Fraud Involving the Understatement of Liabilities - PowerPoint Presentation

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Fraud Involving the Understatement of Liabilities

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Fraud Involving the Understatement of LiabilitiesThe factors that make frauds difficult to detect are things such asCollusion by outsiders, such as bank executivesForgery, which GAAS auditors are not trained to detect

A complex audit trail or fraud that is mainly revealed on internal reports that are not relevant to a financial statement auditLying by management and other key people

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Fraud Involving the Understatement of Liabilities (Continued)Additional Factors that make frauds difficult to detect:A fraud that takes the form of normal-type transactions of the companySilence by individuals who knew or should have known about the fraud

Off-book nature of the fraud

The existence of misleading documentationFrauds that are small, relative to the financial statement balancesCopyright 2014-2015 AICPA Unauthorized copying prohibitedSlide4

Identifying Understatement-of-Liability Fraud ExposuresOne of the easiest ways to identify financial statement fraud exposures is to diagram the various kinds of transactions that involve liabilities that can be understatedCopyright 2014-2015 AICPA Unauthorized copying prohibitedSlide5

Understanding Liability FraudCopyright 2014-2015 AICPA Unauthorized copying prohibitedSlide6

Different Ways in Which Liabilities Can Be UnderstatedCopyright 2014-2015 AICPA Unauthorized copying prohibitedSlide7

Six Primary Types of Transactions That Can Create a Liability for a CompanyPurchase Inventory for Resale (Accounts Payable)Not recording purchases or recording the purchases after the end of the yearOverstating purchase returns or purchase discounts

Making it appear as if liabilities have been paid off or forgiven when they have not

Predating a payment made in a subsequent periodPay Employee Salaries & Accrue Liabilities (Accrued & Payroll Liabilities)Accounts such as salaries payable, payroll taxes payable, rent payable, utilities payable, and interest payable need to be properly accrued While these amounts tend to be small, they are easy to do, and can add up to material amountsCopyright 2014-2015 AICPA Unauthorized copying prohibitedSlide8

Six Primary Types of Transactions That Can Create a Liability for a Company (Continued)Sell Purchased Goods (Unearned Revenues) When someone pays in advance for a service or product, the entry recorded should include a recognition of the cash received and the recording of a liability because a service must be performed or a product delivered in the future

Can recognize revenue early—when cash is received

Service Products Sold (Warranty & Service Liabilities)A liability for promised warranty and service obligations must be recorded at the time of saleCopyright 2014-2015 AICPA Unauthorized copying prohibitedSlide9

Six Primary Types of Transactions That Can Create a Liability for a Company (Continued)Borrow Money (Notes, Mortgages, and Other Payables) Either not reporting or under-recording debt to related partiesBorrowing, but not disclosing, debt incurred on existing lines of credit

Not recording loans incurred

Claiming that existing debt has been forgiven by creditorsClaiming that debt on the company’s books is personal debt of the owners or principals, rather than debt of the business “Park” or hide debt in unconsolidated subsidiariesCopyright 2014-2015 AICPA Unauthorized copying prohibitedSlide10

Six Primary Types of Transactions That Can Create a Liability for a Company (Continued)Incur Contingent Liabilities (Contingent Liabilities)FAS 5* requires contingent liabilities, such as pending lawsuits, to be recorded as liabilities on the balance sheet if the likelihood of loss or payment is “probable”

The fraud is perpetrated by under estimating the probability of occurrence as remote or reasonably possible

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Symptoms Related to Accounts Payable UnderstatementAnalyticalAccounts Payable balances too lowPurchase or Cost of Goods Sold numbers that appear too lowPurchase Returns or Purchase Discounts that appear too high

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Symptoms Related to Accounts Payable Understatement (Continued)Accounting or DocumentaryInvoices received but no liability recordedLarge purchases recorded at beginning of period (should they have been recorded last period?)

Large payments made in subsequent periods, backdated to the current periodPresence of receiving reports with no recorded liability

Amounts listed on vendor statements but no recorded liabilityErrors in cutoff testsCopyright 2014-2015 AICPA Unauthorized copying prohibitedSlide13

Documentary symptoms that relate to all kinds of understatement of liability fraud include:Photocopied purchase-related records where originals should exist.Unusual discrepancies between the entity's records and confirmation replies.Transactions not recorded in a complete or timely manner or improperly recorded amounts.Accounting period, classification, or entity policy; unsupported or unauthorized balances or transactions.

Last-minute adjustments by the entity that significantly affect financial results.Missing documents; significant unexplained items on reconciliations.Denied access to records, facilities, certain employees, customers, vendors, or others from whom audit evidence might be sought.

Duplicate vendor names in the A/P listing.Preferential treatment to a particular vendor. Copyright 2014-2015 AICPA Unauthorized copying prohibitedSlide14

Symptoms Related to Accrued Liabilities UnderstatementAnalyticalReported payroll, payroll tax, rent, interest, utility, or other accrued liabilities that appear too low

To determine if they are too low compare to past period balances, other related accounts, comparisons to other companies

Accounting or DocumentaryDocumentary symptoms relate to specific accountsWith payroll, for example, documentary symptoms might include employees with no withholdings, lack of payments to governmental entities, no year end accruals, payroll tax rates that are too low, fewer employees paid than listed in records, capitalization of employee wages in a start up companyFor interest understatement look for notes payable with no interest expense, bank confirmation shows a note not disclosed by the company, interest expense on tax returns not recorded on financial statements Copyright 2014-2015 AICPA Unauthorized copying prohibitedSlide15

Symptoms Related to Recorded Unearned Revenues UnderstatementAnalyticalSymptoms for premature recognition of unearned revenues involve unearned liability account balances that appear too low and revenue accounts that appear too high

Accounting or DocumentarySymptoms include inconsistencies between revenue recognition criteria and timing specified in contracts and sales agreements

The method and timing with which revenues are recognizedLarge reclassification entries near the end of a period that result in increased revenues and lower liabilitiesLack of shipping documentation for recorded revenueRevenue recognized before customer is billedInconsistencies in timing or method of recording unrecorded liabilitiesCopyright 2014-2015 AICPA Unauthorized copying prohibitedSlide16

Escalation of revenue will show up in increased net income, increased taxesReconcile net income claimed on tax return to net income on financial statements might reveal evidence of fraudCopyright 2014-2015 AICPA Unauthorized copying prohibitedSlide17

Symptoms Related to the Under-Recording of Service (Warranty) LiabilitiesAnalyticalSymptoms include balances in such accounts as warranty, repurchase, and deposits that appear too low Accounting or Documentary

Differences between the amount expensed as warranty or service costs and the amount that should have been expensed based on sales contracts or sales

agreementsDifferences in the way deposits are treatedDifferences in confirmations of repurchase agreement Differences between what the contract defines as a liability and what the company is actually doingCopyright 2014-2015 AICPA Unauthorized copying prohibitedSlide18

Not Recording or Under-Recording Various Liabilities (Notes, Mortgages, and so on)AnalyticalUnreasonable relationships between interest expense and recorded liabilitiesSignificant decreases in recorded debtSignificant purchases of assets with no recorded debt

Recorded amounts of notes

payable, mortgages payable, lease liabilities, pension liabilities, and other debts appear to be too lowRelated parties can be used to hide debtCopyright 2014-2015 AICPA Unauthorized copying prohibitedSlide19

Not Recording or Under-Recording Various Liabilities (Notes, Mortgages, and so on) (Continued)Documentary or AccountingLiabilities listed on bank confirmations but not recorded by the companyPresence of unrecorded liens

Differences between contract amounts and loans recordedPresence of interest expense with no recorded debt

Writing off liabilities without payment of cashSignificant purchases of assets without a comparable decrease in cash or increase in liabilitiesSignificant repayment of debt immediately prior to year-end with new borrowing immediately after year-endCopyright 2014-2015 AICPA Unauthorized copying prohibitedSlide20

Not Recording or Understatement of Contingent LiabilitiesAnalyticalAnalytical symptoms are usually not very helpful in finding contingent liabilities that should be recorded because it is difficult to determine whether or not there should be a contingent liability recorded and, if so, how muchDocumentary

Identification of lawsuits by attorneys

Payments to attorneys without acknowledged litigationCopyright 2014-2015 AICPA Unauthorized copying prohibitedSlide21

Not Recording or Understatement of Contingent Liabilities (Continued)Mention of litigation in corporate minutesCorrespondence with governmental agencies such as the EPA, SEC, and so on

Significant payments to plaintiffs and others

Filing of an Form 8-K with the SECWithdrawal or issuance of an other-than-clean audit opinion by predecessor auditorsCorrespondence from previous auditors, banks, regulators, or othersCopyright 2014-2015 AICPA Unauthorized copying prohibitedSlide22

Analyzing Financial Balances and Relationships Within Financial Statements Look for unusual changes in liability balances from period to period (trends).This is done in three ways: (1) focusing on changes in the actual financial statement numbers, (2) studying the Statement of Cash Flows, and (3) using horizontal analysis.

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In using these three methods to focus on changes in liability balances, the auditor should compare balances over several years and pay special attention to liabilities that have been eliminated, significant changes in the write-down of long-term liabilities, accruals and service liabilities that have not been recorded or are recorded at significantly lower balances than in previous periods and contingent liabilities that have been disclosed in the footnotes but may need to be recorded as liabilities in the financial statements.Copyright 2014-2015 AICPA Unauthorized copying prohibitedSlide24

Remember, when looking for changes in account balances, every liability account is a candidate for fraud. Therefore, when analyzing the results of horizontal analysis, the auditor should look at each liability, consider the most common types of fraud exposures (those discussed in the first section of this topic), and then look to see if those changes that are revealed are suggestive of that type of fraud. Copyright 2014-2015 AICPA Unauthorized copying prohibitedSlide25

Focusing on changes in relationships to identify analytical fraud symptoms is one of the best ways to detect understatement of liability financial statement frauds. This is done in two ways: (1) computing relevant ratios and examining changes in the ratios from period to period, and (2) using vertical analysisCopyright 2014-2015 AICPA Unauthorized copying prohibitedSlide26

Comparing Financial Statement Amounts or Relationships with Nonfinancial Statement Information Compare financial results and trends of the company with those of similar firms in the same industry or to industry averages. Compare recorded amounts in the financial statements with nonfinancial statement amounts.Elimination of mortgage payable or new buildings that have no mortgages (when the company practice is to mortgage all buildings) can represent fraud symptoms and should be investigated.

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Because PCAOB auditors often have a tendency not to follow up as thoroughly as they could with understatement of liability fraud symptoms, auditors may want to retain a trained fraud examiner to investigate possible fraud symptoms. Due to background and orientation, a trained fraud investigator is usually more likely than a PCAOB auditor to determine if a "symptom" represents an actual fraud. Copyright 2014-2015 AICPA Unauthorized copying prohibitedSlide28

Summary: To find Understatement of Accounts PayablePayments made in subsequent periods for liabilities that existed at the balance sheet date and were not recorded.More inventory counted than identified through purchasing and inventory records.Receiving

reports near the end of a period without corresponding purchase invoices.Amounts listed on vendor statements not recorded as purchases.

Differences on confirmations not easily reconciled with purchase records.Discrepancies in cutoff tests.Copyright 2014-2015 AICPA Unauthorized copying prohibitedSlide29

Accrued Liabilities1099s with no withholdings where withholdings should exist.Employees with no withholdings.Vendor statements (utilities, etc.) where no liability is recorded.Loans with no interest expense.

Leased buildings with no rent or lease expense.

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Unearned RevenuesReclassification entries near the end of the period that increase earned revenues and decrease unearned revenues.Differences between customer confirmations and company records about how much revenue has been earned.Copyright 2014-2015 AICPA Unauthorized copying prohibitedSlide31

Service (Warranty) Liabilities, Deposits, Repurchase Agreements – Obligations to Perform Services, Deliver Products or Return Money in the FutureInconsistencies in customer agreements or contracts and recording of expenses.Differences in customer confirmations regarding client obligations (e.g., repurchase agreements, etc.).Warranty payments that exceed warranty liabilities.

Deposits recognized as revenues.

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Liabilities to Pay Money (Notes Payable, Mortgage Payable, Pension Liabilities, Lease Liabilities, etc.)Liens on properties that are supposed to be paid for.Approval of loans by Board of Directors but not listed as liabilities.Loans listed by banks on bank confirmations but not recorded by company.Lack of pension accrual.

Lease payments with no lease liability.Conservative assumptions used to calculate pension liability.

Unusually large credits on bank statements.Copyright 2014-2015 AICPA Unauthorized copying prohibitedSlide33

Contingent LiabilitiesDiscussion of contingent liabilities in board minutes.Contingencies discussed in footnotes.Significant payments to lawyers.Lawsuits brought to your attention for the first time in attorney letters.

Letters from regulators such as OSHA, EPA, SEC, etc.

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