CFA Financial Statement Fraud 2 — Questions and Answers
Question 1: Which of the following is an example of an off-balance-sheet financing scheme?
- Accelerating revenue recognition on long-term contracts
- Using special purpose entities (SPEs) to hide debt (Correct answer)
- Recording fictitious vendor invoices
- Overstating inventory counts at year-end
Correct answer: Using special purpose entities (SPEs) to hide debt
Special purpose entities (SPEs) can be used to move liabilities off the company's balance sheet, making the company appear less leveraged than it actually is.
Question 2: Which scheme involves capitalizing ordinary operating expenses to make a company appear more profitable?
- Round-tripping
- Improper capitalization of expenses (Correct answer)
- Bill-and-hold transactions
- Related-party revenue inflation
Correct answer: Improper capitalization of expenses
Improper capitalization shifts operating expenses to the balance sheet as assets, reducing reported expenses and artificially inflating net income.
Question 3: The Enron scandal is most closely associated with which financial statement fraud technique?
- Fictitious inventory counts
- Premature revenue recognition on product sales
- Concealing debt through special purpose entities (Correct answer)
- Overstating accounts receivable
Correct answer: Concealing debt through special purpose entities
Enron used hundreds of special purpose entities to hide billions in debt from its balance sheet, artificially improving its reported financial position.
Question 4: What analytical technique compares each line item on a financial statement as a percentage of a base amount to detect anomalies?
- Benford's Law analysis
- Vertical (common-size) analysis (Correct answer)
- Horizontal (trend) analysis
- Ratio analysis
Correct answer: Vertical (common-size) analysis
Vertical (common-size) analysis expresses each line item as a percentage of a base (e.g., total revenue), making it easier to spot unusual proportions that may indicate manipulation.
Question 5: In a 'bill-and-hold' fraud scheme, revenue is recognized when:
- Cash is received from the customer
- Goods are invoiced but not yet shipped to the customer (Correct answer)
- The customer signs a long-term service contract
- Returns and allowances are processed
Correct answer: Goods are invoiced but not yet shipped to the customer
Bill-and-hold fraud records revenue when goods are invoiced but remain in the seller's possession, violating the delivery condition for revenue recognition.
Question 6: Which Benford's Law application is most useful in detecting financial statement fraud?
- Comparing expense amounts to budget forecasts
- Testing whether the first digits of large numbers conform to expected frequency distributions (Correct answer)
- Calculating the ratio of operating expenses to revenue
- Reviewing management's discussion and analysis (MD&A) for inconsistencies
Correct answer: Testing whether the first digits of large numbers conform to expected frequency distributions
Benford's Law predicts the frequency distribution of leading digits in naturally occurring data; deviations can indicate fabricated or manipulated numbers.
Question 7: What does the 'Big Bath' earnings management technique involve?
- Inflating revenue by recording future sales in the current period
- Taking large write-offs in a bad year to clear the slate for future reported profits (Correct answer)
- Smoothing earnings by understating good-year revenues
- Using fictitious journal entries to manipulate quarterly results
Correct answer: Taking large write-offs in a bad year to clear the slate for future reported profits
A 'big bath' occurs when management takes excessive write-offs in an already bad period, depressing current-year earnings further to set a lower baseline for improved future results.
CFA Financial Statement Fraud 2
Which of the following is an example of an off-balance-sheet financing scheme?