describes the major requirements of SAS No. 99.
“Double-Entry, Nonstandard Entries, and Fraud,” Douglas Carmichael, CPA Journal (October 2010): 62-65. This article describes fraudulent journal entries recorded at Cendant, WorldCom, and HealthSouth, and provides advice for auditors reviewing journal entries.
“Top 10 Audit Deficiencies,” Mark Beasley, Joseph Carcello & Dana Hermanson, Journal of Accountancy (April 2001): 63-66. This article summarizes lessons auditors can learn from SEC enforcement actions issued between 1987 and 1997.
“Auditing Firms Urge New Ways to Detect Fraud,” David Reilly, Wall Street Journal (November 8, 2006): C3. This article summarizes three proposals to reduce fraudulent financial reporting: (1) subjecting all companies to a forensic audit every three or five years, (2) requiring companies to randomly undergo forensic audits, and (3) permitting investors to choose the intensity of audit they want for a company.
Books:
Called to Account: Fourteen Financial Frauds That Shaped the American Accounting Profession, Paul M. Clikeman, Routledge (2009). The history of public accounting in the U.S. is described as a series of scandals followed by voluntary or mandated reforms. This book describes how accounting frauds from Kreuger & Toll (1932) through Enron and WorldCom (2002) shaped contemporary auditing practices.
Videos:
“Baptist Foundation of Arizona” (15:08). This episode from the CBS newsmagazine 60 Minutes interviews victims of the BFA fraud.
“ESM Government Securities” (21:26). Auditor Jose Gomez describes his role in the ESM Government Securities Fraud.
“Phar-Mor” (33:17). This edited episode from the PBS series Frontline describes how Mickey Monus and his band of conspirators inflated Phar-Mor’s inventory.
“WorldCom” (21:00). This episode from the CNBC series American Greed describes the largest (known) fraud in American history.
“ZZZZ Best” (27:03). Co-conspirator Mark Morze describes how he helped Barry Minkow cook ZZZZ Best’s books.
“The Smartest Guys in the Room” (110:00). This documentary is a little light on accounting details, but does a good job of describing Enron’s aggressive, risk-seeking corporate culture. Available for about $12 at Amazon.com.
Cases:
“A Case of Declining Gross Margins,” Penny Clayton & Larry Ellison, Issues in Accounting Education (February 2011): 133-143. Students use financial statement analysis to assess the probability that fraud is occurring at a privately held wholesaler.
“Consideration of Control Environment and Fraud Risk: A Set of Instructional Exercises,” Maria Sanchez, Kevin Brown & Christopher Agoglia, Journal of Accounting Education (2007): 207-221. Four instructional exercises in which students assess the risk of fraudulent financial reporting and misappropriation of assets after reviewing realistic-looking internal control questionnaires.
“Helecom Communications: Considering Fraud Risk on an Engagement Before and After Analyzing a Key Business Process,” Brian Ballou & Jennifer Mueller, Issues in Accounting Education (February 2005): 99-118. Students must assess the risk of fraud at a cable TV company. Includes a good list of fraud-related research.
“Dickinson Technologies, Inc.: Assessing Control Environment and Fraud Risk,” Christopher Agoglia, Kevin Brown & Dennis Hanno, Issues in Accounting Education (February 2003): 71-78. Students are given the completed internal control environment questionnaire of an international manufacturing company and must assess the risk of fraud.
Research:
Fraudulent Financial Reporting: 1998-2007, Mark Beasley, Joe Carcello, Dana Hermanson & Terry Neal (COSO, 2010). This study examined 347 alleged cases of public company fraudulent financial reporting. The most common fraud techniques involved improper revenue recognition, followed by the overstatement of existing assets or capitalization of expenses. The SEC named the CEO and/or the CFO for some level of involvement in 89 percent of the fraud cases.
“A Decision Aid for Assessing the Likelihood of Fraudulent Financial Reporting,” Timothy Bell & Joe Carcello, Auditing: A Journal of Practice & Theory (Spring 2000): 169-184. The researchers compared 77 KPMG clients known to have committed fraud to a control sample of 305 no-fraud clients. The variables that distinguished the fraud perpetrators were weak internal control environment, rapid growth, inadequate or inconsistent profitability, undue emphasis on meetings earnings projections, and public (vs. private) ownership.
“Auditors’ Experience with Material Irregularities: Frequency, Nature, and Detectability,” James Loebbecke, Martha Eining & John Willingham, Auditing: A Journal of Practice & Theory(Fall 1989): 1-28. 112 KPMG partners described a material fraud or defalcation they had seen in practice. Financial statement fraud is usually committed by top management, with collusion; overstatement of revenue, inventory, and accounts receivable accounts are the most common fraud techniques. Payroll and cash are the most common targets of theft. Substantive tests of details are the most effective procedure for detecting fraud.
Talking about financial statement fraud is a great way to build students’ interest in accounting and auditing. Charles Keating, Barry Minkow, “Crazy Eddie” Antar, and “Chainsaw Al” Dunlap are fascinating characters, and my students love learning how they outwitted their auditors. To make the fraud stories educational, I require the students to identify the internal control weaknesses that allowed the frauds to occur and the audit procedures that should have detected the frauds. I like to spend at least 10 minutes discussing the three proposals to reduce fraudulent financial reporting described in David Reilly’s 11/8/06 Wall Street Journal article.
Called to Account describes 14 infamous financial statement frauds and their influence on the American accounting profession. It makes a good supplement to a traditional auditing text.
Articles:
“SAS 99 – Consideration of Fraud in a Financial Statement Audit,” Patrick Casabona & Michael Grego, Review of Business (2000): 16-20. This article describes the major requirements of SAS No. 99.
“Double-Entry, Nonstandard Entries, and Fraud,” Douglas Carmichael, CPA Journal (October 2010): 62-65. This article describes fraudulent journal entries recorded at Cendant, WorldCom, and HealthSouth, and provides advice for auditors reviewing journal entries.
“Top 10 Audit Deficiencies,” Mark Beasley, Joseph Carcello & Dana Hermanson, Journal of Accountancy (April 2001): 63-66. This article summarizes lessons auditors can learn from SEC enforcement actions issued between 1987 and 1997.
“Auditing Firms Urge New Ways to Detect Fraud,” David Reilly, Wall Street Journal (November 8, 2006): C3. This article summarizes three proposals to reduce fraudulent financial reporting: (1) subjecting all companies to a forensic audit every three or five years, (2) requiring companies to randomly undergo forensic audits, and (3) permitting investors to choose the intensity of audit they want for a company.
Books:
Called to Account: Fourteen Financial Frauds That Shaped the American Accounting Profession, Paul M. Clikeman, Routledge (2009). The history of public accounting in the U.S. is described as a series of scandals followed by voluntary or mandated reforms. This book describes how accounting frauds from Kreuger & Toll (1932) through Enron and WorldCom (2002) shaped contemporary auditing practices.
Videos:
“Baptist Foundation of Arizona” (15:08). This episode from the CBS newsmagazine 60 Minutes interviews victims of the BFA fraud.
“ESM Government Securities” (21:26). Auditor Jose Gomez describes his role in the ESM Government Securities Fraud.
“Phar-Mor” (33:17). This edited episode from the PBS series Frontline describes how Mickey Monus and his band of conspirators inflated Phar-Mor’s inventory.
“WorldCom” (21:00). This episode from the CNBC series American Greed describes the largest (known) fraud in American history.
“ZZZZ Best” (27:03). Co-conspirator Mark Morze describes how he helped Barry Minkow cook ZZZZ Best’s books.
“The Smartest Guys in the Room” (110:00). This documentary is a little light on accounting details, but does a good job of describing Enron’s aggressive, risk-seeking corporate culture. Available for about $12 at Amazon.com.
Cases:
“A Case of Declining Gross Margins,” Penny Clayton & Larry Ellison, Issues in Accounting Education (February 2011): 133-143. Students use financial statement analysis to assess the probability that fraud is occurring at a privately held wholesaler.
“Consideration of Control Environment and Fraud Risk: A Set of Instructional Exercises,” Maria Sanchez, Kevin Brown & Christopher Agoglia, Journal of Accounting Education (2007): 207-221. Four instructional exercises in which students assess the risk of fraudulent financial reporting and misappropriation of assets after reviewing realistic-looking internal control questionnaires.
“Helecom Communications: Considering Fraud Risk on an Engagement Before and After Analyzing a Key Business Process,” Brian Ballou & Jennifer Mueller, Issues in Accounting Education (February 2005): 99-118. Students must assess the risk of fraud at a cable TV company. Includes a good list of fraud-related research.
“Dickinson Technologies, Inc.: Assessing Control Environment and Fraud Risk,” Christopher Agoglia, Kevin Brown & Dennis Hanno, Issues in Accounting Education (February 2003): 71-78. Students are given the completed internal control environment questionnaire of an international manufacturing company and must assess the risk of fraud.
Research:
Fraudulent Financial Reporting: 1998-2007, Mark Beasley, Joe Carcello, Dana Hermanson & Terry Neal (COSO, 2010). This study examined 347 alleged cases of public company fraudulent financial reporting. The most common fraud techniques involved improper revenue recognition, followed by the overstatement of existing assets or capitalization of expenses. The SEC named the CEO and/or the CFO for some level of involvement in 89 percent of the fraud cases.
“A Decision Aid for Assessing the Likelihood of Fraudulent Financial Reporting,” Timothy Bell & Joe Carcello, Auditing: A Journal of Practice & Theory (Spring 2000): 169-184. The researchers compared 77 KPMG clients known to have committed fraud to a control sample of 305 no-fraud clients. The variables that distinguished the fraud perpetrators were weak internal control environment, rapid growth, inadequate or inconsistent profitability, undue emphasis on meetings earnings projections, and public (vs. private) ownership.
“Auditors’ Experience with Material Irregularities: Frequency, Nature, and Detectability,” James Loebbecke, Martha Eining & John Willingham, Auditing: A Journal of Practice & Theory(Fall 1989): 1-28. 112 KPMG partners described a material fraud or defalcation they had seen in practice. Financial statement fraud is usually committed by top management, with collusion; overstatement of revenue, inventory, and accounts receivable accounts are the most common fraud techniques. Payroll and cash are the most common targets of theft. Substantive tests of details are the most effective procedure for detecting fraud.
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