CFE Financial Statement Fraud 3 — Questions and Answers
Question 1: Which of the following is the most common method used to overstate inventory in a financial statement fraud scheme?
- Delaying the write-off of obsolete inventory
- Recording fictitious inventory at inflated prices
- Both A and B (Correct answer)
- Understating the LIFO reserve
Correct answer: Both A and B
Both delaying obsolescence write-offs and recording fictitious inventory at inflated prices are common techniques used to overstate inventory balances.
Question 2: The 'big bath' accounting technique refers to:
- Taking all possible write-downs in a single bad period to improve future reported earnings (Correct answer)
- Gradually overstating earnings across multiple periods to avoid detection
- Recording large one-time gains to offset recurring losses
- Reversing prior-period accruals to inflate current income
Correct answer: Taking all possible write-downs in a single bad period to improve future reported earnings
A 'big bath' involves taking excessive charges in one poor period so that future periods appear more profitable, often occurring during management changes.
Question 3: When auditing for financial statement fraud, which ratio would most directly indicate potential revenue overstatement?
- Current ratio
- Receivables-to-sales ratio trending upward (Correct answer)
- Fixed asset turnover declining
- Interest coverage ratio falling
Correct answer: Receivables-to-sales ratio trending upward
An increasing receivables-to-sales ratio suggests that reported sales are growing faster than actual cash collections, a key indicator of fictitious or premature revenue.
Question 4: Which of the following would be considered a 'related party transaction' red flag in a financial statement fraud investigation?
- Sales to a company partially owned by the CEO at above-market prices (Correct answer)
- Purchasing supplies from an unrelated vendor at market rates
- Issuing stock options to employees at fair market value
- Obtaining a bank loan at the prevailing interest rate
Correct answer: Sales to a company partially owned by the CEO at above-market prices
Sales to a related party at inflated prices can be used to fabricate revenue, making related party transactions a significant red flag for financial statement fraud.
Question 5: In the Beneish M-Score model used to detect earnings manipulation, which variable specifically measures changes in depreciation methods or useful life estimates?
- Asset quality index (AQI)
- Depreciation index (DEPI) (Correct answer)
- Sales growth index (SGI)
- Total accruals to total assets (TATA)
Correct answer: Depreciation index (DEPI)
The Depreciation Index (DEPI) in the Beneish model measures whether a firm is slowing depreciation, which can signal earnings management.
Question 6: A company fails to disclose a material contingent liability in its financial statement footnotes. This omission is best classified as:
- Fictitious revenue
- Improper asset valuation
- Concealed liabilities and expenses (Correct answer)
- Timing difference
Correct answer: Concealed liabilities and expenses
Omitting material contingent liabilities from footnote disclosures is a form of concealing liabilities, even if no journal entry misstatement is involved.
Question 7: Which of the following financial statement fraud schemes would most directly cause gross profit margin to be overstated?
- Capitalizing SG&A expenses as intangible assets
- Understating cost of goods sold (Correct answer)
- Failing to record accrued interest expense
- Overstating accounts payable
Correct answer: Understating cost of goods sold
Gross profit margin equals (Sales minus COGS) divided by Sales, so understating COGS directly inflates this metric.
CFE Financial Statement Fraud 3
Which of the following is the most common method used to overstate inventory in a financial statement fraud scheme?