Accrual accounting provides many opportunities for unscrupulous managers or employees to commit fraud.
The accounts receivable number that shows up in the asset section of a balancer sheet is almost always an estimate of what accounts are actually collectable. Why is the number an estimate? Because even if management can identify the precise amount its customers or clients owe the business, usually it is less than certain that this is the actual number that will ultimately be collected.
Sometimes the valuation of accounts receivable goes beyond simply making a good faith estimate of collectability. In some situations management may be tempted to commit outright fraud. Because no cash is collected when sales are made “on account”, a corrupt management can record fraudulent additional sales by simply creating fictitious customers and recording fictitious sales.
Another time honored-means of inflating accounts receivable and sales revenue involves “keeping the books open” at the end of the accounting period. In this case the customers and sales are real, but January sales are recorded as December sales so the end of year financial statements include inflated assets and revenue.
Part of the audit function is to test the existence and collectability of accounts receivable and this can serve as a brake on such fraudulent practices. In the audit of large companies with millions of dollars of receivables and hundreds of thousands of individual accounts, the audit process relies on statistical sampling, which usually provides a reasonable, but not exact, estimate of collectable accounts.
Management may have a motive to understate payables, as this understates expenses and overstates net income. Usually the amount of payable understatement is not too great and such understatement can easily be detected.
Deferred Revenue and Prepaid Expenses
A manager can overstate income and understate liabilities by treating deferred revenue as earned revenue. Essentially, this shady practice seeks to recognize revenue before it is actually earned. Such mischief often is not easy to detect, because it is not always clear when the earnings process is fully complete.
A manager also can understate current year expenses by claiming they are prepaid expenses. This amounts to a fraudulent claim that payments for a certain service benefit future accounting periods when, in fact they do not.
Management can make a firm appear more profitable than it really is by understating depreciation expense. Depreciation expense can be understated by overstating the useful life of assets. Management can also overstate its assets by keeping obsolete and no longer used assets on its balance sheet. Maintaining obsolete assets on the balance sheet also overstates net income because losses on the disposal of these assets are not recorded.
Inventory offers a big opportunity for management to manipulate their financial statements. If they want gross profits and, hence, operating profits to appear higher, the value of ending inventory simply needs to be overstated. There are many ways this can be done.
The ending inventory value can be fudged upward by overstating the amount of inventory on hand. Unit costs assigned to ending inventory can be inflated as well. Or obsolete or damaged inventory can be included in the ending inventory count.
Sometimes for income tax purposes, management may want to show lower gross and operating profits. Ending inventory mis-measurement can be used for this purpose as well. In this situation, management seeks to undercount and undervalue ending inventory. As such, accrual accounting is a golden haven for white collar crime to flourish. All auditors should pay more attention on all the above by optimizing " investigative minds " rather than 'auditing minds'. This approach would lessen fraud and enhanced shareholders wealth. The government would also benefit when corporations pay their taxes accordingly.
(Adapted from an article by Michael Sack Elmaleh, C.P.A., C.V.A.)