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Intentionally underestimating the costs to complete certain contracts, resulting in early recognition of income or avoidance of recognizing losses. At one point, Paragon even switched from the cost approach of estimat- ing percentage of completion. Under this method, a judgment of the physical progress on a project was used to estimate the percentage completed. The additional judgment involved in this approach allowed Paragon oficials to overestimate the progress on certain contracts.

There are numerous other revenue arrangements in which some factor other than costs must be identified as a basis for measuring the portion of revenue that is attributable to a specific accounting period. Whenever an initial sales price includes an amount allocable for subsequent services, that amount should be deferred and recognized as revenue over the period during which the service is rendered. With some arrangements, this requires that an esti- mate be made by management in order to allocate revenue among account- ing periods. The accounting question in this transaction is: Over how many years should the company allocate the initiation fee?

In other cases, however, using life expectancies is not appropriate. Three forms of revenue are pertinent to the accounting improprieties: 1 an initiation fee paid upon irst joining, 2 monthly membership dues, and 3 a reactivation fee paid when reactivating someone whose membership had lapsed. Initiation fees could be paid up front or inanced over time, usually 36 months.

Revenue recognition principles require that these fees be recog- nized as income over the expected life of the membership. Therefore, a liability for deferred revenue would be recorded and then amortized into income over an estimated period of membership, not just over the initial inancing period 36 months or initial period of membership.

This resulted in premature recognition of revenue. Once lapsed mem- bers had not paid monthly dues for six months or more, they were eligible for reactivation by paying a fee. This fee was lower than the initiation fee described in the preceding paragraph. To reactivate a membership, an individual would sign a new contract. Under revenue recognition principles, recognition of any revenue from reactivation fees would be prohibited until the binding contract had been executed. This revenue was based on projected reactivations up to three years into the future. GAAP for recognizing any of this revenue until a reactiva- tion occurs.

When all of the deliverables are satisied concur- rently, there is little risk of a revenue timing fraud. However, when certain elements of an arrangement are satisied in one period while others are not satisied until a future period, the issue of how much revenue to recognize in each period takes on greater importance.

And the risk of fraud is introduced. IFRS does not have a direct counterpart to the speciic rules included in U. IAS 18 requires that revenue should be recognized as an element of a transaction if that element has commercial substance on its own. Other- wise, separate elements should be linked together and accounted for as a single transaction.

But, IAS 18 does not describe any speciic criteria to be applied in making this determination. GAAP, revenue arrangements with multiple deliver- ables should be divided into their separate units of accounting if all three of the following conditions are present: 1. The delivered item s has value to the customer on a standalone basis. An item has standalone value if it is sold separately by any vendor or the cus- tomer could resell the delivered item s on a standalone basis the ability to resell does not require the existence of an observable market.

There is objective and reliable evidence of the fair value of the undelivered item s. If the arrangement includes a general right of return relative to the deliv- ered item s , delivery or performance of the undelivered item s is consid- ered probable and substantially in the control of the vendor. When a multiple deliverable revenue arrangement meets these three cri- teria, revenue should be allocated among the separate units based on their relative fair value. Then, an appropriate revenue recognition method should be determined for each unit.

The amount allocated to an element is limited to the lesser of the amount otherwise allocable based on fair value or the non- contingent portion of the arrangement. Under ASU No. An item has standalone value if it is sold separately by any vendor or the customer could resell the delivered item s on a standalone basis the ability to resell does not require the existence of an observable market. Arrangement consideration must be allocated at the inception of the arrangement to all deliverables on the basis of their relative selling price the relative selling price method , unless one of the deliverables otherwise must be accounted for at fair value based on some other accounting standard.

The price charged for a deliverable when it is sold separately. For a deliverable not yet being sold separately, the price established by man- agement with the relevant authority it must be probable that the price, once established, will not change before the separate introduction of the deliverable into the marketplace. Misapplication of the criteria for being eligible to segregate a transaction into multiple elements e. In an effort to improve proits, a company may overallocate revenue to elements that are recog- nized irst, while underallocating revenue to elements that may be deferred into future periods.

All other elements—the service, supplies, and inancing—were to be recognized as revenue over the life of the agreement. Therefore, they backed into the fair value by subtracting the fair value of the other elements from the total TCO. In particular, the SEC was critical of the reduction by Xerox multiple times of the discount rate used to measure the portion of TCO associated with inancing revenue.

Qwest , the telecommunications, long distance telephone, and Internet services giant. An IRU is an irrevocable right to use a speciic iber strand or speciic amount of iber capacity for a speciic period of time. Qwest treated its IRU sales as having multiple elements, as follows: 1. Right of way 2. Conduit 3. Fiber 4. Equipment 5. Facilities 6. Operations and maintenance Revenue was recognized up front on three of these elements—iber, equip- ment, and facilities. The other ele- ments, representing just 20 percent of the total, were recognized as revenue over the course of the lease term.

This charge was based on the fact that each of the elements did not represent a separate earnings process. As a result, none of the revenue should have been recognized up front. Rather, all revenue should have been recognized ratably over the term of the lease. When Qwest restated its inancial statements, it acknowl- edged that it did not have suficient evidence on which to objectively determine the appropriate allocation among the six elements identiied. This standard was the focus of a restatement of the inancial statements of SmartForce PLC, a developer of electronic learning courseware, software and ref- erenceware products which subsequently merged into SkillSoft PLC.

Some of these products were treated as multiple element arrangements and SmartForce allo- cated revenue among each element, recognizing certain elements immediately upon a sale and deferring other elements. As a result, these inancial statements relect a deferral of certain revenue that previously was recognized at the time of delivery. Because in most cases the undelivered element related to services provided over time, revenue is generally recognized over the term for which the services are provided.

Financial Statement Fraud: Strategies for Detection and Investigation

This restatement is among a variety of issues that resulted in a class action suit being iled in on behalf of stockholders. It is too early for there to be any cases to report on under the new U. Readers should note that under the new rules, companies must disclose in the notes to the inancial statements which of the three approaches to determining relative selling price was used.

These programs involve the accumulation of customer beneits as a customer purchases goods or services from a company. For example, as a customer purchases goods, points or other credits accumulate, enabling the customer to obtain future goods at no charge or at a discount, based on the amount of credits that have accumulated.

There is no such speciic guidance under U. However, the guidance described in the preceding section on multiple deliverables can be applied. When customers exer- cise their credits, the liability is relieved. Fair value is often equal to the amount of discount that a customer is entitled to for future purchases. However, it may also be the value of other products or services to which a customer is entitled. Take the following example from a footnote in the inancial statements of American Airlines: Frequent Flyer Program The estimated incremental cost of provid- ing free travel awards is accrued when such award levels are reached.

American also accrues a frequent lyer liability for the mileage credits that are expected to be used for travel on participating airlines based on historical usage patterns and contractual rates. American sells mileage credits and related services to companies participating in its frequent lyer program. The portion of the revenue related to the sale of mileage credits, representing the revenue for air transportation sold, is valued at current market rates and is deferred and amortized over 28 months, which approximates the expected period over which the mileage credits are used.

The remaining portion of the revenue, rep- resenting the marketing products sold and administrative costs asso- ciated with operating the AAdvantage program, is recognized upon sale as a component of passenger revenues, as the related services have been provided. The American Airlines note also illustrates a difference between U.

GAAP does not contain speciic guidance directed toward customer loyalty programs, other than guidance indi- cating that a liability exists. How to measure that liability is not clearly stated. As a result, two approaches have emerged. Accordingly, these companies measure a customer loyalty program liability based on the fair value of the credits, and the liability is offset by a reduction in revenue. Other companies, such as Ameri- can Airlines in the inancial statements cited here, utilize an incremental cost approach.

Under this approach, an expense is accrued rather than a reduction in revenue to recognize the liability. Obviously, it is important to read the notes to the i nancial statements carefully to understand how a company is accounting for its customer loyalty programs. Channel stufi ng occurs when an unusually large sale is made to an existing customer, normally a distributor. For example, a customer may nor- mally place monthly orders for products from a company.

On the surface, this may indicate nothing more than a salesperson doing a good job of convincing a customer to accelerate his or her ordering. Perhaps the salesperson merely needed a little extra push to make his sales goal for the month. However, channel stufing should always raise two separate red lags.

Even if the channel stufing sales are legitimate, could their existence be a sign that something else might be going on? This leads to the more likely question: Are these channel stufing sales even legitimate sales in the irst place? Do they meet the criteria for recognition?

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Often, such large and unusual sales to distributors are accompanied by special terms designed to encourage the customer to enter into the transaction. The distributor has virtually no obligation to pay for the products until the products have been sold. However, these two represent the most commonly seen in side agreements, sometimes in writing but often not, between sellers and buyers.

McAfee, Inc. These ploys included attractive sales incentives such as price discounts and rebates. McAfee also paid distributors millions of dollars in exchange for their agreement to hold the excess inventory, rather than returning it for a refund. In some instances, McAfee utilized an undisclosed wholly owned subsidiary to repurchase inventory that had been oversold to distributors.

Krispy Kreme Doughnuts A complaint iled in December quotes a former sales manager at Krispy Kreme as stating that he shipped double orders to customers on the inal Friday and Saturday of in order to meet Wall Street projections, knowing that the doughnuts would be returned for credit the following week, once was under way. ClearOne Communications, Inc. An SEC complaint charged ClearOne with stufing its distribution channels while entering into secret agreements with its distributors beginning in These secret agreements allowed the distributors to hold off on pay- ing ClearOne until they sold the merchandise, in effect making the arrange- ments into consignment sales.

The amounts i lled in would be shipped, but with the understanding that the distributors would not have to pay for the merchandise. Lantronix, Inc. In AAER , the SEC charged Lantronix in with inlating its earn- ings by shipping excessive quantities of products to distributors and granting either full stock rotation rights or return rights.

Stock rotation rights refer to the right to exchange any portion of an order, or even the entire order, for any other product. Return rights allowed distributors to return any unsold items for full credit. The question with a bill and hold transaction is when to record the reve- nue—at the time the order is placed, at the time of delivery, or somewhere in between. The risks of ownership must have passed to the buyer 2. The customer must have made a ixed commitment to purchase the goods preferably in writing 3. The buyer, not the seller, must request that the transaction be on a bill and hold basis 4.

The seller must not have retained any speciic performance obligations such that the earning process is not complete. Each of these criteria, therefore, poses a unique fraud risk. One example of a misstatement caused by improper bill and hold account- ing involved Diebold, Inc.

The transactions in question involved products that were manufactured and shipped to a Diebold warehouse, at which point revenue was recorded. This would be permitted if the preceding criteria were met. However, only some of the criteria were met. Once the products were manufactured and shipped to a Diebold warehouse, the inal three criteria may have been met. In addition, in some instances, required software had not yet been installed in the ATMs that had been manufactured and shipped to the Diebold warehouse for storage, indicating that the ifth criterion had not been met either.

In an even bolder example, Raytheon Company violated the seventh cri- terion, requiring that a product be complete and ready for delivery, in order to meet earnings expectations. Should the entire amount of the sale be recognized in income at the time of the sale? There are two crucial elements to the accounting of these transactions: 1. Determining whether and when a sale can be recorded.

Accounting for the obligation associated with possible future returns. The price is ixed or determinable on the date of the sale. The buyer has either paid the seller or is obligated to pay the seller and this obligation is not contingent on the buyer reselling the product i. If the buyer has purchased the product for resale, the buyer has economic substance apart from that provided by the seller for example, the buyer does not have physical facilities or employees. The seller has no signiicant obligation to directly bring about the resale of the product by the buyer.

The amount of future returns can be reasonably estimated note that the right of a customer to exchange an item for another of the same kind, qual- ity, and price is not considered a right of return. Extremely lenient rights of return can be a sign of a disguised consignment arrangement. See Chapter 3 for a discussion of consignment sales. STI in with improperly recording revenue in connection with sales involving a right of return.

In one example, STI engaged in the practice of shipping merchandise to customers under a loaner program, under which the customer accepted the products on a trial basis with no obligation to purchase the product. Since the customer had not yet accepted the products, STI improperly recognized revenue in connection with these arrangements. In addition, the SEC alleged that STI failed to establish suficient sales return reserves in connection with recorded sales involving the right of return.

IFRS does not explicitly address returns in the same extensive manner as U. In connection with this criterion, IAS 18 notes that if a buyer has the right to rescind a transaction under deined conditions and the seller cannot reasonably estimate the likelihood of such rescission, the sale should not be recognized. Recording a reserve for estimated future returns represents the second aspect of these transactions that has the potential for fraud. Estimating returns is normally based primarily on past history.

That is, they are perpetrated in order to make the current period appear to have been more successful than it really has been. However, sometimes the opposite incentive exists. What, then, can a company do to ensure a steady rate of growth? Deferral of revenue to future periods that should be recognized in the cur- rent period may pose one additional problem for the crooked company. What to do if the revenue has not only been earned, but the customer has already paid the company?

According to the SEC, from to , Beazer expe- rienced strong inancial growth and performance. As a homebuilder, Beazer would recognize revenue and proit upon the close of a sale of a home. Normally, any unused portion of a house to complete reserve left after four to nine months would be eliminated and taken into income.

However, from to , Beazer overreserved these house cost to complete expenses. Many companies have been accused of establishing reserves as liabilities on the balance sheet. They may represent a inancial fraud in the form of creating a cookie jar or rainy day fund that can be dipped into when future periods fall short of revenue expectations. Not many companies can claim to have more effectively and fraudulently abused reserve accounts better than Cardinal Health, Inc.

Cardinal, who will appear later in this book in connection with bogus related party transactions, maintained no less than 60 different reserve accounts. As explained in Chapter 10, liabilities for contingencies should be recorded when it is both probable that a liability has been incurred and the amount of the liability can be reasonably estimated.

Conversely, once the likelihood of a liability becomes less than probable or it is no longer reasonably estimable, the reserve should be removed from the books. Maintaining general reserves that are not associated with any speciic contingent liability cannot be supported under U.

When that need arose, such as in , the reserve was dipped into. These schemes are distinguished from timing difference schemes in that with ictitious rev- enues, the revenue should not be recognized in any period. This is normally accomplished in one of two manners: 1. Recording journal entries for sales without attributing the sales to speciic customers e. Recording sales attributable to ictitious customers A third technique, recording of phony sales to legitimate customers, can be utilized but is less common.

The mechanics of ictitious revenue schemes will be illustrated through descriptions of three cases: 1. Satyam Computer Services Ltd. Symmetry Medical Shefield 3. One of largest reported ictitious revenue cases occurred with Satyam Com- puter Services Ltd. It employed more than 40, people in ofices throughout the world. From at least through September , false and inlated sales invoices were created outside the normal accounting processes by which revenues were recorded. Some of these invoices were false sales to real customers, while others involved ictitious customers altogether.

As with so many inancial reporting frauds, the scheme grew over time. Senior management tried desperately to acquire real assets to ill in the gaps created by the fraud. But the fraud continued to escalate. TPC accounted for a signii- cant portion of the consolidated revenues of its parent company, U. A timing scheme to recognize revenue early had already been in place at TPC as early as However, things got really interesting in , when the strategy shifted from premature revenue recognition to ictitious revenues.

In an attempt to conceal the ictitious revenue, this individual then sent a record of the provisional sales to another person, who calculated and recorded the ictitious cost of goods sold associated with the ictitious sales. These ictitious sales had a material impact on the inancial statements of TPC. Although the perpetrators of this fraud recorded cost of goods sold to align with the ictitious sales, the scheme also involved a separate effort to inlate inventory balances and, therefore, understate cost of goods sold.

The incentive behind the TPC schemes was nothing new—pure greed. The perpetrators received bonuses based on the purported performance of TPC, and they proited handsomely from their sale of parent company Symmetry stock. LocatePlus Holdings Corporation In , the SEC charged LocatePlus Holdings Corporation, a seller of personal information used for investigative searches, with inlating its revenue during and through the creation of a ictitious customer known as Omni Data Services, Inc.

In order to make the transactions appear legitimate, Omni Data paid LocatePlus for the sales. However, these payments were actually funded with cash routed through entities under the control of LocatePlus executives. In addition to its charges that LocatePlus fraudulently reported revenue from this ictitious customer, the SEC also charged LocatePlus with failing to disclose the ictitious customer as a related party! In some cases, the effect of any inlated proits from sales to related par- ties may be eliminated in consolidation, when the related parties involved are under the control of an entity that prepares consolidated inancial statements.

However, when the related party is not included in the consolidated inancial statements of the seller, inancial reporting fraud can result. Dic- tation was disclosed as a related party. These transactions with the banks amounted to nothing more than fully secured loans, not the factoring of receivables. An afiliate is a party that, directly or indirectly through one or more intermediaries, controls, is controlled by, or is under common control with the entity. Principal owners are owners of record or known beneicial owners of more than 10 percent of the voting interests of an entity.

Management includes persons who are respon- sible for achieving the objectives of the entity and who have the authority to establish policies and make decisions by which those objectives are to be pursued. Management normally includes members of the board of direc- tors, the chief executive oficer, chief operating oficer, vice presidents in charge of principal business functions such as sales, administration, or inance , and other persons who perform similar policymaking functions.

Persons without formal titles may also be members of management. Immediate family includes family members whom a principal owner or a member of management might control or inluence or by whom they might be controlled or inluenced because of the family relationship. The Wall Street Journal reported in that 75 percent of the larg- est U.

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The vast majority of these transactions are likely to be legitimate transactions between two entities that are connected through one or more of the relation- ships described above. Revenue from related parties should always be scrutinized carefully. Increasing levels of revenue from related party transactions have been cor- related with an increased risk of inancial reporting fraud—more on this later. The entity and the reporting entity are members of the same group i. One entity is an associate or joint venture of the other entity or an associ- ate or joint venture of a member of a group of which the other entity is a member.

Both entities are joint ventures of the same third party. One entity is a joint venture of a third entity and the other entity is an associate of the third entity. The entity is a postemployment beneit plan for the beneit of employees of either the reporting entity or an entity related to the reporting entity if the reporting entity is itself a plan, the sponsoring employers are also considered to be related to the reporting entity. The entity is controlled or jointly controlled by a person identiied above. A person identiied in 1 above has signiicant inluence over the entity or is a member of the key management personnel of the entity or of a parent of the entity.

GAAP counterpart—it represents the power to participate in the inancial and operating policy decisions of an entity, as differentiated from control. Signii- cant inluence may arise from ownership, but also via a contract or other agree- ment, as well as from a statute. Most of the questionable transactions pertained to related arrangements involving two separate related parties and were executed in order to close the gap between actual and expected inancial results.

For example, in one arrangement, NetEase sold advertis- ing services to one related party, while purchasing offsetting services from another related company. In another example, NetEase sold advertising to one of its stockholders while purchasing an offsetting amount of inancial advisory services from the same stockholder. No services were performed or received in connection with these arrangements. As noted in Chapter 5, barter transactions can involve goods or services that may be dificult to value.

That is exactly what occurred here, with Itex recognizing revenue in connection with bartered artwork and prepaid advertising, as well as completely bogus assets, including leases on vacant property and unpatented and undeveloped mineral claims. Each of these cases involved some form of ictitious revenue resulting from purported sales to related parties. While the focus in this section is on the use of related party transactions to inlate revenue, related transactions can be a source of several types of fraudulent inancial reporting.

Sales of goods or services to a related party 2. Purchases of goods or services from a related party 3. Sales of assets to a related party 4. Purchases of assets from a related party 5. Borrowing from a related party 6. Lending to a related party 7. Investments in equity in a related party 8.

Selling of ownership interests to a related party The authors studied 48 cases in which the SEC alleged fraudulent reporting associated with related party transactions and found examples in each of the preceding eight categories. Related party transactions fall under a disclosure obligation, which serves as a notice for all readers of the inancial statements. These disclosure require- ments are described in Chapter 14 in connection with disclosure frauds. In addition, as explained in Chapter 17, increasing proportions of sales with related parties has been shown to have a high correlation with fraudulent inancial reporting.

Often, ictitious customers stand out among other customers when a detailed customer master ile is examined. Fictitious customers often appear to have certain key data omitted, such as street addresses, telephone numbers, and so on. These signs make it a bit easier to identify the need for investigation. With inlated revenue schemes, however, the customer is real. The inlation of the revenue can come from either of the following: 1. Phony transactions 2. Inlated amounts as part of a legitimate transaction e. The NutraCea case provides a good illustration of one technique used to inlate revenue.

It has been delivered to the retailer by a manufacturer or wholesale distributor, but under special terms that differ from a typical sales transaction. When inventory is held on consignment, the party holding the inventory usually a retailer does not really own the inventory. SAB SEC codiication Topic 13 identiies the following characteristics of a consignment or inancing arrangement in which revenue recognition is prohibited even if title to the product has passed to the buyer: 1. The buyer has the right to return the product, in addition to any of the following circumstances: a. The buyer does not pay the seller at the time of sale, and the buyer is not obligated to pay the seller at a speciied date or dates.

The buyer acquiring the product for resale does not have economic substance apart from that provided by the seller. The seller has signiicant obligations for future performance to directly bring about resale of the product by the buyer. The seller is required to repurchase the product or a substantially identical product or processed goods of which the product is a component at speciied prices that are not subject to change except for luctuations due to inance and holding costs, and the amounts to be paid by the seller will be adjusted, as necessary, to cover substantially all luctuations in costs incurred by the buyer in purchasing and holding the product including interest.

The seller has a practice of refunding or intends to refund a portion of the original sales price representative of interest expense for the period from when the buyer paid the seller until the buyer resells the product. The product is delivered for demonstration purposes From a revenue recognition perspective, the primary fraud risk here involves recognition of revenue by the manufacturer or wholesaler upon deliv- ery to the retail customer, when the transaction qualiies as a consignment transaction.

This results in early revenue recognition. One example of improper revenue recognition in connection with a con- signment inventory transaction involved Nortel Networks Corporation. In a complaint iled by the SEC, Nortel was charged with a variety of inancial reporting misstatements.

However, the usual risks of ownership were not transferred from Nor- tel to Telamon, who was not required to pay Nortel until the products were resold and Telamon collected payment from the end customer. In addition, Telamon routinely returned unsold products to Nortel. Generally, transactions that purport to be a sale of inventory should be treated as i nancing arrangements when the risks and rewards of ownership have not been transferred to the purchaser.

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The company may not record the transaction as a sale nor may it remove the covered product from its balance sheet. Delphi, an auto parts sup- plier, had planned to sell an inventory of precious metals, earmarked for use in coating catalytic converters, to another company its former parent company and largest customer by the end of December However, in November , Delphi learned that this transaction would not come to fruition in , but would instead be postponed to early In a desperate attempt to record a gain from the precious metals in its inancial statements while remain- ing able to honor its commitment to transfer the precious metals to its former parent, Delphi concocted an alternative transaction.

As a result of this arrangement, Delphi recorded a gain on the sale of the precious metals in December , followed by a purchase in January So, how is Delphi falsely stating its income for this transaction? The answer lies in the terms of the agreement to purchase the precious metals back from the bank. The agreement called for Delphi to purchase the metals at a price that was ixed at the time of the agreement, the same date as when Delphi sold the metals to the bank.

The establishment of a ixed, and slightly higher, price at which virtually the same quantity and speciications of assets were to be transferred back to Delphi was the accounting equivalent of Delphi borrowing funds from the bank in December and repaying the funds, with interest, in January The bank simply stored the metals for Delphi. Adding to the dubious nature of the transaction was the fact that there was no ixed date for the delivery of the metals by Delphi to the bank.

Delphi had the right to not actually deliver the metals. Instead, it was permitted to simply pay the bank a ixed rate per ounce for any undelivered metals. Indeed, some of the metals purportedly sold by Delphi to the bank were actually still in the possession of Delphi suppliers. All the bank had to do was present a bill of sale in January for the metals remaining in the possession of Delphi. Sound odd? There was even a written sales agreement documenting the transaction.

However, there was also an unwritten side deal under which the consulting company sold an identical inventory of items to Delphi on January 5, , all at the original price, plus a transaction fee. While the net proit or loss of the company is not misstated when this is done, an incorrect picture of its operations is presented. Cardinal is a provider of health care services and products, including its pharmaceutical distribution operation, which accounted for more than 80 percent of its revenues.

The lawsuit was iled in May Never mind the fact that recogni- tion of such a gain contingency could not be supported under U. Not only did Cardinal inappropriately record a gain contingency, they recorded it as a reduction to cost of goods sold in order to improperly pump up operating income for the quarter. Once again, this amount was recorded as a reduction in cost of sales. Earlier, the accounting for customer loyalty programs was addressed. In this section, the topic of special incentives is covered.

Other incentives, also known as promotional allowances, involve cash payments, rebates, or reductions in amounts due in exchange for a variety of beneits. Accounting schemes associated with sales incentives fall into two of the revenue categories explained in connection with other schemes: 1.

Misclassiication schemes 2. Timing schemes These schemes can potentially impact the revenues or sales of either the vendor or the customer. However, there are two possible excep- tions from this treatment: 1. If the payment received represents a payment for an identiiable beneit goods or services delivered to the vendor, the payment should be classiied as revenue when recognized. The vendor can reasonably estimate the fair value of the beneit. The logic behind the second condition is that if the consideration paid by the vendor exceeds the fair value of the beneit received from the customer, the excess should be classiied as a reduction in revenue earned from the customer.

Either the customer or the vendor could engage in misclassiication schemes. There is no impact on net income in a misclassiication scheme. However, other key performance measures could be manipulated using a misclassiication scheme. This company shows a gross proit of 60 percent. A similar impact could be derived by a vendor wishing to improperly account for incentives provided to customers. The rebates should have been recognized only when agreed purchasing thresholds were met. However, the documentation for the real purchasing thresholds was substituted with phony documents supporting the early recognition.

One of these involved the recognition of promotional allowances received from vendors by U. The typical promotional allowance agreement involved USF committing to purchase a certain minimum volume from a vendor at established prices, in exchange for which the vendor would pay a per unit rebate of a portion of the original purchase price charged to USF, based on a payment schedule.

Some promotional allowances were paid as they were earned. In order to meet its earnings targets, USF recorded completely ictitious promotional allowances in amounts suficient to cover any budget shortfalls in earnings. USF executives attempted to cover up their scheme using a variety of techniques, including lying to the audi- tors, who were incorrectly informed that none of these promotional allowance arrangements were documented in the form of agreements.

What clearly places this case in the category of fraud, as opposed to an unintentional error or misapplication of an accounting rule, are the great lengths that USF executives went to in order to hide their scheme. In addition to lying to the auditors, USF executives rigged the conirmation process used by the auditors.

Conirmation requests were sent to various vendors. USF contacted vendors informing them to sign the con- irmations without question. In some cases, side letters were sent to vendors assuring them that they did not owe the amounts stated in the conirmation requests. It involves the timing of the recognition of revenue reductions associated with incentives provided to customers by a supplier.

In fact, some involve the deception of the accounting department by other personnel. These accommodations, based on the rules described earlier, are normally accounted for as reductions in sales revenue. Under the matching principle inherent in U. GAAP and IFRS, expenses or revenue reductions associated with revenue transactions should be recog- nized in the same accounting period as the revenue. The assistant was also instructed to include inaccurate data on the supporting documentation, particularly infor- mation about the original sales date to which the accommodation applied.

This tricked the accounting department into matching the accommodations with the wrong later sales. Of course, as the amounts involved escalated, the lies extended beyond merely creating false supporting documentation. Even in , additional charges continue to be made in connection with this scheme. The goal can also be to appear larger, processing a greater volume of transactions and activities. Under both U. In addition, IAS 18 notes when goods or services are exchanged for other goods or services that are similar in nature, revenue should not be recognized.

Instead, the agent company should merely record any net amount from the transaction as revenue. The amount to be remitted to the principal should be accounted for as a liability when it is received. The liability is then eliminated when payment is remitted to the principal. Examples of transactions in which this issue emerges are plentiful.

One of the most common examples involves a company that sells products and ser- vices to customers. The products that it provides to its customers, however, are provided by an unrelated supplier. A series of characteristics of this transaction will determine whether the company is acting as a principal or as an agent for the supplier, though the determination is not always easy to make. Under ASC , eight questions should be addressed in making this determination: 1.

Who is the primary obligor in the transaction? If the company is respon- sible for fulilling the obligations to a customer in an arrangement, this is consistent with the company recording amounts it receives as revenue. However, if a supplier to the company has the primary responsibility for fulilling an order for products or services to be provided to a customer, this is an indicator that the company should not recognize revenue for the por- tion of the transaction for which the supplier has primary responsibility.

Simply having responsibility for arranging for transportation of products is not an indicator of being the primary obligor in a transaction. Who has inventory risk in the transaction? Inventory risk exists when a com- pany assumes ownership of inventory before the inventory has been ordered by a customer. Thus, if a company does not own the inventory until after it has been ordered by a customer e. Having inventory risk is consistent with being a principal in a transaction. No inventory risk is an indicator of being an agent.

Does the reporting entity have latitude in pricing? If a company has latitude in establishing the price it charges its customer, this indicates it is acting as principal by the fact that it possesses the risks and rewards consistent with such relationships. However, if the price it charges a customer is ixed by the supplier, this is consistent with acting as an agent. Does the entity change the product or provide part of the service? Does the entity have supplier discretion? Does the entity have a role in determining product or service speciications?

Does the entity have physical loss inventory risk?

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Does the entity have credit risk? Credit risk exists when a sales price has not been fully collected at the time a product or service is delivered. While requiring prepayment, by itself, does not preclude recognition of revenue as principal, the existence of credit risk is a common characteristic of being a principal in a transaction.

Whereas, if the supplier does not receive payment from the agent until after the agent receives payment from the customer, the intermediary company may be serving in the capacity of an agent. With one exception, agent transactions improperly recorded as principal transactions affect gross operations, but do not generally have an impact on proits or loss, unless the transactions overlap accounting periods. However, consignment sales transactions, described in Chapter 3, are a form of agent transaction in which proits can be affected, since improperly recorded sales are offset by cost of goods sold, resulting in proits being recorded in the wrong period, or where none should be recognized e.

Often the prod- ucts or services are of a similar nature e. Generally, barter transactions result in revenue and expenses or assets for both companies involved in the transaction. The October agree- ment also described another sale of 62, pairs of shoes. Once again, the shoes in the second agreement were not shipped. Obviously, a major element of this fraud deals with the failure to ship any shoes associated with the recording of revenue. As a result, revenue for the one transaction was recorded in two different accounting periods.

For example, Company A sells a product to Company B for cash, while at the same time, Company B sells a product to Company A for cash, often for an equivalent or similar amount as the irst transaction. In other cases, unrelated third parties may be utilized to perpetrate the fraud. This is exactly the nature of the charges brought by the SEC in against former executives of Homestore, Inc. The essence of these transactions was a circular low of money by which Homestore recognized its own cash as revenue. Speciically, Homestore paid inlated sums to various ven- dors for services or products; in turn, the vendors used these funds to buy advertising from two media companies.

The media companies then bought advertising from Homestore either on their own behalf or as agents for other advertisers. Homestore recorded the funds it received from the media companies as revenue in its inancial state- ments, in violation of applicable accounting principles.

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These credits were recorded as cur- rent income. However, the CEO then directed the vendors to rebill Duane Reade for the credited amounts in later periods using ictitious invoices. This timing scheme resulted in the fraudulent recording of income in one period, offset by the recording of expenses in a subsequent period. In these cases, the fraud may be so simple as to only involve the recording of artiicial revenue and expenses in equal amounts.

There is no effect on net proit with this scheme. However, by appearing larger, it can help a company meet market expectations for overall growth in sales. These accruals were imme- diately reversed in January Since accounting involves two sides to every transaction, schemes involving revenue inla- tion can impact inancial statements in several other manners: 1. Overstating assets e. Understating liabilities e. Overstating expenses e. Understating gains or other nonoperating revenue e. This method instantly takes expenses, which reduce net income, and converts them into assets.

There are several categories of expenses that are the most likely candidates for improper capitalization, including the following: 1.


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Research and development costs 3. Repairs and maintenance capitalized as property and equipment 4. Software development and acquisition 5. Websites 6. Development of intangible assets 7. Advertising 8. Normally, the costs capitalized in adding new production lines included internal plant labor and other internal costs, in addition to amounts paid to third parties.

Capitalizing internal labor costs is consistent with accounting principles. This led to the i rst method of improperly capitalizing expenses—AIPC capitalized internal costs based on its budget rather than on any actual measurement of those costs note that the lack of internal controls in this case raised doubts about all capitalized internal costs, even though some portion of the internal costs likely were legitimately capitalized.

The second method AIPC used involved the capitalization of normal manufacturing expenses that exceeded the original manufacturing budget. In other words, any excess manufacturing costs simply got dumped into i xed assets. The third approach utilized by AIPC was to capitalize the impact on proit of sales shortfalls. For example, if sales fell short of expectations in one period, the proit shortfall would be restored by increasing a capital asset. In assigning the increased basis to speciic assets, in some cases AIPC even charged the amounts to assets that had already been installed and were in operation.

The fourth method of improper expense capitalization involved internal and external information technology costs and really involved multiple methods. As explained later, certain internal and external costs of developing software for internal use may be capitalized.

However, much like with its plant labor, AIPC capitalized internal information technology labor costs based solely on a budget, without any supporting documentation or correlation to speciic capitalizable tasks. In addition, AIPC improperly capitalized numerous other types of internal and external information technology costs, such as hardware leasing, software maintenance, communications, and noncapitalizable outside labor.

Development is described as the translation of research indings or other knowledge into a plan or design for a new product or process, or for a signii- cant improvement to an existing product or process, whether intended for sale or use. It includes the conceptual formulation, design, and testing of product alternatives, construction of prototypes, and operation of pilot plants.

Research and development costs are to be expensed as incurred. There are several examples of cases in which research and development costs were improperly capitalized as a way of inlating proits. The SmartForce PLC case, introduced in Chapter 2 in connection with a revenue recognition scheme, is one such example.

One of the allegations against SmartForce was that it improperly capitalized research and development costs associated with some of its courseware content. Most reported property and equipment is owned by the reporting entity. How- ever there are certain exceptions to this ownership requirement, most notably for property utilized under leases that qualify as capital leases. With one important exception that will be explained later in this section, U. Accounting for the Acquisition Property and equipment should be initially recorded at cost.

Cost is generally based on the cash paid for an asset, or the amount borrowed to acquire an asset. However, when consideration other than cash is provided in exchange for property and equipment, fair value of the consideration is generally utilized to measure the acquired asset. This includes the purchase price, related taxes associated with the purchase e.

If the property is real estate and con- struction, acquisition costs may also include architect fees, remodeling costs, excavation costs, payments to construction contractors, materials, building permits, and labor. Costs must be speciically identiied in order to be eligible for capitalization. In the case of Qwest Communications International, Inc.

If an asset retirement obligation exists, the estimated cost of dismantling and removing the asset should also be capitalized, with a corresponding credit to a liability account. See Chapter 10 for further explanation of this liability. Costs Incurred during Ownership Once an entity has capitalized an asset, additional costs are usually incurred on an ongoing basis to maintain the asset.

This introduces another inancial reporting fraud risk. Those costs that do not meet one of these criteria should be expensed. Thus, repair and maintenance costs asso- ciated with merely maintaining an asset in proper working condition, ensuring it lasts for its expected useful life, should be expensed rather than capitalized. If a component part of an asset is replaced, the cost of the component replace- ment part may be capitalized and the component part that was replaced would be derecognized its cost and accumulated depreciation removed from the books.

One excellent example of the improper capitalization of expenses involves Buca, Inc. Under this scheme, Buca misclassiied certain workers as independent contractors who should have been classiied as employees. This helped in improperly capitalizing amounts paid to these workers. Similarly, Buca laid off its vice president of real estate, then hired her as an independent contractor shortly thereafter. In effect, the severance payment made to the laid off employee was recorded as an asset.

Buca also improperly capitalized payments made to legitimate independent contractors. Buca is discussed again later in connection with an asset inlation scheme see Chapter 7. One inal consideration involves the subsequent revaluation of property and equipment.

As will be explained in the section on impairment losses in Chapter 7, property and equipment should be assessed for impairment. But what about those situations in which the fair value of property and equipment has increased to an amount greater than recorded net book value? Under IFRS, revaluing property and equipment to relect these unrealized gains is permissible. GAAP, recording such increases is prohibited. When recording these increases in accordance with IFRS, consideration must be given to the type of property and equipment involved.

Investment property is also addressed in Chapter 7.

Financial Statement Fraud : Gerard M. Zack :

Rather, these increases are credited directly to equity as a revaluation surplus unless a previous revaluation resulted in an expense, in which case the revaluation would irst restore the previously rec- ognized expense. Accordingly, the surplus is relected in other comprehensive income rather than in the income statement. GAAP, the accounting for costs incurred in the development or acquisition of software is covered in two areas, depending on whether the soft- ware is for internal use only e.

In determining and periodically reassessing the estimated useful life over which capitalized costs should be amortized, organizations should consider the effects of obso- lescence, changes in technology, competition, and other economic factors. Internal costs incurred to create computer software are expensed as incurred until technological feasibility for the product has been reached.

Technological feasibility is established upon completion of a detailed program design or, in its absence, completion of a working model. About this product. Stock photo. Brand new: lowest price The lowest-priced brand-new, unused, unopened, undamaged item in its original packaging where packaging is applicable. Gerard M. Founder of the Nonprofit Resource Center, a training, publishing, and resource center serving CFOs and external auditors of nonprofits, Zack is a certified fraud examiner and has worked almost exclusively with nonprofit organizations for over two decades and has consulted on fraud prevention with a variety of organizations.

See details. See all 3 brand new listings. Buy It Now. Add to cart. Zack , Hardcover. Be the first to write a review About this product. About this product Synopsis Financial Statement Fraud: Strategies for Detection and Investigation will provide comprehensive coverage on the different ways financial statement fraud is perpetrated, including those that capitalize on the most recent accounting standards developments, such as fair value issues. It will also provide numerous ratios and red flags useful in detecting FS Fraud, and cross-reference them to each of the fraud schemes supplemental web materials will cross-reference all red flags to specific fraud schemes and vice versa, and cross-reference ratios to specific fraud schemes and vice versa, so the researcher can look at it from both perspectives.

Valuable guidance for staying one step ahead of financial statement fraud Financial statement fraud is one of the most costly types of fraud and can have a direct financial impact on businesses and individuals, as well as harm investor confidence in the markets. While publications exist on financial statement fraud and roles and responsibilities within companies, there is a need for a practical guide on the different schemes that are used and detection guidance for these schemes.

Describes every major and emerging type of financial statement fraud, using real-life cases to illustrate the schemes Explains the underlying accounting principles, citing both U. GAAP and IFRS that are violated when fraud is perpetrated Provides numerous ratios, red flags, and other techniques useful in detecting financial statement fraud schemes Accompanying website provides full-text copies of documents filed in connection with the cases that are cited as examples in the book, allowing the reader to explore details of each case further Straightforward and insightful, "Financial Statement Fraud" provides comprehensive coverage on the different ways financial statement fraud is perpetrated, including those that capitalize on the most recent accounting standards developments, such as fair value issues.

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