1. Overstatement of Asset Fraud
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2. CUC fraud
One of the ways in which CUC allegedly committed financial statement fraud was to defer costs that should have been expensed into future periods by recording them as deferred charges (assets). By delaying recognition of these expenses, CUC was able to boost its current period net income (at the expense of future net income), as well as artificially inflate the amount of assets on the balance sheet.
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3. CUC perpetrated the scheme by recognizing all the revenue from the sale of a service contract at the time of sale, but then deferring the marketing expenses incurred in making the sale to future periods.
To further perpetrate the fraud scheme, near the end of each fiscal year, CUC's management would insist on a moratorium in recognizing expenses until after year-end, thus further inflating the current year's net income. The deferral of expenses appears to have been intentional, pervasive, and material.
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4. Identifying Asset Overstatement Fraud
As was the case with liabilities, different assets can be overstated in different ways
The following exhibit identifies the five most common types of assets that are overstated.
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5. Asset Overstatement Fraud
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6. Improper Capitalization of Costs as Assets That Should Be Expenses in the Current Period
A fairly common way to overstate assets is to capitalize as intangible assets such things as start-up or pre-operation costs, advertising costs, research and development, and certain salaries and other initial costs as intangible assets.
Management of these companies often argue that the costs are in the start-up or development phase and, therefore, should be capitalized as deferred charges and written off against profitable operations in the future.
In some cases, these deferred charges are justified; in other cases, they are clearly fraudulent. The question of whether these types of costs should be capitalized is usually a question of whether the costs are being incurred to generate future revenues or whether there is likelihood that sufficient future revenue will be generated against these costs.
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7. Capitalizing costs that should be expensed has the effect of increasing net income by the same amount of the capitalized costs, since expenses that should be deducted from revenues are not deducted until the future periods in which they are amortized. In many cases, these illicit capitalized costs may not be written off for many years.
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8. Inflated Assets Through Mergers and Acquisitions (or Restructuring)
There have been several financial statement fraud cases where companies involved in mergers or acquisitions have overstated their assets.
This is typically done by inappropriately using market values instead of book values, by having the wrong entity act as the purchaser of the other entity, through improperly allocating book values to assets (e.g., assigning higher book values to assets that will be amortized or depreciated over longer periods, or not depreciated at all and lower values to assets that will be amortized or depreciated over shorter periods), or through other means.
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9. A common scheme used to perpetrate financial statement fraud during mergers is to create various kinds of merger reserves. These reserves are then reversed into income to make resulting income appear high.
In other cases, assets are overstated in mergers by using market values instead of book values.
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10. Income and higher asset values were recognized by both Silver and Pacific on the exchange of these properties. The appraisals for the mining properties were performed by three individuals who were officers and directors of Silver and Pacific. Therefore, the appraisals were not prepared by independent parties.
The inflated asset values and the false income resulting from the exchange of assets between Silver and Pacific were eventually reported on the financial statements of Alta, causing the financial statements of Alta to be materially misstated.
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11. Overstatement of Fixed Assets (Property, Plant, and Equipment)
Some of the most common ways to overstate fixed assets are
Leaving worthless or expired assets on the books
Under-reporting depreciation expense (This can be done by using asset lives that are too long or by using salvage values that are too high or by just failing to make the accrual entries for depreciation.)
Overstating residual values
Recording fixed assets at inflated values
Fabricating fixed assets to record on the financial statements
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12. Barden, a supplier of molds and dies to Surgical, conspired to assist Surgical in falsifying its financial statements. Surgical accounted for a large portion of Barden's total revenues (15%). Molds and dies supplied by Barden, and used by Surgical in its manufacture of medical supplies, were capitalized by Surgical, and parts were inventoried. The parts were eventually expensed through cost of goods sold. Barden allegedly falsified invoices to charge Surgical more for molds and dies and less for parts, thus enabling Surgical to overstate its fixed assets and understate its cost of goods sold.
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13. Overstatement of Cash and Short-Term Investments (Including Marketable Securities)
It is generally quite hard to overstate cash, because cash balances can be easily confirmed with banks and other financial institutions
While there are several famous cases where marketable securities were materially overstated, it is generally quite hard to overstate cash because cash balances can be easily confirmed with banks and other financial institutions. Theft of cash by employees or vendors, however, can be very common and, without management's knowledge, can often result in a material misstatement in the financial statements.
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14. It is usually easier for management to overstate marketable securities, especially securities that are not widely traded. What many auditors do not realize is that the term "publicly traded" can mean more than just companies whose securities are traded on the New York Stock Exchange, the American Stock Exchange, and the NASDAQ.
There are many smaller, over-the-counter stocks, for example, that are commonly traded and may not even be actively listed by small over-the-counter stock exchanges, but whose stock prices are circulated among brokers by such means as "pink sheets."
In order to perpetrate fraud dishonest management will materially overstate the value of these securities.
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15. In many companies, securities that are not widely traded are valued by complex computer models. In these situations, it is often difficult for auditors to know whether or not the securities are properly valued.
Another way dishonest management can manipulate the reported amounts of marketable securities in its financial statements is to mis-classify them. Marketable securities are accounted for differently, depending upon the intent of management.
The accounting for these various types of securities is different, and is totally dependent upon both management's intent to hold or sell the securities and the level of ownership in the investee company.
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16. Overstatement of Accounts Receivable and Inventory
Sometimes accounts receivable and/or inventory can be overstated in an attempt to overstate assets and cover thefts of cash rather than to overstate reported income
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17. Summary of Overstatement-of-Asset Fraud Exposure
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18. To identify these overstatements the auditor need only determine which listed assets are overstated or fictitious. Auditors can start their detection process by examining the assets that make up the reported amounts and ask themselves if these assets really exist. If the assets do exist, the auditor can then determine if the amounts listed are appropriate.
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19. Questions an auditor should ask include:
Do the deferred charges have future benefits that are specifically identifiable?
Is it likely that there will be sufficient future revenues and profits against which the costs can be specifically written off and if so, when?
Are the deferred charges the types of charges that could be acceptable under GAAP (in most cases, for example, research and development costs are not) and are capitalized by other, similar companies?
Are there strong incentives for management to manage earnings or "find profits" in this company?
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20. Analytical Fraud Symptoms
You would almost always want to examine changes in the deferred charge financial statement relationships from period to period and would probably want to compare the financial statement amounts and capitalization policies with those of other, similar companies. You should be concerned, for example, if deferred charges make up a major portion of a company’s total assets. Probably the most appropriate financial statement relationships to focus on would be the following:
Total Deferred Charges and Total Assets
Total Deferred Charges and Total Intangible Assets
Deferred Charge Write-offs (Amortization) and Deferred Charge Balance
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21. One of the best ways to detect inappropriate capitalization of costs is by making comparisons with other, similar companies. If the client is the only firm (or one of only a small minority of firms) that is capitalizing certain kinds of expenditures as deferred charges, the auditor should probably be skeptical of the practice. Expensing questionable costs in the current period is the conservative accounting approach and, other things being equal, it is preferable to choose the conservative approach. If the client is capitalizing certain costs while other, similar firms are expensing them in the current period, auditors should ask, "What is unique about my client that makes capitalizing more appropriate for them than for other companies?"
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22. Documentary or Accounting Symptoms
Some of the general documentary or accounting asset-overstatement symptoms are
Asset-related transactions not recorded in a complete or timely manner or improperly recorded as to amount, accounting period, classification, or entity policy
Unsupported or unauthorized asset-related balances or transactions
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23. Documentary or Accounting Symptoms
Last minute asset adjustments by the entity that significantly improve financial results
Missing documents related to assets
Unavailability of other than photocopied documents to support asset transactions when documents in original form are supposed to exist
Asset-related ledgers that do not balance
Unusual discrepancies between the entity’s asset-related records and corroborating evidence or management explanations
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24. Overstating Assets Through Mergers, Acquisitions or Restructurings
Analytical Fraud Symptoms
Usually not very helpful in determining asset overstatements related to mergers or restructurings
With analytical symptoms, you are comparing trends and changes
When there is a merger or other change in the form of a business entity, you have a new, reformatted entity that has no history
It may be helpful to compare various asset ratios for the individual companies prior to the merger and the combined company after the merger
Accounting
Verify appropriate accounting methods, and ensure transaction amounts make sense
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25. By looking at such asset ratios as total intangible assets divided by total assets, total fixed assets divided by total assets and total current assets divided by total assets, the auditor can quickly get an idea of how the structure of the companies has changed.
The auditor should be concerned, for example, if total intangible assets as a percentage of total assets increased from an average of 10% in the two previous companies to 40% of total assets in the combined company.
It is often helpful to compare the recorded, post-merger assets with the actual assets they are supposed to represent. If reported asset values have increased substantially, for example, the auditor should ensure that the assets are not listed on the balance sheet at amounts that exceed their fair market values.
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26. Overstatement of Fixed Assets
Overstated fixed assets generally get on the financial statements in one of four ways:
Inflated amounts are recorded in non-arm’s-length purchase transactions
Assets are not written down to their appropriate book, market, or residual values because insufficient depreciation is recorded, they are obsolete, or their values are otherwise impaired
Assets that are sold or discarded are left on the books
Assets that simply do not exist are fictitiously recorded in financial statement accounts
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27. Overstatement of Fixed Assets
Analytical Symptoms
Use horizontal analysis, analysis of the Statement of Cash Flows, or compare account balances from period to period
Useful Ratios Include
Total Fixed Assets and Total Assets
Individual Fixed Asset Account Balances and Total Fixed Assets
Total Fixed Assets and Long-term Debt
Depreciation Expense for Various Categories of Assets and Assets Being Depreciated
Accumulated Depreciation and Depreciable Assets (Per Asset Category)
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28. Because fixed assets have tangible existence, auditors can compare the financial statement balances with actual assets to determine if the recorded amounts represent assets that do exist and are recorded in approximately the appropriate amounts. While an auditor may not know enough about how much complicated or company-specific assets should cost or be valued on the books, there are many different types of analyses that can be made.
Comparing total fixed assets or fixed assets as a percentage of total assets with other similar companies is helpful in determining if a company's recorded asset totals are reasonable.
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29. Accounting or Documentary Symptoms
Were there appraisals of purchased fixed assets?
Were the purchase transactions recorded near the end of the year?
Did the transaction(s) involve exchanges of assets or a purchase of assets?
Are the assets purchased the kinds of assets the company would normally purchase, or are they assets that are tangential to the business?
Are there inconsistencies in the documentation for the transactions?
Are the assets recorded on the books of the client at the same or lower amounts than they were on the seller's books?
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30. Unsupported or unauthorized asset-related balances or transactions.
Asset-related transactions not recorded in a complete or timely manner or improperly recorded as to amount, accounting period, classification, or entity policy.
Unsupported or unauthorized asset-related balances or transactions.
Last minute asset adjustments by the entity that significantly improves financial results.
Missing documents related to assets.
Availability of original documents, instead of photocopied documents, to support asset transactions.
Asset-related ledgers that do not balance.
Unusual discrepancies between the entity's asset-related records and corroborating evidence or management explanations
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31. Overstatement of Cash and Short-Term Investments
Analytical Symptoms
Examine relationships over time:
Current Assets/Current Liabilities (and Quick ratio)
Current Assets/Total Assets
Marketable Securities/Total Current Assets
Cash/ Total Current Assets
Documentary or Accounting Symptoms
The best accounting symptoms for discovering cash or marketable security, or both, over- or under-statements are usually differences between recorded amounts and amounts confirmed with banks, brokers, and other independent parties
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