FINANCIAL STATEMENT FRAUD PAST PAPERS WITH ANSWERS

QUESTION 1 : Like most other types of fraud, the motivation for financial statement fraud almost always involves personal gain.

True
False

Unlike some other types of fraud (such as embezzlement), the motivation for financial statement fraud does not always involve personal gain. Most commonly, financial statement fraud is used to make a company’s earnings appear better on paper. Financial statement fraud occurs through a variety of methods, such as valuation judgments and manipulating the timing of transaction recording. These more subtle types of fraud are often dismissed as either mistakes or errors in judgment and estimation. Some of the more common reasons why people commit financial To encourage investment through the sale of stock To demonstrate increased earnings per share or partnership profits interest, thus allowing increased dividend/distribution payouts To cover inability to generate cash flow To avoid negative market perceptions To obtain financing, or to obtain more favorable terms on existing financing To receive higher purchase prices for acquisitions To demonstrate compliance with financing covenants To meet company goals and objectives To receive performance-related bonuses

QUESTION 2 : How does vertical analysis differ from horizontal analysis?

Vertical analysis expresses the percentage of component items to a specific base item, while horizontal analysis analyzes the percentage change in individual financial statement items from one year to the next.
Vertical analysis compares items on one financial statement to items on a different financial statement, while horizontal analysis compares items on the same financial statement.
Vertical analysis is a means of measuring the relationship between any two different financial statement amounts, whereas horizontal analysis examines the relationship between specific financial statement ratios.
Vertical analysis compares the performance of a parent company to its subsidiary, while horizontal analysis compares different companies across an industry.

Vertical analysis is the expression of the relationship or percentage of component items to a specific base item on the income statement or balance sheet. Horizontal analysis is a technique for analyzing the percentage change in individual financial statement items from one year to the next.

QUESTION 3 : ABC Corporation is the defendant in a class-action lawsuit for selling defective consumer products. While the lawsuit is estimated to continue for several more years, ABC’s management believes that it is reasonably possible that the company will lose the lawsuit and be ordered to pay a significant amount of damages to the plaintiffs. ABC does NOT have to disclose a liability related to the lawsuit in its financial statements.

True
False

Typical liability omissions include the failure to disclose loan covenants or contingent liabilities. Loan covenants are agreements, in addition to or as part of a financing arrangement, that a borrower has promised to keep as long as the financing is in place. The agreements can contain various types of covenants, including certain financial ratio limits and restrictions on other major financing arrangements. Contingent liabilities are potential obligations that will materialize only if certain events occur in the future. A corporate guarantee of personal loans received by a company officer and potential losses from ongoing litigation are examples of contingent liabilities. Under generally accepted accounting principles, a company’s potential liability must be disclosed in the notes to the financial statements if the liability is reasonably possible. A potential liability must be recorded if it is probable that a loss will occur and the amount of the loss can be reasonably estimated.

QUESTION 4 : Which of the following is a common method that fraudsters use to conceal liabilities and expenses in order to make a company appear more profitable than it actually is?

Improperly capitalizing costs rather than expensing them
Omitting liabilities or expenses
Failing to disclose warranty costs and product-return liabilities
All of the above

Understating liabilities and expenses is one of the ways financial statements can be manipulated to make a company appear more profitable than it actually is. Because pre-tax income will increase by the full amount of the expense or liability not recorded, this financial statement fraud method can significantly affect reported earnings with relatively little effort by the fraudster. There are three common methods for concealing liabilities and expenses: Omitting liabilities and/or expenses Improperly capitalizing costs rather than expensing them Failing to disclose warranty costs and product-return liabilities

QUESTION 5 : Which of the following is a common reason why people commit financial statement fraud?

To demonstrate compliance with loan covenants
To cover inability to generate cash flow
To encourage investment through the sale of stock
All of the above

QUESTION 6 : Which of the following statements is TRUE with regard to a fictitious revenue scheme?

Uncollected accounts receivable are a red flag of fictitious revenue schemes.
If a fictitious revenue scheme has taken place, there will typically be no accounts receivable on the books.
The debit side of a fictitious sales entry usually goes to accounts payable.
Fictitious revenues must involve sales to a fake customer.

Fictitious or fabricated revenues involve the recording of sales of goods or services that did not occur. Fictitious sales most often involve fake customers but can also involve legitimate customers. At the end of the accounting period, the sale will be reversed (as will all revenue accounts), which will help to conceal the fraud. Recording the sales revenue is easy, but the challenge for the fraudster is how to balance the other side of the entry. A credit to revenue increases the revenue account, but the corresponding debit in a legitimate sales transaction typically either goes to cash or accounts receivable. Since no cash is received in a fictitious revenue scheme, increasing accounts receivable is the easiest way to get away with completing the entry. Unlike revenue accounts, however, accounts receivable are not reversed at the end of the accounting period. They stay on the books as an asset until collected. If the outstanding accounts never get collected, they will eventually need to be written off as bad debt expense.

QUESTION 7 : Management has an obligation to disclose all events and transactions in the financial statements that are likely to have a material effect on the entity’s financial position.

True
False

Accounting principles require that financial statements include all the information necessary to prevent a reasonably discerning user of the financial statements from being misled. Disclosures only need to include events and transactions that have or are likely to have a material impact on the entity’s financial position.

QUESTION 8 : Which of the following is the correct calculation of the quick ratio?

(Cash + marketable securities) / accounts payable
(Cash + marketable securities + receivables) / current liabilities
Current assets / current liabilities
(Cash + receivables) / current liabilities

The quick ratio, commonly referred to as the acid test ratio , compares quick assets (i.e., those that can be immediately liquidated) to current liabilities. This ratio is a measure of a company’s ability to meet sudden cash requirements. It is important to note that while the current ratio includes inventory in its current assets, the quick ratio does not. Thus, the quick ratio offers a more conservative view of a company’s liquidity because it excludes inventory and other current assets that are more difficult to rapidly turn into cash. The equation for the quick ratio is: Quick ratio

QUESTION 9 : Early revenue recognition is classified as what type of financial fraud scheme?

Improper disclosures
Fictitious revenues
Timing differences
Improper asset valuations

Financial statement fraud might involve timing differences—that is, the recording of revenues or expenses in improper periods. This can be done to shift revenues or expenses between one period and the next, increasing or decreasing earnings as desired. Early revenue recognition is a common type of timing difference scheme since companies are often trying to make themselves look as profitable as possible.

QUESTION 10 : actually is.

True
False

Understating liabilities and expenses is one of the ways financial statements can be manipulated to make a company appear more profitable. Because pre-tax income will increase by the full amount of the expense or liability not recorded, this financial statement fraud method can significantly affect reported earnings with relatively little effort by the fraudster. There are three common methods for concealing liabilities and expenses: Omitting liabilities and/or expenses Improperly capitalizing costs rather than expensing them Failing to disclose warranty costs and product-return liabilities

QUESTION 11 : Which of the following is a means of measuring the relationship between two different financial statement amounts?

Transaction detail analysis
Relational comparison
Statement comparison
Ratio analysis

Ratio analysis is a means of measuring the relationship between two different financial statement amounts. The relationship and comparison are the keys to the analysis, which allows for internal evaluations using financial statement data. Traditionally, financial statement ratios are used in comparisons to an entity’s industry average. They can be very useful in detecting red flags for a fraud examination.

QUESTION 12 : A company must disclose all contingent liabilities in the notes to the financial statements, regardless of the liabilities’ probability or materiality.

True
False

Contingent liabilities are potential obligations that will materialize only if certain events occur in the future. A corporate guarantee of personal loans received by a company officer and potential losses from ongoing litigation are examples of contingent liabilities. Under generally accepted accounting principles, a company’s potential liability must be disclosed in the notes to the financial statements if the liability is reasonably possible. A potential liability must be recorded if it is probable that a loss will occur and the amount of the loss can be reasonably estimated.

QUESTION 13 : Which of the following financial statement manipulations is NOT a type of improper asset valuation scheme?

Recording expenses in the wrong period
Booking of fictitious assets
Inflated inventory valuation
Overstated accounts receivable

Most improper asset valuations involve the fraudulent overstatement of inventory or receivables, with the goal being to strengthen the appearance of the balance sheet and/or certain financial ratios. Other improper asset valuations include manipulation of the allocation of the purchase price of an acquired business to inflate future earnings, misclassification of fixed and other assets, or improper capitalization of inventory or start-up costs. Improper asset valuations usually take the form of one of the following classifications: Inventory valuation Accounts receivable Business combinations Fixed assets

QUESTION 14 : A large amount of overdue accounts receivable on the books is a red flag of a fictitious revenue scheme.

True
False

Fictitious or fabricated revenues involve the recording of sales of goods or services that did not occur. Fictitious sales most often involve fake customers but can also involve legitimate customers. Recording the sales revenue is easy, but the challenge for the fraudster is how to balance the other side of the entry. A credit to revenue increases the revenue account, but the corresponding debit in a legitimate sales transaction typically either goes to cash or accounts receivable. Since no cash is received in a fictitious revenue scheme, increasing accounts receivable is the easiest way to get away with completing the entry. However, accounts receivable stay on the books as an asset until they are collected. If the outstanding accounts never get collected, they will eventually need to be written off as bad debt expense.

QUESTION 15 : Failing to record bad debt expense for the period will result in fraudulently overstated accounts receivable.

True
False

Managers can overstate their company’s accounts receivable balance by failing to record bad debt expense. Bad debt expense is recorded to account for any uncollectible accounts receivable. The debit side of the entry increases bad debt expense, and the credit side of the entry increases the allowance (or provision) for doubtful accounts, which is a contra account that is recorded against accounts receivable. Therefore, if the controller fails to record bad debt expense, the allowance (or provision) for doubtful accounts will be understated.

QUESTION 16 : Which of the following is a common reason why someone might commit financial statement fraud?

To harm a competitor’s reputation
To misuse company assets
To attempt to get a coworker fired
To obtain favorable terms on financing

QUESTION 17 : Vertical analysis can best be described as a technique for analyzing a percentage change from one accounting period to the next.

True
False

QUESTION 18 : There is nothing inherently wrong with a company engaging in related-party transactions, as long as the transactions are fully disclosed.

True
False There is nothing inherently wrong with related-party transactions, as long as they are fully disclosed.

QUESTION 19 : Which of the following is NOT one of the three common methods for concealing liabilities and expenses on a company’s financial statements?

Liability/expense omissions
Channel stuffing
Failure to disclose warranty costs and product-return liabilities
Capitalized expenses

There are three common methods for concealing liabilities and expenses: Omitting liabilities and/or expenses Improperly capitalizing costs rather than expensing them Failing to disclose warranty costs and product-return liabilities

QUESTION 20 : Which of the following would be considered a timing difference financial statement fraud scheme?

Waiting to record revenue on a contract until a construction job is complete
Recording revenue in Year 1 when the payment is received, even though the service won’t be performed until Year 2
Recognizing revenue in Year 1 when the service is performed, even though the customer doesn’t have to pay until Year 2
Recognizing a percentage of revenue on a construction project corresponding to the percentage of the project that is complete

Financial statement fraud often involves timing differences—that is, the recording of revenues or expenses in improper periods. This can be done to shift revenues or expenses between one period and the next, increasing or decreasing earnings as desired. This practice is also referred to as income smoothing . Examples of timing difference fraud schemes include: Premature revenue recognition—in general, revenue is recognized when (or as) an entity satisfies a performance obligation by transferring a promised good or service (asset) to a customer. Consequently, even if the seller has received payment for a service, revenue cannot be recognized until the service has been performed, thus satisfying Long-term contracts—in some jurisdictions, revenue on long-term contracts can be recognized under one of two methods. The completed-contract method does not record revenue until the project is 100% complete. The percentage-of-completion method, on the other hand, recognizes revenues and expenses in proportion to what Recording expenses in the wrong period—per the matching principle, expenses must be recognized in the same period as the corresponding revenues. The timely recording of expenses is sometimes compromised due to pressures to meet budget projections and goals

QUESTION 21 : The asset turnover ratio is calculated by dividing net sales by average total assets.

True
False

The asset turnover ratio is used to determine the efficiency with which assets are used during the period. The asset turnover ratio is typically calculated by dividing net sales by average total assets (net sales / average total assets). However, average operating assets can also be used as the denominator (net sales / average operating assets).

QUESTION 22 : Traditionally, there are two methods of percentage analysis of financial statements. They are:

Vertical and historical analysis
Balance sheet and income statement analysis
Horizontal and vertical analysis
Horizontal and historical analysis

Traditionally, there are two methods of percentage analysis of financial statements. Vertical analysis is a technique for analyzing the relationships among the items on an income statement, balance sheet, or statement of cash flows by expressing components as percentages of a specified base value. Horizontal analysis , on the other hand, is a technique for analyzing the percentage change in individual financial statement items from one year to the next. The first period in the analysis is considered the base

QUESTION 23 : In investigating whether financial statements have been manipulated to make a company appear more profitable, a Certified Fraud Examiner should look for liabilities that have been overstated.

True
False

QUESTION 24 : ABC Company purchases a material amount of products from another entity whose operating policies can be controlled by ABC Company’s management, but it does not disclose this situation on its financial statements. In which type of improper disclosure scheme has ABC Company engaged?

Improper asset valuation
Related-party transaction
Significant event
Accounting change

Related-party transactions are business deals or arrangements between two parties who hold a pre-existing connection prior to the transaction. These transactions generally occur when a company does business with another entity whose management or operating policies can be controlled or significantly influenced by the company or by some other party in common. There is nothing inherently wrong with related-party transactions, as long as they are fully disclosed. If the transactions are not fully disclosed, the company might injure its shareholders by engaging in economically harmful dealings without their knowledge. The financial interest that a company official might have might not be readily apparent. For example, common directors of two companies that do business with each other, any corporate general partner and the partnerships with which it does business, and any controlling shareholder of the corporation with which he/she/it does business are all illustrations of related parties. Family relationships can also be considered related parties, such as all direct descendants and ancestors, without regard to financial interests.

QUESTION 25 : _____________________ is the deliberate misrepresentation of the financial condition of an enterprise accomplished through the intentional misstatement or omission of amounts or disclosures in the financial statements

Occupational fraud
Accounting fraud
Material misstatement
Financial statement

fraud Financial statement fraud is the deliberate misrepresentation of the financial condition of an enterprise accomplished through the intentional misstatement or omission of amounts or disclosures in the financial statements to deceive financial statement users.

QUESTION 26 : Fraud in financial statements generally takes the form of overstated assets or revenue and understated liabilities and expenses.

True
False

Fraud in financial statements takes the form of overstated assets or revenue and understated liabilities and expenses. Overstating assets or revenue falsely reflects a financially stronger company by inclusion of fictitious asset costs or artificial revenues. Understated liabilities and expenses are shown through exclusion of costs or financial obligations. Both methods result in increased equity and net worth for the company. This overstatement and/or understatement results in increased earnings per share or partnership profit interests or a more stable picture

QUESTION 27 : 285 of 424 There are two methods for recognizing revenue on long-term construction contracts. Which of the following is one of those methods?

Contract-valuation method
Partial-contract method
Percentage-of-completion method
Cost-to-completion method

Long-term contracts can cause special problems for revenue recognition. In some jurisdictions, for example, revenues and expenses from long-term construction contracts can be recorded using either the completed-contract method or the percentage-of-completion method, depending on the circumstances. The completed contract method does not record revenue until the project is 100% complete. The percentage-of-completion method, on the other hand, recognizes revenues and expenses as measurable progress on a project is made. This method is particularly vulnerable to manipulation because managers can falsify the percentage of completion and the estimated costs to complete a construction project in order to recognize revenues prematurely and conceal contract overruns.

QUESTION 28 : Events occurring after the close of the period that could have a significant effect on the entity’s financial position must be disclosed in the entity’s financial statements.

True
False

Events occurring or becoming known after the close of the period that could have a significant effect on the entity’s financial position must be disclosed. Fraudsters typically avoid disclosing court judgments and regulatory decisions that undermine the reported values of assets, that indicate unrecorded liabilities, or that adversely reflect upon management’s integrity. A review of subsequent financial statements, if available, might reveal whether management improperly failed to record a subsequent event that it had knowledge of in the previous financial statements.

QUESTION 29 : The quick ratio is used to determine the efficiency with which a company uses its assets.

True
False

The quick ratio, commonly referred to as the acid test ratio , compares quick assets (i.e., those that can be immediately liquidated) to current liabilities. This calculation divides the total of cash, securities, and receivables by current liabilities to yield a measure of a company’s ability to meet sudden cash requirements. The quick ratio offers a more conservative view of a company’s liquidity because it excludes inventory and other current assets that are The asset turnover ratio is used to determine the efficiency with which asset resources are used by the entity.

QUESTION 30 : The asset turnover ratio is used to assess a company’s ability to meet sudden cash requirements.

True
False

The asset turnover ratio (net sales divided by average total assets) is used to determine the efficiency with which asset resources are used by the entity. The asset turnover ratio is one of the more reliable indicators of financial statement fraud. A sudden or continuing decrease in this ratio is often associated with improper capitalization of expenses, which increases the denominator without a corresponding increase in the numerator. The quick ratio is used to assess a company’s ability to meet sudden cash requirements. The quick ratio, commonly referred to as the acid test ratio , compares quick assets (i.e., those that can be immediately liquidated) to current liabilities. It is calculated by dividing the total of cash, securities, and receivables by current liabilities.

QUESTION 31 : The debt-to-equity ratio is computed by dividing current liabilities by total equity.

True
False

The debt-to-equity ratio is computed by dividing total liabilities by total equity. This financial leverage ratio is one that is heavily considered by lending institutions. It provides a clear picture of the comparison between the long-term and short-term debt of the company and the owner’s financial injection plus earnings to date. Debt-to-equity requirements are often included as borrowing covenants in corporate lending agreements.

QUESTION 32 : Horizontal analysis is a technique for analyzing the relationships among the items on an income statement, balance sheet, or statement of cash flows by expressing line items as percentages of a specific base item.

True
False

Horizontal analysis is a technique for analyzing the percentage change in individual income statement or balance sheet items from one year to the next. The first period in the analysis is considered the base period, and the changes in the subsequent period are computed as a percentage of the base period. Vertical analysis is the expression of the relationship or percentage of component items to a specific base item on the income statement or balance sheet. Ratio analysis is a means of measuring the relationship between any two different financial statement amounts.

QUESTION 33 : A fraud scheme in which an accountant fails to write down obsolete inventory to its current fair market value has what effect on the company’s current ratio?

The current ratio will be artificially deflated.
It is impossible to determine.
The current ratio will be artificially inflated.
The current ratio will not be affected.

Many schemes are used to inflate current assets at the expense of long-term assets. In the case of such schemes, the net effect is seen in the current ratio, which divides current assets by current liabilities to evaluate a company’s ability to satisfy its short-term obligations. By misclassifying long-term assets as short-term, the current ratio will appear artificially stronger. This type of misclassification can be of critical concern to lending institutions that often require certain financial ratio minimums to be maintained. This is of particular consequence when the loan covenants are on unsecured or under-secured lines of credit and other short-term borrowings.

QUESTION 34 : Which of the following types of accounting changes must be disclosed in an organization’s financial statements? I. Changes in estimates II. Changes in accounting principles III. Changes in reporting entities

II and III only
I and II only
I and III only
I, II, and III

In general, three types of accounting changes must be disclosed to avoid misleading the user of financial statements: changes in accounting principles, estimates, and reporting entities. Although the required treatment for these accounting changes varies for each type and across jurisdictions, they are all susceptible to manipulation. For example, fraudsters might fail to properly retroactively restate financial statements for a change in accounting principle if the change causes the company’s financial statements to appear weaker. Likewise, they might fail to disclose significant changes in estimates such as the useful lives and estimated salvage values of depreciable assets or the estimates underlying the determination of warranty or other liabilities. They might even secretly change the reporting entity by adding entities owned privately by management or by excluding certain company-owned units

QUESTION 35 : What effect would the improper recording of an expenditure as a capitalized asset rather than as an expense have on the financial statements?

Expenses would be overstated, giving the appearance of poor financial performance
Assets would be falsely overstated, giving the appearance of a stronger company
Net income would be falsely understated, lowering the company’s tax liability
None of the above

Improperly capitalizing expenses is one way to increase income and assets and make the entity’s financial position appear stronger. If ineligible expenditures are capitalized as assets and not expensed during the current period, income will be overstated. As the assets are depreciated, income in following periods will be understated.

QUESTION 36 : James runs an electronics store. One of the main challenges in his business is keeping up with technological advances. Because of this, his auditors want to ensure inventory is not fraudulently overstated on the store’s balance sheet. Which of the following actions should the auditors take to ensure inventory is not overstated?

Ensure that James has written off obsolete inventory
Ensure that inventory is recorded at the lower of cost or net realizable value
View the inventory and conduct a physical count
All of the above

Under many countries’ accounting standards, including U.S. GAAP and IFRS, inventory must be recorded at the lower of cost or net realizable value. This means that inventory must be valued at its acquisition cost, except when the cost is determined to be higher than the net realizable value, in which case it should be written down to its net realizable value or written off altogether if it has no value. Failing to write down or write off inventory results in overstated assets and the mismatching of cost of goods sold with revenues. Other methods by which inventory can be improperly stated include manipulation of the physical inventory count, inflation of the unit costs used to price out inventory, and failure to adjust inventory for the costs of goods sold. Fictitious inventory schemes usually involve the creation of fake documents, such as inventory count sheets and In some instances, friendly co-conspirators claim to be holding inventory for companies in question. Other times, companies falsely report large values of inventory in transit, knowing that it would be nearly impossible for the auditors to observe. When possible, fraud examiners should perform a physical inventory count, checking to make sure the inventory exists as described in the records. There have been cases of fraudsters assembling pallets of inventory with hollow centers, placing bricks in sealed boxes instead of high-value products, and shuttling inventory

QUESTION 37 : What financial statement fraud scheme involves recording revenues and expenses in improper periods?

Timing differences
Improper disclosures
Improper asset valuations
Concealed expenses

QUESTION 38 : Laura, the sales manager of Sam Corp., is afraid sales revenue for the period is not going to meet company goals. To make up for the shortfall, she decides to mail invoices to fake customers and credit (increase) revenue on the books for these sales. What account will she most likely debit to balance these fictitious revenue entries and conceal

Inventory
Accounts payable
Cash
Accounts receivable

QUESTION 39 : Failure to record corresponding revenues and expenses in the same accounting period will result in an understatement of net income in the period when the revenue is recorded and an overstatement of net income in the period in which the corresponding expenses are recorded.

True
False

According to generally accepted accounting principles, revenue and corresponding expenses should be recorded or matched in the same accounting period. The timely recording of expenses is often compromised due to pressures to meet budget projections and goals or due to lack of proper accounting controls. As the expensing of certain costs is pushed into periods other than the ones in which they actually occur, they are not properly matched against the income that they help produce. For example, revenue might be recognized on the sale of certain items, but the cost of goods and services that went into the items sold might intentionally not be recorded in the accounting system until the following period. This might make the sales revenue from the transaction almost pure profit, inflating earnings.

QUESTION 40 : In a financial statement fraud scheme in which capital expenditures are recorded as expenses rather than assets, the transactions will have the following effect on the organization’s financial statements:

Sales revenue will be overstated
Net income will be overstated
Total assets will be understated
All of the above

Typically, a fraudster’s goal when committing a financial statement fraud scheme is to make the entity look stronger and more profitable. This goal is often achieved by concealing liabilities and/or expenses. To do this, he might fraudulently understate liabilities or improperly capitalize a cost that should be expensed. Just as capitalizing expenditures that should be expensed is improper, so is expensing costs that should be capitalized. Improperly expensing costs will result in a lower net income, as well as understated assets. There are several reasons an entity might want to make itself look worse than it actually is. For example, the organization might want to minimize its net income due to tax considerations. Expensing an item that should be depreciated over a period of time would help accomplish just that—net income would be lower and so would taxes. The result for the current accounting period is that total assets will be understated, and expenses will be overstated.

QUESTION 41 : Which financial ratio is calculated by dividing current assets by current liabilities?

Profit margin
Quick ratio
Receivable turnover
Current ratio

The current ratio—current assets divided by current liabilities—is probably the most-used liquidity ratio in financial statement analysis. This comparison measures a company’s ability to meet present obligations from its liquid assets; specifically, the current ratio measures the amount of times current assets would be able to pay back current liabilities. In detecting fraud, this ratio can be a prime indicator of manipulation of accounts involved. Embezzlement will cause the ratio to decrease. Liability concealment will cause a more favorable ratio.

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Written by MJ