When a company is struggling, it is tempting to manipulate the financial statements to make things look better. Even when things are going well, management may want or need the company to look even better than it already does. Banks, investors, and other interested parties are looking at the financial statements and making important decisions about the company.
Enhancing the balance sheet is a common financial statement fraud scheme, and asset overstatement is one part of it. Increased assets make financial ratios look better and generally make a company look stronger and more attractive. What are some of the most common methods used to inflate assets?
Improper valuation of investments can fraudulently inflate a company’s assets. The risk generally lies in classifying the investments correctly. They can be classified as trading, held to maturity, or available for sale. Each of these classifications requires a different value to be shown on the balance sheet. Management may be unwilling to record a write-down for unrealized losses, and may therefore try to misclassify an investment to avoid that. The classification may also change if management is interested in recording a gain.
It is popular to overstate accounts receivable, especially since bank lending decisions are often heavily influenced by the strength of a company’s assets. Inventory is another area of the balance sheet that is ripe for fraud, because it is so easy to get away with. Inflating inventory also has a positive impact on profits, making it even more desirable. If inventory is overstated, cost of goods sold is understated, and therefore profit is overstated. Schemes to inflate inventory values include overstatement of quantities on hand, overstatement of the value of inventory items, and improper capitalization of costs to inventory.
Overstatement of the quantity of inventory on hand involves reporting more items on hand than are actually there. The false journal entries may be supported by phony shipping and receiving documents and invoices, and possibly by empty boxes stored in a warehouse. It is common knowledge that outside auditors perform a limited number of tests on inventory, so inflating the value of inventory on hand is not all that difficult. Auditors typically only inspect the inventory at a small number of locations, even if a company has many warehouses. Their inspections are often incomplete. Even if their inspections meet the professional standards by which auditors must adhere, there is still a relatively small amount of verification of inventory done.
Sam Antar is the former CFO of Crazy Eddie who pleaded guilty to federal charges of fraud in the securities case that blossomed out of a massive fraud and the eventual bankruptcy of the electronics retailer. His tales of fooling the auditors in charge of verifying inventory are legendary, and they include “helping” the auditors with test counts, making changes to audit work papers that were left relatively unsecured at the Crazy Eddie offices at night, and fabricating paperwork to support the inventory valuation.
It is easy to see how auditors could be fooled by phony documentation or empty boxes in a warehouse, which cannot all be examined. Signs that an inventory fraud might be in progress include:
- Inventory at locations at which access is restricted, denied, or otherwise impossible
- Increases in inventory at locations company management knows will not be subject to physical examination by auditors
- Insufficient or nonexistent documentation to prove the existence of inventory
- Unusual patterns of shipping and receiving, especially ones that result in large increases of inventory toward the end of the accounting period
- Excessive movement of inventory between company locations with insufficient recordkeeping
- Large differences in inventory test counts
- Unusually large quantities of high value items on the books
- Reversing entries booked to inventory accounts shortly after the close of an accounting period
Fraudulent inventory counts can happen many different ways, and it is not necessarily difficult for management to succeed with one of these schemes. Fraudulent inventory valuations are even harder for auditors and investigators to find and prove. It is difficult to prove that a company did not write-off obsolete inventory or did not create a proper reserve for inventory with a reduced value. Red flags of inventory valuation schemes include low or nonexistent inventory reserves, few write-offs of obsolete inventory, and the apparent ownership of similar items of inventory from year-to-year without any write-offs or allowances.
The more progressive an industry is, the bigger this issue may be. For example, the technology surrounding personal computers changes quickly. It stands to reason that a manufacturer of computers might regularly have write-offs or write-downs due to the quick changes in the industry. If there are not any such adjustments to inventory values, it would seem suspicious.
Improper capitalization of costs to inventory is a process by which costs such as sales, administrative, advertising, and other costs are not expensed but are booked to the inventory cost. This creates two problems: the inventory balance is overstated on the balance sheet, and expenses are understated on the profit and loss statement. It is important to examine what costs a company is charging to inventory, and make sure that they are only adding to the inventory balance the amounts directly related to producing that inventory.
Recording nonexistent fixed assets can inflate a balance sheet and is desirable because it increases an asset class that may be borrowed against. Fixed asset values are also propped up when a company records less depreciation in a period than it should.
When fraud related to fixed assets is suspected, the investigator should:
- Examine fixed asset records looking for a legitimate business purpose for the items.
- Physically inspect fixed assets to verify their existence.
- Look for assets that might need to be written down or written off.
- Verify the cost on the books with purchase documentation.
- Examine depreciation for evidence of using inappropriate lives or methods.
Assets with impaired values should be written down, and this applies not only to fixed assets, but also to other assets like goodwill, trademarks, patents, and other intangible assets. These are undeniably difficult manipulations to detect, because often the process of valuing such assets is complex and involves judgment on the part of management.
In general, investigators looking for evidence of asset overstatement should:
- Examine adjusting entries, especially toward the end of an accounting period, that increase assets.
- Look at periods following the accounting period in question to see if reversing entries are recorded, suggesting that the original accounting treatment was improper.
- Look for entries of large, round numbers that may suggest manipulation of financial statements, especially when such transactions occur toward the end of an accounting period.
- Look for trends in asset balances and unusual items that fall outside normal trends.
- Trace assets back to supporting documentation to verify their existence and cost.
- Examine skeptically any capitalization of items other than fixed assets, looking for a motive to reduce current period expenses. Do not accept explanations at face value, and instead demand authoritative guidance that proves such capitalization is acceptable.
- Be suspicious of altered or missing documentation, particularly when it relates to accounts or transactions that are already deemed questionable.
There are so many ways that assets can be manipulated. Management is often one step ahead of anyone (such as a fraud investigator) looking for this fraud. They know where things are hidden, and you don’t. That’s a natural advantage.