Financial Statement Fraud

ZABIHOLLAH REZAEE, PHD, CPA, CFE, CIA, CGFM, CMA, is the Thompson-Hill Chair of Excellence and Professor of Accountancy at the University of Memphis and served a two-year term on the Standing Advisory Group (SAG) of the Public Company Accounting Oversight Board (PCAOB). He has published over 175 articles in a variety of accounting and business journals and six books, including Corporate Governance and Ethics (Wiley). RICHARD RILEY, PHD, CPA, CFE, is a Louis F. Tanner Distinguished Professor of Public Accounting at West Virginia University. He was recognized as the 2008 ACFE Educator of the Year and by the American Accounting Association in 2009 for his innovations in accounting education. He is a forensic accountant and a Certified Fraud Examiner who has developed and implemented educational programs for the United States National Institute of Justice and the Internal Revenue Service. In addition to his distinguished academic career, he was employed as a senior accountant in the accounting firm of Deloitte & Touche.

Foreword xi

Preface xiii

Acknowledgments xix

Part One: Financial Reporting and Financial Statement Fraud 1

1 Financial Statement Fraud Defined 3

Will History Repeat Itself? 3

A Closer Look 4

Definition of Financial Statement Fraud 4

Nature of Financial Statement Fraud 8

High-Impact Fraud Cases 11

Cost of Financial Statement Fraud 13

Fraud Studies and Regulatory Responses 16

Antifraud Programs 19

Occurrence, Prevention, and Detection 22

Lessons Learned and Applications for Practice 25

Notes 28

2 Financial Reporting Structure 31

Introduction 31

Financial Reporting System 31

Importance of Financial Information 33

Annual Financial Reporting Requirements 38

High-Quality Financial Reports 39

Six-Legged Stool of the Financial Reporting Process 41

Corporate Financial Reports 42

Corporate Reporting Challenges 44

Financial Restatements 45

Fair Value 46

Stock Options Accounting 46

XBRL-Generated Financial Reports 47

Antifraud Applications for Practice 48

Notes 52

Part Two: Financial Statement Fraud Profile, Taxonomy, and Schemes 55

3 Cooking the Books Equals Fraud 57

Introduction 57

Why Does Financial Statement Fraud Occur? 57

Profile of Financial Statement Fraud 58

Waste Management, Inc.: Financial Statement Fraud Analysis 70

Antifraud Applications for Practice 72

Notes 76

4 Realization, Prevention, and Detection 78

Introduction 78

Realization 78

The 3Cs Model 79

Financial Statement Fraud Prevention 84

Financial Statement Fraud Detection 86

Correction Procedures 87

Prevention, Detection, and Correction Strategies 87

Antifraud Applications for Practice 89

Notes 96

5 Taxonomy and Schemes 97

Introduction 97

Symptoms of Financial Statement Fraud 97

Common Fraud Schemes 101

Common Revenue Fraud Schemes 103

Financial Statement Fraud Red Flags 105

Whistle-blower Regulations 112

Antifraud Applications for Practice 114

Notes 117

Part Three: Corporate Governance and Its Role in Preventing and Detecting Financial Statement Fraud 119

6 Role of Corporate Governance 121

Introduction 121

Definition of Corporate Governance 122

Role of Corporate Governance 122

Corporate Governance Structure 125

Characteristics of Corporate Governance 127

Corporate Governance Functions 128

Global Corporate Governance 132

Antifraud Applications for Practice 134

Notes 136

7 Board of Directors’ Oversight Responsibility 138

Introduction 138

Role of the Board of Directors 138

Composition of the Board of Directors 139

Functions of the Board of Directors 142

Attributes of Boards of Directors 145

Antifraud Applications for Practice 151

Protocol: A Plan for Reaction to Allegations of Misconduct 152

Notes 155

8 Audit Committees and Corporate Governance 157

Introduction 157

Audit Committee 157

Audit Committee Attributes 166

Audit Committee Roles and Responsibilities 168

Audit Committee Charters 172

Chairperson of Audit Committees 173

Audit Committee Report 173

Audit Committee Roles in Preventing and Detecting Financial Statement Fraud 177

Antifraud Applications for Practice 178

Notes 183

9 Management Responsibility 184

Introduction 184

Management Financial Reporting Responsibilities 184

Management’s Role in Financial Statement Fraud Prevention and Protection 190

Management Motives and Incentives 191

Management Override of Internal Control 192

Gamesmanship 194

Risk Management 196

Antifraud Applications for Practice 200

Notes 204

10 Role of the Internal Auditor 206

Introduction 206

Internal Auditors and Corporate Governance 206

Internal Auditors’ Responsibilities 208

Internal Audit Fraud Standards 212

Efficacy of Internal Audit in Financial Statement

Fraud Prevention and Detection 214

Cooperation between External and Internal Audit 215

Internal Audits and the Audit Committee 217

Internal Control 218

Antifraud Applications for Practice 225

Notes 227

11 Role of External Auditors 229

Introduction 229

Independent Audit of Financial Statements 229

Independent Auditor and Financial Statement Fraud 234

Independent Audit and Internal Control 237

Report on Internal Controls 238

Fraud Detection Audit Procedures 240

Materiality Guidance 246

Risk Factors of Financial Statement Fraud 249

Communication of Fraud 253

Antifraud Applications for Practice 254

Notes 256

12 Governing Bodies 258

Introduction 258

Role of Regulation in Corporate Governance 259

Sarbanes-Oxley Act of 2002 260

Securities and Exchange Commission 263

SEC’s Regulation Fair Disclosure 267

Financial Fraud Detection and Disclosure Act of 1992 268

Private Securities Reform Act of 1995 268

SEC and Financial Statement Fraud 269

SEC Fraud Prevention Activities 269

SEC Fraud Detection Activities 270

SEC Fraud Enforcement Activities 270

Role of the Financial Accounting Standards Board 273

Antifraud Applications for Practice 276

Notes 279

Part Four: Digital (Computer) Approaches to Fraud and Forensic Accounting 281

13 Fraud in a Digital Environment 283

Introduction 283

Digital Economy 284

Electronic Commerce 285

Changes in Business Environment 288

Electronic Financial Reporting 292

Antifraud Applications for Practice 302

Notes 305

14 Fraud Examination Practice, Education, and Research 306

Introduction 306

The Interrelationship: Auditing, Fraud Examination, and Forensic Accounting 307

Forensic Accounting Practice 308

Fraud Examination 310

Certification in Financial Forensics 313

Training Competent and Ethical Fraud Examiners and Forensic Accountants 313

Fraud Examination and Forensic Accounting Education 315

Role of Research in a Profession 316

Antifraud Applications for Practice 318

Notes 321

Appendix: Summary of Six Recent Fraud Studies 323

About the Authors 327

Index 329