Detecting Financial Statement Fraud: Part 2

In the previous post, I reviewed common motivations for committing financial statement fraud, as well as several common ways that financial statements can be manipulated. This post covers additional misrepresentations and how forensic accountants identify them.

Concealed Liabilities and Expenses: Concealed liabilities can include warranties attached to sales, underreported Incurred-but-not-Reported (IBNR) health benefits, or simple omission of liabilities. Expenses can be concealed by capitalization that spreads the expense out over a number of years by recording an asset and annual depreciation rather than properly recognizing the entire expense in one year.

A red flag for concealed liabilities and expenses includes any significant estimates that are made on financial statement items that require subjective judgment and for which specific support is not available. It is sometimes helpful to compare the entity to another in the same industry – what significant liabilities or expenses are present? In a search for concealed liabilities and expenses, an auditor will review transactions that occurred after the financial statement date, compare expenses by type to the prior year, and ask client personnel questions for additional information. The use of gross profit margin (sales less cost of goods sold/total sales) and the current ratio (current assets/current liabilities) can be helpful to detect irregularities with liabilities and expenses.

Improper Disclosures: Financial statements should include all information necessary to prevent an informed reader from being misled. So, the information that is disclosed must be accurate and presented in a way that is not misleading. This means that items such as subsequent events, related-party transactions, contingent liabilities, and changes in accounting principles must all be disclosed when they are material. Reviewing subsequent transactions, inquiring of employees, and reviewing minutes of those charged with governance (Board of Trustees) are always excellent steps to take to ensure proper disclosures. Highly complex transactions or organizational structures might cause auditors to question the appropriateness of the disclosures.

Improper Asset Valuations: Estimates are often used in accounting, and each estimate used increases risk. Inventory, investments, and accounts receivable all require a valuation of some type. Inventory should be carried at lower of acquisition cost or current market value; therefore the value shown on the financial statements should be the acquisition cost unless that cost is higher than the current market value, in which case that market value is used. A simple way to test this is to review a listing of all inventories and determine if cost for each of the items included appears to be high based on current prices, and to look at the inventory and determine if it appears to be out dated or obsolete. Confirmations can be sent to determine the collectability of accounts receivable.

To investigate the value of investments, tracing purchases and sales and testing the value of individual securities at year end is appropriate. Fixed assets should be recorded at cost; however, impairments of value should be recorded. Comparing the relationship between fixed assets and depreciation recorded from year to year may help identify fraudulent activity.

It is important to remember that there isn’t one sure way to detect fraud in financial statements. It is helpful to start by determining any motivation to manipulate the statements, attempt to determine how a person with intent to mislead would do so with the controls in place, then, create a plan of investigation. This list, while limited, can provide the basis for efficient financial statement fraud detection and prevention.

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