Chapter 11
1. Identify an example of a perceived pressure that can motivate financial statement fraud.
a.
The ability to obfuscate the fraud behind complex transactions
b.
Failure to meet Wall Street’s earnings expectations
c.
Rationalizing that all companies use aggressive accounting practices
d.
A weak board of directors
b
a.
Incorrect. This is an example of perceived opportunity.
b.
c.
Incorrect. This is an example of rationalization.
d.
Incorrect. This is an example of perceived opportunity.
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2. Which of the following is an example of a perceived opportunity that can lead to financial statement fraud?
a.
Inability to compete with other companies
b.
Independent audit and a strong board of directors
c.
Thinking that fraud is good for the company
d.
Inadequate internal controls
d
a.
Incorrect. This is an example of perceived pressure.
b.
Incorrect. This is way to eliminate perceived opportunity.
c.
Incorrect. This is an example of rationalization.
d.
Correct. This is an example of perceived opportunity.
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3. There has been an auditor change at Company X. Which of the following situations may NOT signal a potential fraud
problem?
a.
Failure to pay an audit fee
b.
Auditee believing that the auditor’s fees are too high
c.
Suspected fraud or other problems by the auditor
d.
Auditor-auditee disagreement
b
b.
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4. Which of the following statements is true?
a.
Most financial statement frauds occur in large historically profitable companies.
b.
Most people who commit management fraud are first-time offenders.
c.
An active board of directors or audit committee does little to deter fraud.
d.
Perpetrating fraud is much easier in an organization with democratic leadership, where the decision making is
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spread among several individuals.
b
b.
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5. Your firm has just acquired a new audit client. The new client is highly leveraged with borrowing from several
institutions. It is planning to expand the business by obtaining additional debt finance in the near future. Based on these
facts, which one of the following should be most carefully examined?
a.
Transactions that result in healthy revenues
b.
Large market capitalization
c.
Loans and other financing transactions between related entities
d.
Dividend paid out in the previous year
c
a.
Incorrect. The facts do not suggest that revenue transactions are particularly at risk.
b.
d.
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6. The study done by the Committee of Sponsoring Organizations (COSO) on financial statement frauds that occurred
during the period from 1987–1997 had many key findings. Which of the following is NOT one among them?
a.
Frauds were most commonly perpetrated by improper revenue recognition, overstatement of assets, and
understatement of expenses.
b.
Most of these firms had audit committees that met at least four times a year.
c.
Severe consequences were associated with companies who committed financial statement fraud.
d.
Most companies were experiencing net losses or were just holding break-even positions in periods prior to the
fraud.
b
a.
Incorrect. This statement is true.
b.
Correct. Most of these firms had no audit committee, or one that met only once per year.
c.
Incorrect. This statement is true.
d.
Incorrect. This statement is true.
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7. Your audit team working with a newly acquired client, discovers that there has been fraudulent financial reporting for
the past 5 years. Who is most likely to have been involved in the fraud?
a.
Middle management in positions of trust
b.
Disgruntled employees
c.
Top management
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d.
The accountants in charge of preparing the financial statements
a.
b.
d.
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8. Company XYZ had a long-standing relationship with a leading law firm. In fact, the law firm’s business with this
company was one of its most profitable relationships. If the law firm decides that it no longer wants to conduct business
with the company, this is:
a.
indicative that the company might have a lot of customer law suits against it.
b.
not any sort of meaningful indicator of fraud activity.
c.
a large cause for concern that financial statement fraud may be occurring.
d.
an indication that the client has likely outgrown the law firm.
a.
b.
c.
Correct. Lawyers rarely give up a profitable client unless something is very wrong.
d.
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9. While generally accepted accounting principles do allow flexibility, standards of _________, ________, and ________
must always prevail in the financial statements.
a.
subjectivity; integrity; validation
b.
objectivity; integrity; judgment
c.
recording; reporting; accounting
d.
quality; excellence; and judgment
b
a.
b.
Correct. Standards of integrity, objectivity, and judgment must always prevail.
c.
d.
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10. Frauds are more likely to occur in:
a.
large, historically profitable companies.
b.
companies with an active board of directors.
c.
smaller companies where one or two individuals have almost all control in decision making.
d.
any company, as the probability of a fraud does not change with the size of a company.
a.
b.
11. Understanding a company’s relationships with financial institutions and bondholders is important because:
a.
it can indicate the extent to which the company is leveraged.
b.
it can reveal whether significant short selling of the company’s stock has occurred.
c.
it can uncover the fraudulent transactions from special purpose entities.
d.
it may help in raising additional funds from the financial institutions.
a
b.
Incorrect. This has to do with a company’s relationship with investors..
d.
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12. Examining a company’s relationships with other individuals and entities can reveal important information about
financial statement fraud. Identify the piece of information that is correctly linked to its source.
a.
Examining relationships with financial institutions will show whether there has been significant “short selling”
of the company’s stock.
b.
Examining relationships with related parties will show whether there are unusual transactions that significantly
improve the company’s reported financial performance.
c.
Examining a company’s relationships with its lawyers will show whether management is able to unduly
influence the selection of accounting principles and the determination of significant estimates.
d.
Examining relationships with regulatory bodies will show whether the company has recently changed legal
counsel.
b
b.
d.
Incorrect. This information comes from investigating a company’s relationship with its lawyers.
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13. Which of the following organizational characteristics is an indicator of a possible fraud?
a.
A board of directors comprised mainly of outsiders.
b.
An independent internal audit department.
c.
An audit committee comprised mainly of insiders.
d.
An overstaffed accounting department.
c
d.
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14. According to study of financial statement frauds by the Committee of Sponsoring Organizations (COSO) , the average
fraud lasts for how many months?
a.
12 months
b.
18 months
c.
24 months
d.
30 months
a.
b.
c.
Correct. The average period of a financial statement fraud is 24 months.
d.
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15. According to study of financial statement frauds by the Committee of Sponsoring Organizations (COSO), who is the
most common perpetrator of financial statement fraud?
a.
Chief Executive Officer
b.
Chief Financial Officer
c.
Chief Operating Officer
d.
Finance Controller
a.
Correct. The CEO is the most common perpetrator of financial statement fraud.
b.
c.
d.
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16. Which of the following is NOT a kind of questions that should be asked in order to understand the exposure to
management fraud?
a.
Is a legitimate business purpose apparent for each separate entity of the business?
b.
Have significant recent changes occurred in the nature of the organization?
c.
Are the accounting and information technology staff and organization effective?
d.
How many employees are there in the organization who have many years with the organization?
d
a.
b.
c.
d.
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17. Should nonfinancial indicators be used for assessing fraud risk? Why or why not?
a.
No. A company’s financial statement data need not always be consistent with its nonfinancial measures.
b.
Yes. Management can more easily manipulate financial numbers but finds it harder to keep all the
nonfinancial information consistent with the financial information.
c.
No. Nonfinancial measures are indicative of physical assets alone.
d.
Yes. Management attempts to commit fraud first show up in these indicators. Financial statement fraud is an
attempt to cover up those attempts.
b
a.
b.
c.
d.
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18. Which of the following is a finding of the Treadway Commission?
a.
Financial statement frauds occur very often, the average fraud lasts about two years.
b.
The CEO perpetrates the fraud in 72% of the cases.
c.
While financial statement frauds occur infrequently, they are extremely costly.
d.
Financial statement fraud occurs mostly in companies that are listed.
a.
b.
c.
d.
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19. Which of the following related party transactions need to most carefully examined for fraud?
a.
Transactions that generate operating income
b.
All transactions that appear anywhere within the company
c.
Absence of loans or other financing transactions between related entities
d.
Transactions that result in goodwill being recognized in the financial statements
d
a.
b.
c.
d.
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20. In addition to changes in financial statements, which of the following can indicate financial statement fraud has
occurred?
a.
Information in the footnotes to the financial statements
d.
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b.
Stable dividend payout ratio
c.
Increased hiring of qualified employees by the company
d.
Addition of an independent member on the board
a
b.
c.
d.
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21. What is the meaning of “short sell”?
a.
Buy shares from a brokerage firm and enter into a forward transaction to sell the shares at today’s price on a
future date.
b.
Sell the shares at today’s price to an investor and enter into an option agreement to buy the shares back in near
future.
c.
Buy shares from one brokerage firm and sell the shares to another brokerage firm with a view to make quick
money.
d.
Borrow shares from a brokerage and sell the shares at today’s price with the intention to repay the borrowed
stock they sold at some future time when the stock is trading for a lower price.
d
a.
b.
c.
d.
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22. Which of the following is NOT one of the components of the fraud exposure rectangle?
a.
Accounting system controls
b.
Management and directors
c.
Financial results and operating characteristics
d.
Organization and its industry
a
a.
b.
c.
d.
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23. Which of the following is a performance evaluation method that focuses on both financial and nonfinancial
indicators of performance such as customer satisfaction?
a.
360 degree survey
b.
Critical incidents method
c.
Balanced scorecard
d.
Pareto chart
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c
a.
b.
c.
d.
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24. Which of the following is the term for a practice where the effective dates on stock options are deliberately changed
for the purpose of securing extra pay for management?
a.
Backtracking
b.
LEAP
c.
Arbitrage
d.
Backdating
d
a.
b.
c.
d.
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25. Which of the terms refers to the ability to anticipate a fraud perpetrator’s likely method of concealing a fraud?
a.
Zero-order reasoning
b.
Deductive reasoning
c.
Strategic reasoning
d.
Low-order reasoning
c
a.
b.
c.
d.
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26. Which of the following occurs when an auditor and auditee only consider conditions that directly affect themselves
but not the other party?
a.
Zero-order reasoning
b.
Deductive reasoning
c.
First-order reasoning
d.
Higher-order reasoning
a
a.
b.
c.
d.
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27. Which of the following is depicted when the auditor simply considers his or her own incentives, such as audit fees,
sampling costs, and penalties?
a.
Higher-order reasoning
b.
Zero-order reasoning
c.
First-order reasoning
d.
Deductive reasoning
b
a.
b.
c.
d.
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28. Which of the following refers to when the auditor considers conditions that directly affect the auditee?
a.
Low-order reasoning
b.
Zero-order reasoning
c.
Deductive reasoning
d.
First-order reasoning
d
a.
b.
c.
d.
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29. An auditor adjusts the audit plan by introducing unexpected audit procedures in response to what the auditor believes
management may be doing to conceal a fraud based on management’s strategic reasoning. Which order of reasoning is
occurring here?
a.
Low-order reasoning
b.
Zero-order reasoning
c.
Higher-order reasoning
d.
First-order reasoning
a.
b.
d.
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30. 10-K forms refer to which of the following?
a.
the corporate reports filed with the SEC.
b.
the tax returns filed with the IRS.
c.
the press releases to the newswires.
Chapter 11
d.
the bankruptcy filing document.
a
a.
b.
c.
d.
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31. Which of the following are considered the backbone of capitalism and allow investors, lenders, and regulators to
measure the performance of a business?
a.
Government policies
b.
Financial statements
c.
Stock prices
d.
Credit reports
b
a.
b.
c.
d.
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32. Which is a common method of providing executive compensation by allowing top management to purchase stock at a
fixed share price?
a.
Stock splits
b.
Arbitrage
c.
Dividends
d.
Stock options
d
a.
b.
c.
d.
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33. Which of the following observations concerning backdating of options is true?
a.
It will not result in restatement of financial statements.
b.
The extraordinary timing and frequency of occurrences defied statistical probability.
c.
There is no concrete evidence that managers gained because of this practice.
d.
It is an accepted means of compensating managers who perform exceedingly well.
b
a.
b.
c.
d.
34. A CEO believes that the company should try to keep the stock price high by manipulating the financial statements to
protect its shareholders. Which element of the fraud triangle is discussed here?
a.
Perceived opportunity
b.
Trauma
c.
Rationalization
d.
Perceived pressure
c
a.
b.
c.
Correct. Fraud perpetrators must have some way to rationalize their actions as acceptable.
d.
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35. Which types of questions should be asked about a company’s relationship with financial institutions?
a.
Is a significant part of the company’s income or revenues derived from one or two large transactions?
b.
Has management placed unreasonable demands on the auditor, including unreasonable time constraints?
c.
Has significant “short selling” of the company’s stock occurred? If so, for what reasons?
d.
Is the organization highly leveraged through bank or other loans?
d
a.
b.
c.
d.
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36. In this phase of the economy, most businesses appear to be highly profitable.
a.
Trough
b.
Recession
c.
Recovery
d.
Boom
d
a.
b.
c.
d.
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37. What are special purpose entities (SPEs)?
a.
Fictitious organizations formed in order to perpetrate a financial statement fraud.
b.
Business interests formed solely in order to accomplish some specific task or tasks.
c.
Bodies formed to establish audit reporting standards and rules.
d.
Independent audit boards set up to ensure that the financial statements are verified.
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Chapter 11
b
a.
b.
c.
d.
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38. Many financial statement frauds have been perpetrated because:
a.
management needed to report high income to support stock prices.
b.
management wanted to decrease the total tax payable by the company.
c.
management wanted to show artificial losses to employees.
d.
management wanted to pay lower dividends to the shareholders.
a.
b.
c.
d.
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39. According to the study done by the Securities and Exchange Commission, greatest number of enforcement actions was
in the area of ________.
a.
improper use of off-balance-sheet arrangements
b.
improper expense recognition
c.
improper accounting for business combinations
d.
improper revenue recognition
d
a.
b.
c.
d.
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40. Which legislation led to the establishment of the Public Company Accounting Oversight Board?
a.
Private Securities Litigation Reform Act
b.
Sarbanes-Oxley Act
c.
Gramm-Leach-Bliley Act
d.
Glass-Steagall Act
b
a.
b.
c.
d.
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41. Which of the following is NOT an activity specifically listed in the text as prohibited by the Sarbanes-Oxley Act for
an auditor of a company to perform contemporaneously?
a.
Appraisal or valuations services
b.
Actuarial services
c.
Income tax preparation services
d.
Bookkeeping services
c
a.
b.
c.
d.
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42. Corporate financial statement fraud resulted in how many of the ten largest corporate bankruptcies in United States
history occurred in 2001?
a.
seven
b.
six
c.
nine
d.
eight
a
a.
b.
c.
d.
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43. Which of the following actions by the company auditor increases the potential to detect fraud?
a.
comparing current procedure test results to a prior year
b.
performing new procedures not conducted in prior years
c.
assigning the same audit staff to the audit from year to year
d.
carefully checking the audit test results
b
a.
Incorrect; this is normally done
b.
Correct; this prevents management from concealing fraud by anticipating auditor actions
c.
Incorrect; this builds predictability and opportunity for management to conceal fraud
d.
Incorrect; this is normally done
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44. Which of the following is an example of examining nonfinancial data to detect fraud?
a.
noting an increase in billing charges per customer
b.
comparing the dates of sales to shipment dates
c.
comparing line item current expenses to prior
d.
calculating the percent increase in inventory amounts
b
45. Which of the following would be least likely to indicate potential fraud activity?
a.
increased borrowing at one specific bank
b.
increased numbers of short sales by investors
c.
increased business with related parties
d.
increased customer appreciation activities
d
a.
b.
c.
d.
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46. According to the text authors, educators have failed in three areas and contributed to “the perfect fraud storm” that saw
a rise in fraud activity in recent years. Which of the following is NOT one of those areas?
a.
They have not trained students how to handle realistic ethical dilemmas.
b.
They have not taught business students the elements of fraud.
c.
They have not taught accounting students how to detect fraud during audits.
d.
They have taught content as an end unto itself rather than using content as a context for developing analytical
skills.
c
a.
b.
c.
d.
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47. Which of the following is least likely to indicate possible financial statement fraud?
a.
purchase of a small competitor that resulted in goodwill
b.
transactions that generate nonoperating income
c.
an unusually large transaction that resulted in income for the organization
d.
financing transactions between related parties
a
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a.
b.
c.
d.