Common Fraud Schemes

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Common Fraud
Schemes
Copyright 2011 Deloitte Development LLC. All rights reserved. 2 Footer
Common Fraud Schemes
Revenue Recognition Schemes
Reserve Manipulation
Improper Expense Capitalization

Revenue Recognition
Revenue should be recognized when it is earned and realizable
Revenue is generally realizable and earned when all of the following
conditions are met:
Persuasive evidence of an arrangement exists
Delivery has occurred or services have been rendered
The seller's price to the buyer is fixed or determinable
Collectability is reasonably assured

Revenue Recognition
Common revenue fraud schemes often include one or more of the
following characteristics which attempt to bypass the GAAP recognition
requirements:
Excessive Rights of Return
Side Letter Arrangements (written or oral)
Channel Stuffing
Guaranteed Sales
Consignment Sales
Holding the Quarter Open
Improper Bill and Hold Transactions
Round-Trip / Barter Transactions
Fictitious Sales
Revenue Recognition: Example
Background
A manufacturer of high-tech equipment conducting all sales through
distributors. It launched its IPO recently.
Multiple schemes employed to improperly increase Revenue including:
Excessive Rights of Return / Side-Letter Arrangements
Round-Trip Investment-Related Sale

Manufacturer Multiple Schemes
Revenue Recognition: Example
Excessive Rights of Return / Side Letter Arrangements
Provided distributors a letter with terms that would jeopardize full and
immediate revenue recognition.
To satisfy auditors, a revised letter without problematic terms was sent
Management contacted distributor via email confirming the intent of the
original letter agreement.
Round-Trip Investment-Related Sales
Manufacturer invested millions of its cash in the equity or debt of start-up
companies
Investees used the cash they received to purchase equipment through
distributors and manufacturer recorded revenue
The value of consideration (equity and debt instruments) received
quickly deteriorated (or was not supportable to begin with) but these
losses were recorded below the line
Manufacturer Multiple Schemes
Possible Indicators and Detection Methods of
Revenue Recognition Fraud
Absence of valid business purpose for transactions
Significant transactions at quarter-end
Existence of side-letters, verbal agreements or emails that appear to
alter the standard terms of sale
Product returns in excess of standard policies
Changes in customer purchasing and payment trends
Unusual distributor inventory activity

Revenue Recognition Fraud (Continued)
Data Analytics
Compare customer listing to vendor listing
Filter for manual journal entries to Revenue accounts
Review A/R aging for deterioration
o A/R Turnover = Net Revenue / Average A/R Balance
o Days Sales Outstanding = 365 / A/R Turnover
Review significant sales where no commission was paid

Reserves
Companies book reserves for a variety of things:
Accounts Receivable
Sales Returns
Warranties
Restructuring
Aging Inventory

Setting a reserve entails a certain amount of judgment by management
with regards to what will potentially happen in the future.

Reserves Liability accounts (credits) on the balance sheet. Reserves
must meet the definition of liabilities and therefore MUST be specific.
General, excess, rainy-day, cookie-jar, cushion and
unallocated reserves are not allowable under GAAP

These improper reserve accounts often include excess reserves which
can be reversed to inflate earnings in order to:
Meet profitability targets
Avoid net losses
Smooth operating results

It was the best of times
Companies experiencing
fantastic operating performance
may seek to defer earnings into
future periods
To reduce market expectations
of future performance, and
To establish reserves for use
in covering future period
expenses
It was the worst of times
Companies may decide to take
a Big Bath during periods of
poor financial performance.
To describe current year
performance as fluke
Reserves often established
through non-recurring
expenses
Reserve Manipulation Illustration
Dr. Expense $1,500
Cr. Liability $1,500
Creation of excess
reserve
Actual expenses
incurred of $1,000,
however company
books expenses of
$1,500
Payment of actual
liability
Settles actual liability
of $1,000 by paying
cash, however $500
remains in the liability
account as a credit

Year 1 Year 2 Year 3
Dr. Liability $1,000
Cr. Cash $1,000
Release of excess
reserve
Releases excess
liability and
improperly CREDITS
expense, which
increases net
income in Period 3
Dr. Liability $ 500
Cr. Expense $ 500
The market expects net income of $3,000, but preliminary results show net
income to be $3,500. The management decides to create cookie jar reserve of
$500.
Not accruing for known expenses, for which invoices have
not been received
Deferring the recognition of expenses that belong in the
current period to future periods by capitalizing them
Record lower expenses than actually incurred
Hiding invoices
Inflate inventory cost by creating fake documentation (e.g.,
invoices)
Inflate sale price and quantity in order to justify not
recording an obsolescence reserve

Possible Indicators and Detection Methods
of Reserve Manipulation
Poor financial performance followed by period of outstanding results
Significant, unexpected financial losses in the period
Upcoming acquisition or IPO
Existence of new reserve accounts, general reserve accounts, or
increased activity in previously dormant accounts
Post-closing and top-side entries creating credits on balance sheet
Booking expenses to budget
Data Analytics
Analyze significant CREDITS to expense/loss accounts on the income
statement and review offsetting DEBITS for reasonableness
Isolate manual journal entries, and sort by user
Review for post-closing adjusting journal entries that have no or vague
supporting documentation
Debits to the reserve accounts and credits to the expense accounts

Improper Capitalization of Expenses
Capitalized Expenses
Under GAAP certain costs are allowed to be capitalized on the balance sheet
as assets and expensed over time if they will contribute to the production of
revenue in the future (i.e. property, machinery, patents).
These assets are expensed through the income statement over the course of
their estimated useful lives using Depreciation or Amortization expense.
Example Company purchases a piece of equipment for use in production of
its inventory for $500,000. It is expected to be productive for 10 years, after
which it will have no estimated residual value.
Date of purchase

End of first year (and consecutive years)

Dr. Machinery (Asset) $ 500,000
Cr. Cash (Asset) $ 500,000
Dr. Depreciation Expense $ 50,000
Cr. Accumulated Depreciation (Asset) $ 50,000
Occurs when a company capitalizes certain costs that do not
meet the criteria established by GAAP.
Occurs when expenses are effectively deferred over the useful
life of the asset as opposed to being charged to the income
statement immediately.

Unexplained increase in fixed assets such as property, plant, and
equipment.
Related increase in depreciation / amortization
Review additions to these accounts that were NOT processed
through standard purchasing process
Lower than expected expenses
As percentage of revenue (vertical analysis)
As compared to prior periods (horizontal analysis)
Manual journal entries posting increases to capital asset accounts
where systematic process exists
Unexplained significant variances between actual capital expenditures
and budgeted amounts

Data Analytics
Analyze significant CREDITS to expense/loss accounts on the income
statement and review offsetting DEBITS for reasonableness
Isolate manual journal entries, and sort by user
Review for post-closing adjusting journal entries that bring the company
into line with earnings expectations
Management does not usually know what the consolidated earnings
are until after period-end
Late, manual journal entries are often posted to tweak earnings to
meet expectations

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Common Fraud Schemes

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