Spotting Creative Accounting on the Balance Sheet

Companies that use accrual accounting can book revenue in accounts receivable as soon as a sale is made. Thus, the processing of accounts receivable can be one high risk area for premature or fabricated revenues. Companies that manipulate their balance sheet are often seeking to increase their net income earnings power in order to create the appearance accounting articles of a stronger financial condition or stronger management performance. After all, financially sound companies can more easily obtain lines of credit at low interest rates, as well as more easily issue debt financing or issue bonds on better terms. Companies may also be looking to overstate their overall asset position to potential creditors.

The matter involved significant consideration of the rules regarding accounting restatements and related issues. Any time you change your accounting methods, there’s a chance of misstatement. Suppose you start your business using cash accounting, then switch to the accrual method. Under accrual accounting, you don’t wait for payment; you enter income as soon as you’ve earned it.

The auditor should inform the audit committee about adjustments arising from the audit that could, in his judgment, either individually or in the aggregate, have a significant effect on the entity’s financial reporting process. For purposes of this section, an audit adjustment, whether or not recorded by the entity, is a proposed correction of the financial statements…. As noted above, assessments of materiality should never be purely mechanical; given the imprecision inherent in estimates, there is by definition a corresponding imprecision in the aggregation of misstatements involving estimates with those that do not involve an estimate.

Europe’s fraud frontlines

Your financial statements for any given period have to be accurate, so catching misstatements is a must. Overstating assets and revenues falsely reflects a financially stronger company by inclusion of fictitious asset costs or artificial revenues. Understated liabilities and expenses are shown through exclusion of costs or financial obligations. This overstatement and/or understatement results in increased earnings per share or partnership profit interests or a more stable picture of the company’s true situation. Another type of accounting fraud takes place when a company does not record its expenses.

• Companies can manipulate their balance sheets in many different ways, ranging from inventory accounting to contingent liabilities.
• Then, potential investors will believe that the company has enough liquid assets to cover all of its liabilities.
• 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.
• Understated liabilities and expenses are shown through exclusion of costs or financial obligations.
• Under the governing principles, an assessment of materiality requires that one views the facts in the context of the «surrounding circumstances,» as the accounting literature puts it, or the «total mix» of information, in the words of the Supreme Court.

This SAB is not intended to change current law or guidance in the accounting or auditing literature.50 This SAB and the authoritative accounting literature cannot specifically address all of the novel and complex business transactions and events that may occur. Accordingly, registrants may account for, and make disclosures about, these transactions and events based on analogies to similar situations or other factors. The staff may not, however, always be persuaded that a registrant’s determination is the most appropriate under the circumstances.

The attorney as fraud investigator

The Securities and Exchange Commission (SEC) may well charge that CEO with fraud. However, it is not accounting fraud because no financial records were falsified. Detecting and preventing overstatements often involve implementing strong internal controls, adhering to accounting standards, and conducting regular audits or reviews of financial statements. When an accountant finds an understated or overstated balance, he needs to conduct research to discover the error. Double-posted entries, transposed numbers or incorrect amounts entered into the general ledger are often the most common errors. Two accounts will have the error, leading the accountant to discover both sides of the entry.

• Some companies use more than one system of software, for example, using different programs for accounts payable and cash.
• Thus, the impact of the overstatement on net income after taxes is the amount of the overstatement, less the applicable amount of income taxes.
• To go back to the preceding example, if ABC Company would otherwise have had a net profit before tax of $3,500, the overstatement of ending inventory of $500 now reduces the cost of goods sold by $500, which increases ABC’s net profit before tax to $4,000.
• Lenders for example, regularly account for uncollected debts incurred through defaults and often discuss this area when earnings reports are released.
• Assume PartsPeople sold goods to a customer with terms FOB shipping on December 29, 2019.

Specifically, this paper considers whether conservatism increases due to SFAS 87, 106, 121, 142, and 123R, conditional on the firm being an aggressive reporter. To test these standards, I perform two time-series analyses from 1976 though to 2010. The first analysis compares the number of observations with a book to market ratio (BTM) greater than one to all observations at the industry level. The second determines whether each standard is correlated with a reduction in the probability of a firm having a BTM greater than one. I use the BTM greater than one to identify firms that should be more conservative (avoid equity overstatement), and to exclude those that are biasing earnings to artificially low levels. The results are consistent with only some of the standards, SFAS 106 (Employers’ Accounting for Postretirement Benefits Other Than Pension) and SFAS 142 (Goodwill and Other Intangible Assets), being effective in reducing equity overstatement.

In a double-entry accounting or bookkeeping system, another account will also have an incorrect amount. “I think a lot of companies got very aggressive during these boom times, and across the board we’re going to see a move to greater conservatism, and long run, that’s a very good thing.” – Richard Breeden, former chairman, SEC. Charlene Rhinehart is a CPA , CFE, chair of an Illinois CPA Society committee, and has a degree in accounting and finance from DePaul University. In prior readings we’ve gone over the different types and posting adjusting entries, but here is a quick example of an adjusted entry made to the general ledger after a physical count of inventory corrected an inventory discrepancy.

Welcome to Accounting Education

Discover how to identify accounting errors and see different types and their importance. Review accounting errors before seeing the error of principle, transposition and commission errors, rounding errors and errors of omission, and counterbalancing errors. Simple steps such as reconciling your bank statement should catch more errors. If a company reports that its prepaid insurance is $8,000, but the true or correct amount of prepaid insurance is only $7,000, the accountant will say that the reported amount of prepaid insurance is overstated by $1,000.

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.

What Is Accounting Fraud? Definition and Examples

Understated and overstated are two terms that describe the inaccuracy of accounting figures. The terms also apply to other situations, however, often found in a company’s general ledger or subsidiary journals. Accounting errors can mislead financial statements users when making decisions. The following charts and examples should help you with understanding how inventory errors impact the financial statements. After 2020, as noted above, the error would have corrected itself, so no adjustment would be required. However, the 2019 financial statements used for comparative purposes in future years would have to be restated to reflect the correct amounts of inventory and cost of goods sold.

Registrants and their auditors first should consider whether each misstatement is material, irrespective of its effect when combined with other misstatements. The literature notes that the analysis should consider whether the misstatement of «individual amounts» causes a material misstatement of the financial statements taken as a whole. As with materiality generally, this analysis requires consideration of both quantitative and qualitative factors.

In these cases, there are a variety of tools for fraudulent inventory overstatement, such as reducing any inventory loss reserves, overstating the value of inventory components, overcounting inventory items, overallocating overhead, and so forth. The first test is at the industry level and compares the ratio of observations with a BTM greater than one to total observations by industry-year. This ratio is then regressed on indicator variables that are equal to one after the successive accounting standards become effective. The second test is also a time-series analysis, but instead of at the industry level, I perform the analysis at the firm level using a probit regression differentiated by whether the BTM ratio is greater or less than one. For accounting fraud to take place, a firm must deliberately falsify financial records. Now suppose the CEO of a publicly-traded company knowingly makes false statements about the firm’s prospects.

The observations used in this paper are unlikely to be abusing conservatism and are, in fact, likely overstating equity. Public companies can be a better universe for the sourcing of investments for everyday retail investors because of the regulations that have been instituted by the Securities Exchange Commission. If an investor feels they may have spotted creative accounting that involves fraudulent reporting-a review of publicly available audit statements and related financial disclosures can be the first place to look. Sometimes though, methods may be hidden, which can lead to shareholder investigations and potentially lawsuits if solid evidence is found for unlawful manipulations. Reading the financial statements, understanding a company’s business, and integrating an appropriate knowledge for spotting questionable practices can be important steps for all investors to take before making substantial investments. Staying away from questionable investments or taking proactive steps to move out of investments when creative accounting measures have been spotted can also be prudent steps to take.

For example, a U.S.-based company operating in China through various subsidiaries in which it appears to exert control could create an environment ripe for manipulation. Assume PartsPeople sold goods to a customer with terms FOB shipping on December 29, 2019. The company correctly recorded this as a sale on December 29, but due to a data-processing error, the goods, with a cost of $900, were not removed from inventory. Further, assume that a supplier sent a shipment to PartsPeople on December 29, also with the terms FOB shipping, and the cost of these goods was $500. These goods were not received until January 4 of the following year, but due to poor cut-off procedures at PartsPeople, these goods were not included in the year-end inventory balance.

The purpose of this paper is to examine the effectiveness of accounting standards on decreasing equity overstatement. Instead of using a general measure of conservatism, this paper specifically focuses on firms with book values exceeding market values. This is done to help determine whether the accounting standards are beneficial when firms could be using aggressive accounting, as opposed to those who are using conservatism to defer income for later periods, or “cookie-jar” accounting.

Undervaluing Liabilities

Estimates, by their nature, tend to over- or understate your company’s future performance. Income statements have to estimate potential revenue losses from sales returns and from customers who don’t pay their bills. If you overestimate your losses, your company income looks worse than it really is. Tongaat said PwC identified certain areas in which financial restatements are required and management is in the process of quantifying the adjustments and the financial impact will be included in the 2018 and 2019 annual reports, due to be released shortly. Shares in Tongaat have shed around 75% of their value this year, with investors jittery about accounting irregularities after multinational retailer Steinhoff International Holdings NV revealed a more than $12 billion hole in its accounts in late 2017.

If the company overstates its revenues, it would drive up the firm’s share price and create a false image of financial health. Remember, we have an external expectation of materiality as we saw in the introduction to this section, looking at Ernst & Young, LLP accounting firm’s opinion on the Alphabet, Inc. financial statements. For Alphabet, the numbers on the balance sheet are rounded to the nearest million. A $100,000 error may not be material if it won’t affect the reported numbers. An incorrect inventory balance causes the reported value of assets and owner’s equity on the balance sheet to be wrong. This error does not affect the balance sheet in the following accounting period, assuming the company accurately determines the inventory balance for that period.

From the chart, working capital and the current ratio are understated because part of the ending inventory is missing (not included in the count). Inflating assets can lead to higher revenues or higher inventory values that can make a company’s asset position stronger than it actually is. To go back to the preceding example, if ABC Company would otherwise have had a net profit before tax of $3,500, the overstatement of ending inventory of $500 now reduces the cost of goods sold by $500, which increases ABC’s net profit before tax to $4,000. If ABC has a marginal income tax rate of 30%, this means that ABC must now pay an additional $150 ($500 extra income x 30% tax rate) in income taxes.