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ASSET OVERSTATEMENT FRAUD: INTERESTING INFORMATION COMPILED BY ER. AVINASH KULKARNI

Saturday Brain Storming Thought (173) 27/05/2023

ASSET OVERSTATEMENT FRAUD

This form of fraud occurs when a company overstates assets by failing to apply an appropriate depreciation schedule or valuation reserve, like inventory reserves

Impact of overstating of assets

If a company overstates assets or understates liabilities, it will result in an overstated net income, which carries over to the balance sheet as retained earnings and therefore inflates shareholders equity

Fraud of overstating revenue

Accounting fraud is the illegal alteration of company’s financial statements in order to manipulate a company’s apparent health or hide profits or losses

Overstating revenue, failing to record expenses, and misstating assets and liabilities are all ways to commit accounting fraud

Key Takeaways of Accounting Fraud

1) Accounting fraud is the illegal alteration of company’s financial statements in order to manipulate a company’s apparent health or to hide profits or losses

2) overstating revenue, failing to record expenses, and misstating assets and liabilities are all ways of commit accounting fraud

3) The Enron Scandal is one of the most famous examples of accounting fraud in history

4) for accounting fraud to take place, a firm must deliberately falsify financial records

5) fraud requires intent, which can be difficult to prove

Warning signs of Accounting Fraud

1) growing revenues without a corresponding growth in cash flows

2) consistent sales growth while competitor’s are struggling

3) a significant surge in company’s performance within the final reporting period of fiscal year

4) depreciation methods and estimates of assets useful life that don’t correspond to those of the overall industry

5) weak internal corporate governance, which increases the likelihood of financial statement fraud occuring unchecked

6) outsized frequency of complex third party transactions many of which do not add tangible value and can be used to conceal balance sheet debt

7) the sudden replacement of auditor resulting in missing paperwork

8) A disproportionate amount of management compensation derived from bonuses based on short term targets, which incentivizes fraud

Financial Statement Fraud Detection Methods

1) vertical and horizontal financial statement analysis introduces a straightforward approach to fraud detection

2) vertical analysis involves taking every item in the income statement as a percentage of revenue and comparing the year over year trends that could be a potential flag cause of concern

3) using total assets as the comparison benchmark, to monitor significant deviations from normal activity

4) horizontal analysis implements, financial information is represented as a percentage of the base years figure

5) compatitive ratio analysis likewise helps analysts and auditors spot accounting irregularities

6) by analysing ratios, information regarding days sales in receivables, leverage multiples, and other vital metrics can be determined and analysed for inconsistencies

7) Beneish model evaluates eight ratios to determine the likelihood of earnings manipulation, including asset quality, depreciation, gross margin and leverage

8) M score less than 2.22 suggests that the company is not a manipulator

9) M score greater than 2.22 warrents further investigations

Net worth/Net income overstatements

1) fictitious revenues

2) manipulate timing

3) concealed liabilities and expenses

4) improper asset valuations

5) improper disclosures

Manipulating timing

1) early revenue recognition

2) postponing expenses

3) recording a sale when there are still items or services to be provided

4) recording a sale before the sale contract has been finalized and before shipment to customers

5) recording a sale when items are sent on consignment, on approval or with a right of return

6) recording a sale to associated parties

7) recording a sale when an order is received

8) issuing invoices for non existing sales and recording the transaction

Procurement Fraud

1) Employee/Supplier collision

2) conflict of interest

3) Fake companies

4) inflated bills / under delivery

5) false statements of obtaining contracts

Mischaracterised expenses

1) items that don’t seem to have a business connection

2) meals and entertainment when employees aren’t working, traveling or on weekends or holidays

3) items or meals for children

4) establishment in the employees neighborhood

Potential indicators of overstated expenses

1) incomplete or inadequate expense report

2) supporting documents such as receipts that are suspicious

3) receipts show signs of fabrication (eg inconsistent font, colour, visible correcting fluid/tape, pixelation, scratched out information)

Fictitious Expenses

1) multiple expense reports submitted close together from the same company, from the same employee

2) taxi, hotel, flight or other travel related receipts for dates and times the employee was known to not be on company business

3) receipt amounts that are significantly higher than similar reports submitted by other employees

4) expenses that are nor pre approved

Multiple Reimbursements

1) compare dates, amounts and payees claimed on one report to those on other reports from the same employee

2) look for evidence of the original version of a lost receipt connected to another expense report

Tips to prevent financial statement fraud

1) institute strong internal accounting control

2) dividing responsibility for bookkeeping, deposits, reporting and auditing between different people to reduce temptation and opportunities to commit fraud

3) perform periodic audits of financial statements

4) when employees know an external auditor will be reviewing their work, they are less likely to stray from honest path

5) set a tone of honesty at the top

6) use enterprise resource planning (ERP) accounting software

7) the system enforces segregation of duties and strict approval mechanism which help prevent unauthorised transactions

8) establish an internal hotline/reporting system

9) don’t tie management bonuses and compensation to short term goals

10) follow up on gut instincts

11) if communication with key accounting personal are vauge or misleading, something may be a missing

Steps of correcting an Overstatement of revenue

Negative adjusting entries are used to correct errors in the income, statement revenue and expense account

The exersise of prudence means the assets and income are not overstated and liabilities and income are not understated

Three sides of fraud risks

1) some kind of perceived pressure

2) some perceived opportunity

3) some way to rationalize the fraud as not being inconsistent with one’s values

Most types of accounting errors

1) data entry error

2) error of omission

3) error of commission

4) error of transportation

5) compensating error

6) error of duplication

7) error of principle

8) error of entry reversal

Soft indicators of fraud

1) risk taker

2) likes to beat the system

3) refusal to take time off

4) coming in early and staying late

5) drug or alcohol abuse

6) lavish lifestyle

7) personal financial problems

8) divorce or family problems

9) self control issues

Hard indicators of fraud

1) discrepancies in accounting records

2) conflicting or missing documentation

3) frequent changes in accounting estimates

4) frequent resignations of accounting or finance personals

5) transactions not completed in a complete or timely manner

6) unsupported or unauthorised balances or transactions

7) last minute adjustments that significantly affect accounting results

8) evidence of management override

9) unexplained differences between subledgers and control assets

10) financial reporting results significantly different from competitor’s in the same industry

Who commits fraud

1) age of fraudster – between 36 and 55

2) overwhelmingly male

3) generally a member of management

4) the fraudster works in finance or operations/sales and is frequently the CEO

5) time with the organisation – 33% over 10 years and 56% between 3 to 10 years

6) fraud was committed in collusion with others 69% of the time

7) internal controls were overridden in 74% of the cases

Compiled by:

Er. Avinash Kulkarni
9822011051

Chartered Engineer, Govt Regd Valuer, IBBI Regd Valuer

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