It is more difficult for auditors to detect an unrecorded item that should be included than to detect an error of an item that has been recorded but using the wrong amount. In contrast, if an item has not been recorded, it is not possible for the auditors to select that item for testing from the population of recorded items. Overstating assets will achieve the same objectives as understating liabilities. The more assets a company has, the healthier it appears. This effect occurs because if an asset is overstated, the company is not going to record a corresponding nonexistent or overstated debt for the nonexistent or overstated asset.
Rather , there is usually a revenue that also was recorded. As was explained earlier in this chapter, if revenues are overstated, net income is overstated, which in turn overstates equity. Again notice how these fraudulent financial reporting schemes are not necessarily mutually exclusive.
For a manufacturing or retail business, inventory usually constitutes a large proportion of total assets. Despite this requirement, the auditors still can be fooled if management is intent on doing that. In the late s and early s, Phar-Mor, Inc. The number of stores and the states in which the stores were located grew at a phenomenal rate during that time. He also employed a strategy of offering low prices to Phar-Mor customers in order to compete with competitors such as Wal-Mart.
However, the prices were so low on so many products that Phar-Mor stopped earning a legitimate profit in The losses suffered by the company never were reflected in the financial statements since the COO and several top executives began to engage in fraudulent financial reporting. Inventory was one of their prime targets, and the company began to overstate inventory by inflating the amount of reported inventory for each individual store.
Furthermore, it was reported that the auditors told Phar-Mor executives ahead of time which stores they would be observing. That slip made it a simple matter for the company to ensure that the records and counts would be accurate at those few stores. Accounts receivable also may be overstated. Recall that when a receivable is recorded, so is the related revenue. Thus, not only are assets overstated, so are revenues and net income and therefore equity. Auditors nearly always will confirm a sample of receivables, however.
When auditors confirm information, they are requesting that an independent third party, such as a customer, directly verify to the auditors, usually in writing, that some specific information is correct e. However, the auditors can be fooled if management is so inclined. Instead, management was able to persuade the auditors to accept internal documentation relating to its receivables, which of course had been manufactured by management. Fixed assets also may be overstated, but, in a method that is unique to them, management may intentionally understate the depreciation expense each year, such as by using an unrealistic service life.
The smaller expense translates into a larger net income, which increases equity. The accumulated depreciation contra asset account that appears on the balance sheet also is understated so that the net plant and equipment added on the asset side of the balance sheet is overstated.
Thus, the balance sheet still balances. Recall that GAAP requires that detailed and extensive footnotes accompany financial statements.
Thus, there are probably limitless ways in which management can mislead financial statement readers via the footnotes. Damaging information known to management may not be mentioned, or facts can be misstated.
Those actions certainly do not conform to the full disclosure principle, but any method of misstating financial statements fraudulently does not conform to any concept of financial reporting. The Enron case is a classic example of improper disclosure. Enron developed special purpose entities SPEs to finance growth and report profits without reporting the related debt on its balance sheet. Thus, Enron could use the capital raised by the SPE without having to report the related debt on its balance sheet.
This debt avoidance was significant since the SPEs were structured to meet the minimum 3 percent rule, meaning that the remaining 97 percent of the capital typically was contributed by loans from banks. For example, the outside investors providing the 3 percent capital sometimes were individuals within Enron e.
Enron used the these entities for other purposes as well. It sold some of its assets at grossly overstated amounts to its SPEs, enabling it to report substantial paper gains on its income statement. Log in. Multi-award-winning investigative journalist Dan McCrum overcame many roadblocks while investigating the Wirecard fraud scandal for the Financial Times. Watch him discuss how he brought this important story to light.
View the video. For full access to story, members may sign in here. Not a member? Inventory represents the value of goods that were manufactured but not yet sold. Inventory is usually valued at wholesale but sold with a markup. When inventory is sold, the wholesale value is transferred over to the income statement as cost of goods sold and the total value is recognized as revenue.
As a result, overstating any inventory values could lead to an overstated cost of goods sold, which can reduce the revenue earned per unit. Some companies may look to overstate inventory to inflate their balance sheet assets for the potential use of collateral if they are in need of debt financing. Typically, it is a best practice to buy inventory at the lowest possible cost in order to reap the greatest profit from a sale.
One example of manipulated inventory includes Laribee Wire Manufacturing Co. Investors can detect overvalued inventory by looking for telling trends like large spikes in inventory values.
The gross profit ratio can also be helpful if it is seen to fall unexpectedly or to be far below industry expectations. This means net revenues may be falling or extremely low because of excessive inventory expensing. Other red flags can include inventory increasing faster than sales, decreases in inventory turnover , inventory rising faster than total assets, and rising cost of sales as a percentage of sales. Any unusual variations in these figures can be indicative of potential inventory accounting fraud.
When public companies make large investments in a separate business or entity, they can either account for the investment under the consolidation method or the equity method depending on their ability to control the subsidiary. Regardless, these investments are booked as assets. This can leave the door open for companies to potentially use subsidiaries, ownership investments, and joint venture structuring for concealment or fraudulent purposes-oftentimes, off-balance sheet items are not transparent.
Under the equity method, the investment is recorded at cost and is subsequently adjusted to reflect the share of net profit or loss and dividends received. While these investments are reported on the balance sheet and income statement, the methodologies can be complex and may create opportunities for fraudulent reporting.
Investors should be cautious—and perhaps take a look at the auditor's reliability—when companies utilize the equity method for accounting in situations where they appear to control the subsidiary. For example, a U. Undervaluing liabilities is a second way to manipulate financial statement reporting from the balance sheet. Contingent liabilities are obligations that are dependent on future events to confirm the existence of an obligation, the amount owed, the payee , or the date payable.
For example, warranty obligations or anticipated litigation losses may be considered contingent liabilities. Companies can creatively account for these liabilities by underestimating them or downplaying their materiality.
Companies that fail to record a contingent liability that is likely to be incurred and subject to reasonable estimation are understating their liabilities and overstating their net income and shareholders' equity.
Investors can watch for these liabilities by understanding the business and carefully reading a company's footnotes , which contain information about these obligations. Lenders for example, regularly account for uncollected debts incurred through defaults and often discuss this area when earnings reports are released.
Some other ways companies may manipulate expenses can include: delaying them inappropriately, adjusting expenses around the time of an acquisition or merger, or potentially overstating contingent liabilities for the purpose of adjusting them in the future as an increase to assets.
Moreover, in the realm of expenses, subsidiary entities as mentioned above, can also be a haven for off-balance sheet reporting of some expenses that are not transparently realized.
Pension obligations are ripe for manipulation by public companies, since the liabilities occur in the future and company-generated estimates need to be used to account for them. Companies can make aggressive estimates in order to improve both short-term earnings as well as to create the illusion of a stronger financial position.
There are two key assumptions that companies may adjust. In general, pension obligations are a result of the present value of future payments paid to employees. One way to potentially manipulate this is through the discount rate used. Increasing the discount rate can significantly reduce the pension obligation. Companies may also overstate the expected return on plan assets. Overstating expected return creates more assets from which to pay pension liabilities, effectively reducing the overall obligation.
Since pension obligations can be ongoing for a company, accountants could potentially make various adjustments over the full length of the obligations in order favorably manipulate net income in the short-term or at some time in the future.
See also: Analyzing Pension Risk. Some of these ratios may include debt to equity, total assets to equity, and total liabilities to equity. Companies can manipulate their balance sheets in many different ways, ranging from inventory accounting to contingent liabilities. Oftentimes, the goal is to increase net income, which comes with integration of actions that also show on the income statement.
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