Financial Statement Fraud Archives

Aug 22

Accounting Tricks Used to Inflate Earnings

By Charles Hall | Financial Statement Fraud

Companies can inflate earnings easily with accounting tricks such as cookie jar reserves.

This article explores how businesses inflate profits and sometimes decrease them, depending on the company’s desires.

Today, I show you how fraudsters alter financial statements to magically transform a company’s appearance. Then, you will know how to detect these tricks.

Inflate Earnings

Companies can inflate earnings by:

Accruing fictitious income at year-end with journal entries
Recognizing sales for products that have not been shipped
Inflating sales to related parties
Recognizing revenue in the present year that occurs in the next year (leaving the books open too long)
Recognizing shipments to a re-seller that is not financially viable (knowing the products will be returned)
Accruing projected sales that have not occurred
Intentionally understating receivable allowances

Think about it: A company can significantly inflate earnings with just one journal entry at the end of the year. How easy is that?

You may be thinking, “But no one is stealing anything.” Yes, true, but the purpose of manipulating earnings might be to increase the company’s stock price. Once the price goes up, the company executives sell their stock and make their profits. Then, the company can, in the subsequent period, reverse the prior period’s inflated entries.

Inflate Earnings: Control Weakness

Such chicanery usually flows from unethical owners, board members, or management. The “tone at the top” is not favorable. These types of accounting tricks typically don’t happen in a vacuum. Usually, the top brass demands “higher profits,” often not dictating the particulars. Then, years later, they plead ignorance once the fraud is detected, saying their lieutenants worked alone.

Such possibilities are why the control environment, an entity-level control, is so important. Ethical leadership is foundational to a company’s health. Additionally, controls such as codes of conduct and conflict of interest statements matter.

So, how can companies lessen the risk of earnings manipulation?

Inflate Earnings: Lower the Risk

Transparency is the remedy to someone inflating earnings.

This sentence sounds simple, but transparency usually removes the temptation to inflate earnings. When fraudsters believe they’ll get caught, they usually will not act.

A robust internal audit department can put some fear in the heart of fraudsters and provide additional transparency. The board should hire internal auditors who report directly to them. Moreover, the company’s internal auditors should know that the board has their back.

But what if board members don’t desire transparency such as the WorldCom fraud? Consider removing them, if possible.

Now, let’s consider whether a company might desire decreased earnings.

Deflate Earnings (Cookie Jar Reserves)

Though much less likely, some businesses fraudulently decrease their earnings. Why? The company may want to save current year earnings for future periods, especially if highly profitable in the current period.

For example, what if a company bases bonuses on profits and has high current-year earnings? Then management might defer some of the profits to the following period (to increase the possibility of bonuses in the next year).

Deferring earnings is called a cookie jar reserve.

For example, if a company’s allowance for uncollectible receivables is acceptable within a range (say 1% to 2% of receivables), it might use the higher percent in the current year. The higher reserve decreases current-year earnings (the allowance is credited, and bad debt expense is debited, increasing expenses and decreasing net income). Then, the following year, the company might use 1% to increase earnings (even though 1.75% might be more appropriate).

Such actions are called smoothing.

Inflate Earnings Summary

So, as an auditor, know whether your audit client desires higher or lower profits–or whether they want the numbers to fall honestly.

And be aware of fraud incentives such as management bonuses. Then, audit accordingly.

How to Audit Journal Entries

If you want to know how to audit for potential fraudulent journal entries used to inflate earnings, see Get a Grip on Journal Entry Testing.

Dec 22

Related Party Transactions: Fraud

By Charles Hall | Auditing , Financial Statement Fraud , Fraud

Related party transactions can be a means to fraudulent financial reporting. Yet, auditors often don't detect the financial statement manipulation, leading to audit failure. This article explains how to understand and find fraudulent related party transactions.

Related Party Transaction

What is a related-party transaction?

It’s a transaction between two parties that have a close association. For example, two commonly owned businesses sell services or goods to one another. In another example, a business buys property from a board member or from the owner.

Normal Related Party Transactions

Related party transactions are typical and often expected. For example, a business might rent real estate from a commonly owned entity. In such an arrangement, the rental rate can be at fair value. So if a company pays for twelve months' rent at a standard rate, everything is fine. No manipulation is occurring.

Reason for Related Party Fraud

But in some cases, companies use related party transactions to deceive financial statement readers. Why? Because the business is not performing as well as desired, or maybe the company is not in compliance with debt covenants. (Noncompliance can trigger a call for repayment, or the loan can become a current liability based on accounting standards.)

Fraudulent Increase in Net Income

Imagine this scene. It's December 15th, and management is reviewing its annual financial results. The CEO and CFO receive substantial bonuses if the company's net profit is over $10 million. At present, it looks as if the business is just short, with an expected net income of $9.7 million. They need another $300,000.

So they develop a related party transaction whereby a commonly owned company pays their business $350,000 for bogus reasons--what auditors call a transaction outside the normal course of business. Since the CEO and CFO also manage the related entity, they control the accounting for both entities.

Management performs the trick on December 27th, and soon they are toasting drinks in the back room. The bonus enables the CEO to buy his wife a new Tesla and the CFO to take a one-month trip to Europe. And it was so easy.

In considering related party transactions, know that they are more likely with smaller entities, especially when one person owns several entities. So you'll want to know if associated businesses are making payments or loans to commonly owned companies.

Related Party Audit Procedures

As you begin your audit, request a list of all related-party transactions. Also, pay attention to such activity in the company's minutes. Additionally, electronically search company receipts, payments, and journal entry descriptions using the related party names. Then investigate any abnormal transactions outside the normal course of business, especially if they involve round-dollar amounts (e.g., $350,000).

In performing your fraud inquires, ask about related party transactions and if any unusual transactions occurred during the year (or after the year-end). And make sure you interview persons responsible for initiating, approving, or recording transactions. In other words, inquire of the CEO and CFO, but also ask questions of others such as the cash receipts or the accounts payable supervisor. The CEO and CFO might hide the bogus transaction, but, hopefully, the cash receipts supervisor will not.

As you can tell in the above example, you want to be aware of incentives for fraud, such as bonuses or the need to comply with debt covenants.

Does It Make Sense?

If you see an unusual transaction, request supporting information to determine its legitimacy. I once saw a $5 million transaction at year-end, and when I asked for support, the journal entry said, "for prior services provided." You might receive some mumbo jumbo explanation for such a payment. But know this: vague reasons usually imply fraudulent activity.

So, see if the economics make sense. Would a company pay that much for the services or products received? If not, you may need to propose an audit entry to correct the misstatement.

Representation Letter

And, by the way, having the client sign a management representation letter saying the transaction is legitimate does not absolve the auditor. Either the payment is economically supportable, or it is not.

Fraudulent Decrease in Net Income

Strangely, some companies desire to deflate their earnings. For example, maybe the company has had an unusually good year and wants to defer some net income for the future. So it is possible that related party payments are made to decrease earnings, and then the company might receive the same amount in the future from the related entity. The result: expenses in the current year and revenue in the subsequent year. Again, we as auditors need to understand the goals and incentives of the company to understand how and why fraud might occur.

Related Party Disclosures

Even if related party transactions are legitimate, businesses are required to disclose them. The related party disclosure should include the reason the other entity is a related party and the amount of the transactions.