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Fraud Involving the Understatement of Liabilities Copyright 2014-2015 AICPA Unauthorized copying prohibited Fraud Involving the Understatement of Liabilities The factors that make frauds difficult to detect are things such as Collusion by outsiders, such as bank executives Forgery, 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 audit Lying by management and other key people Copyright 2014-2015 AICPA Unauthorized copying prohibited 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 company Silence by individuals who knew or should have known about the fraud Off-book nature of the fraud The existence of misleading documentation Frauds that are small, relative to the financial statement balances Copyright 2014-2015 AICPA Unauthorized copying prohibited Identifying Understatement-ofLiability Fraud Exposures One of the easiest ways to identify financial statement fraud exposures is to diagram the various kinds of transactions that involve liabilities that can be understated Copyright 2014-2015 AICPA Unauthorized copying prohibited Understanding Liability Fraud 1. Purchase Inventory for Resale (Accounts Payable) 2. Pay Employee Salaries & Accrue Liabilities (Accrued & Payroll Liabilities) 6. Incur Contingent Liabilities (Contingent Liabilities) 5. Borrow Money (Notes, Mortgages, and Other Payables) 3. Sell Purchased Goods (Unearned Revenues) 4. Service Products Sold (Warranty & Service Liabilities) Copyright 2014-2015 AICPA Unauthorized copying prohibited Different Ways in Which Liabilities Can Be Understated 1. Transaction Purchase inventory Accounts Involved Inventory, Accounts Payable 1. 2. 3. 4. 5. 2. Incur payroll and other accrued liabilities 3. Sell products purchased 4. Service products sold, repay deposits or repurchase something in the future (future commitments) Borrow money 5. Payroll tax expense, Salary expense, Various expenses, Salaries payable, Payroll-taxes payable, Various accrued liabilities Accounts receivable, Sales revenue, Unearned revenue Warranty (service) expense, Warranty or service liability 6. 7. Cash, Notes payable, Mortgages payable, Etc. 8. Record unearned revenues as earned revenues 9. 10. 11. 12. Not record warranty (service) liabilities Under-record liabilities Record deposits as revenues Not record repurchase agreements & commitments 13. 14. 15. 16. 17. Borrow from related parties Do not record liabilities Borrow against asset equities Write-off liabilities as forgiven Claim liabilities as personal debt rather than debt of the entity Park liabilities in unconsolidated related entities Not record contingent liabilities Record contingent liabilities at too low an amount 18. 6. Incur contingent liabilities Loss from contingencies, Losses payable Fraud Schemes Record payable in subsequent period Do not record purchase Overstate purchase returns and purchase discounts Record payment made in later period as being paid in an earlier period Fraudulent recording of payment (e.g., kiting) Not accrue liabilities Record accruals in later period 19. 20. Copyright 2014-2015 AICPA Unauthorized copying prohibited Six Primary Types of Transactions That Can Create a Liability for a Company Purchase Inventory for Resale (Accounts Payable) Not recording purchases or recording the purchases after the end of the year Overstating 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 period Pay 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 amounts Copyright 2014-2015 AICPA Unauthorized copying prohibited 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 sale Copyright 2014-2015 AICPA Unauthorized copying prohibited 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 parties Borrowing, but not disclosing, debt incurred on existing lines of credit Not recording loans incurred Claiming that existing debt has been forgiven by creditors Claiming 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 subsidiaries Copyright 2014-2015 AICPA Unauthorized copying prohibited 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. Copyright 2014-2015 AICPA Unauthorized copying prohibited Symptoms Related to Accounts Payable Understatement Analytical Accounts Payable balances too low Purchase or Cost of Goods Sold numbers that appear too low Purchase Returns or Purchase Discounts that appear too high Copyright 2014-2015 AICPA Unauthorized copying prohibited Symptoms Related to Accounts Payable Understatement (Continued) Accounting or Documentary Invoices received but no liability recorded Large purchases recorded at beginning of period (should they have been recorded last period?) Large payments made in subsequent periods, backdated to the current period Presence of receiving reports with no recorded liability Amounts listed on vendor statements but no recorded liability Errors in cutoff tests Copyright 2014-2015 AICPA Unauthorized copying prohibited 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 prohibited Symptoms Related to Accrued Liabilities Understatement Analytical Reported 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 Documentary Documentary symptoms relate to specific accounts With 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 company For 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 prohibited Symptoms Related to Recorded Unearned Revenues Understatement Analytical Symptoms for premature recognition of unearned revenues involve unearned liability account balances that appear too low and revenue accounts that appear too high Accounting or Documentary Symptoms include inconsistencies between revenue recognition criteria and timing specified in contracts and sales agreements The method and timing with which revenues are recognized Large reclassification entries near the end of a period that result in increased revenues and lower liabilities Lack of shipping documentation for recorded revenue Revenue recognized before customer is billed Inconsistencies in timing or method of recording unrecorded liabilities Copyright 2014-2015 AICPA Unauthorized copying prohibited Escalation of revenue will show up in increased net income, increased taxes Reconcile net income claimed on tax return to net income on financial statements might reveal evidence of fraud Copyright 2014-2015 AICPA Unauthorized copying prohibited Symptoms Related to the Under-Recording of Service (Warranty) Liabilities Analytical Symptoms 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 agreements Differences in the way deposits are treated Differences in confirmations of repurchase agreement Differences between what the contract defines as a liability and what the company is actually doing Copyright 2014-2015 AICPA Unauthorized copying prohibited Not Recording or Under-Recording Various Liabilities (Notes, Mortgages, and so on) Analytical Unreasonable relationships between interest expense and recorded liabilities Significant decreases in recorded debt Significant 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 low Related parties can be used to hide debt Copyright 2014-2015 AICPA Unauthorized copying prohibited Not Recording or Under-Recording Various Liabilities (Notes, Mortgages, and so on) (Continued) Documentary or Accounting Liabilities listed on bank confirmations but not recorded by the company Presence of unrecorded liens Differences between contract amounts and loans recorded Presence of interest expense with no recorded debt Writing off liabilities without payment of cash Significant purchases of assets without a comparable decrease in cash or increase in liabilities Significant repayment of debt immediately prior to yearend with new borrowing immediately after year-end Copyright 2014-2015 AICPA Unauthorized copying prohibited Not Recording or Understatement of Contingent Liabilities Analytical Analytical 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 much Documentary Identification of lawsuits by attorneys Payments to attorneys without acknowledged litigation Copyright 2014-2015 AICPA Unauthorized copying prohibited Not Recording or Understatement of Contingent Liabilities (Continued) Mention of litigation in corporate minutes Correspondence 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 SEC Withdrawal or issuance of an other-than-clean audit opinion by predecessor auditors Correspondence from previous auditors, banks, regulators, or others Copyright 2014-2015 AICPA Unauthorized copying prohibited 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. Copyright 2014-2015 AICPA Unauthorized copying prohibited 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 prohibited 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 prohibited 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 analysis Copyright 2014-2015 AICPA Unauthorized copying prohibited 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. Copyright 2014-2015 AICPA Unauthorized copying prohibited 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 prohibited Summary: To find Understatement of Accounts Payable Payments 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 prohibited Accrued Liabilities 1099s 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. Copyright 2014-2015 AICPA Unauthorized copying prohibited Unearned Revenues Reclassification 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 prohibited Service (Warranty) Liabilities, Deposits, Repurchase Agreements – Obligations to Perform Services, Deliver Products or Return Money in the Future Inconsistencies 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. Copyright 2014-2015 AICPA Unauthorized copying prohibited 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 prohibited Contingent Liabilities Discussion 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. Copyright 2014-2015 AICPA Unauthorized copying prohibited
