Albrecht, Albrecht, Albrecht, Zimbelman © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Fraud Examination, 4E Chapter 13: Liability, Asset, and Inadequate Disclosure Frauds

Albrecht, Albrecht, Albrecht, Zimbelman © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Learning Objectives  Identify fraudulent schemes that understate liabilities.  Discuss the understatement of liabilities fraud.  Describe fraudulent schemes that overstate assets.  Understand the overstatement of assets fraud.

Albrecht, Albrecht, Albrecht, Zimbelman © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Learning Objectives  List fraudulent schemes that inadequately disclose financial statement information.  Explain the inadequate disclosure fraud.

Albrecht, Albrecht, Albrecht, Zimbelman © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Types of Financial Statement Fraud  Understating liabilities  Overstating assets  Inadequate disclosure A few year’s ago Waste Management, Inc., the leading provider of comprehensive waste and environmental services in North America improperly inflated its operating income and other measures of performance by deferring current-period operating expenses into the future by netting one-time gains against current and prior period misstatements and current period operating expenses.

Albrecht, Albrecht, Albrecht, Zimbelman © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Understatement of Liabilities Fraud Schemes that understate liabilities  Understating Accounts Payable  Understating Accrued Liabilities  Recognizing Unearned Revenue as Earned Revenue  Underrecording Future Obligations  Not Recording or Underrecording Various Types or Debt (Notes, Mortgages, etc.)  Omission of Contingent Liabilities

Albrecht, Albrecht, Albrecht, Zimbelman © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Understatement of Liabilities Fraud  Understating Accounts Payable  Accounts Payable can be understated by a combination of:  Not recording purchases or recording the purchases after the end of the year.  Overstating purchase returns or purchase discounts.  Making it appear as if liabilities have been paid off or forgiven when they have not.

Albrecht, Albrecht, Albrecht, Zimbelman © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Understatement of Liabilities Fraud  Understating Accrued Liabilities  Common accrued liabilities accounts:  Salaries payable  Payroll taxes payable  Rent payable  Utilities payable  Interest payable

Albrecht, Albrecht, Albrecht, Zimbelman © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Understatement of Liabilities Fraud  Recognizing Unearned Revenue as Earned Revenue  Recognizing revenues instead of recording a liability has a positive effect on a company’s financial statements because it understates the company’s liabilities and overstates its revenues and net income.  By manipulating the timing of revenue recognition, a company can very easily either understate or overstate deferred revenue liabilities.  To understand the motivation of these types of frauds, remember that stock prices are affected by both risk and return.

Albrecht, Albrecht, Albrecht, Zimbelman © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Understatement of Liabilities Fraud Underrecording Future Obligations Future obligations examples include:  Warranty  Service Obligations This type of fraud is easy to perpetrate and results in overstated net income and understated liabilities.

Albrecht, Albrecht, Albrecht, Zimbelman © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Understatement of Liabilities Fraud Not Recording or Underrecording Various Types or Debt (Notes, Mortgages, etc.)  Either not reporting or underrecording debt to related parties  Borrowing but not disclosing debt incurred on existing lines of credit  Not recording loans incurred  Claiming that existing debt has been forgiven by creditors  Claiming that debt on the company’s books is personal debt of the owners or principals, rather than debt of the business

Albrecht, Albrecht, Albrecht, Zimbelman © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Understatement of Liabilities Fraud Omission of Contingent Liabilities  If likelihood of loss is reasonably possible, the contingent liability should be disclosed in the footnotes to the financial statements.  Contingent liabilities can be used to fraudulently misstate financial statements by underestimating the probability of occurrence and not recording or disclosing contingent liabilities in the financial statements.

Albrecht, Albrecht, Albrecht, Zimbelman © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Understatement of Liabilities Fraud  Ways to detect understatement of liabilities  Analytical symptoms  Accounting or Documentary symptoms

Albrecht, Albrecht, Albrecht, Zimbelman © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Understatement of Liabilities Fraud Analytical Symptoms  Accounts Payable:  Balances appear too low  Cost of goods sold numbers are low  Unearned Revenue:  Payables or other accrued liabilities are low  Income that is “too smooth”

Albrecht, Albrecht, Albrecht, Zimbelman © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Understatement of Liabilities Fraud Analytical Symptoms  Recognition of Unearned Revenues:  Unearned liability balances appear too low and revenue accounts appear too high  Under- or nonrecording of services/warranty:  Balances in warranty, repurchases, or deposits accounts appear too low  Unrecorded contingent liabilities:  Analytical symptoms are not particularly helpful to detect unrecorded contingent liabilities

Albrecht, Albrecht, Albrecht, Zimbelman © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Understatement of Liabilities Fraud Analytical Symptoms  Unrecorded Notes/Mortgages:  Unreasonable relationship between interest expense and recorded liabilities  Significant purchases of assets with no recorded debt  Recorded amounts of notes payable, mortgages payable, lease liabilities, pension liabilities and other debts are too low

Albrecht, Albrecht, Albrecht, Zimbelman © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Understatement of Liabilities Fraud  Accounting or Documentary Symptoms  Photocopied records where originals should exist  Unusual discrepancies between the entity’s records and confirmation replies  Transactions not recorded in a complete or timely manner or improperly recorded amounts  Balances or transactions that lack supporting documents  Missing documents  Unexplained items on reconciliations  Denied access to records, facilities or others whom audit evidence might be sought

Albrecht, Albrecht, Albrecht, Zimbelman © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Overstatement of Asset Fraud

Albrecht, Albrecht, Albrecht, Zimbelman © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Overstatement of Asset Fraud  Overstatement of Fixed Assets by:  Leaving worthless or expired assets on the books  Underreporting depreciation expense  Overstate asset costs with related parties  Colluding with outside parties to overstate assets (e.g., allocating inventory costs to fixed assets)  Fabricating fixed assets to record on the financial statements

Albrecht, Albrecht, Albrecht, Zimbelman © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Overstatement of Asset Fraud  Overstatement of Receivables and Inventory  Cover thefts of cash or other assets by overstating receivables or inventory

Albrecht, Albrecht, Albrecht, Zimbelman © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Overstatement of Asset Fraud  Overstatement of Cash, Short-Term Investments, and Marketable Securities Schemes  Reporting restricted cash as unrestricted on the balance sheet  Having vendors or employees steal significant amounts of cash over time so that financial statements are misstated  Cash is quite hard to overstate because of verification from financial institutions

Albrecht, Albrecht, Albrecht, Zimbelman © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Overstatement of Asset Fraud  Use market values rather than book values to record assets.  Have the wrong entity be the “purchaser.”  Allocate costs among assets in inappropriate ways.  Record fictitious assets or inflate the value of assets in intercompany accounts or transactions

Albrecht, Albrecht, Albrecht, Zimbelman © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Overstatement of Asset Fraud  Overstatement of Intangible or Deferred Assets  Startup companies can fraudulently capitalize intangible assets like start- up costs, advertising costs, salaries by writing them off as deferred charges.

Albrecht, Albrecht, Albrecht, Zimbelman © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Overstatement of Asset Fraud  Ways to detect overstatement of assets  Compare changes and trends in financial statement account balances  Compare changes and trends in financial statement relationships  Compare financial statement balances with nonfinancial information or things, such as the assets they represent  Compare financial statement balances and policies with those used by other similar companies

Albrecht, Albrecht, Albrecht, Zimbelman © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Inadequate Disclosure Fraud  Disclosure Fraud Schemes  Misrepresentation about the nature of the company or its products  Misrepresentations or omissions in the MD&A  Misrepresentations or omissions in the footnotes to the financial statements

Albrecht, Albrecht, Albrecht, Zimbelman © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Inadequate Disclosure Fraud  Ways to identify Disclosure Fraud  Look for inconsistencies between disclosures and information in the financial statements  Inquire of management concerning related-party transactions, contingent liabilities, and contractual obligations  Review a company’s files and records with the SEC and other regulatory agencies