Assignment 5

Code of Professional Ethics and Conduct

Dawna Berry, Rochelle Morton, Jose Pinto

ACC 499 – Undergraduate Accounting Capstone

Professor Dr. M. Austin Zekeri

December 12, 2012

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Leases on technology assets seem inflated

Current lease accounting standards have come under criticism for not meeting the needs of users

of financial statements. In response, the Financial Accounting Standards Board (FASB) and the

International Accounting Standards Boards (IASB) issued a joint discussion paper on March 19,

2009 titled Leases: Preliminary Views.

Existing lease accounting standards require lessees to classify their lease contracts as either

capital leases or operating leases. Capital leases are those leases that transfer to the lessee

substantially all the risks and rewards accompanying to ownership of the leased asset. All other

leases are operating leases. Under a capital lease, the lessee recognizes in its balance sheet the

leased asset and a requirement to pay rentals. The lessee depreciates the leased asset and

allocates lease payments between a finance charge and a reduction of the outstanding liability.

Under an operating lease, the lessee does not identify the asset or liability associated with the

leased asset, but rather recognizes lease payments as an expense. As for lessors, current

accounting guidance requires that lessors distinguish a lease as one of the following: sales type

lease, direct financing lease, leveraged lease or operating lease.

The current lease accounting model has been the subject of criticism for many years. Financial

statement users have argued that certain operating leases give rise to assets (the right to use the

leased asset) and liabilities (the obligation to pay rentals), thus users have attempted to capitalize

the asset when analyzing a company's financial statements and projecting forecasts. Criticism has

also been made that the current lease rules are too complex. The bright line tests are too difficult

to apply and similar transactions can be accounted for differently, thus reducing comparability

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for users. Furthermore, arguments have been made that the existing standards provide

opportunities for companies to structure leases so as to achieve a particular lease classification.

The US Securities and Exchange Commission (SEC) recognized that the current lease

accounting model is conceptually flawed in its June 2005 report, report and recommendations

pursuant to section 401(c) of the Sarbanes-Oxley Act of 2002 arrangements with off-balance

sheet implications, special purpose entities, and transparency of filings by issuers and

recommended that the FASB undertake a project to reconsider the leasing standards, preferably

as a joint project with the IASB.

Proposed Changes to Lease Accounting Standards

The projected changes will eliminate the difference between capital and operating leases and

basically require lessees to treat all leases as capital leases. The FASB and IASB believe that

upon entering a lease contract, a lessee has acquired an asset through its right to use the asset and

assumed a liability through its commitment to pay rentals. The new approach would require a

lessee to record an asset signifying its right to use the leased item for the lease term and a

liability for its obligation to make rent payments. As for initial dimension, it was tentatively

decided that the lessee would record its right-of-use asset at cost, which would come to the

present value of the lease payments discounted at the lessee's incremental borrowing rate. The

requirement to make rent payments would be recorded at the present value of the lease payments,

discounted at the lessee's incremental borrowing rate.

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Regarding changes to lessors accounting, the FASB and IASB deferred consideration of lesser

accounting in the discussion paper, but have been deliberating lesser accounting in subsequent

meetings. The Boards have decided to adopt the performance obligation approach to lesser

accounting. Under this approach, a lesser would identify an asset representing its right to receive

rental payments and identify a liability representing its performance obligation under the lease

(its obligation to permit the use of its asset). No revenue would be known at inception of the

lease but would be recognized over the lease term.

Another projected change is the treatment of options to renew a lease. Current standards only

allow contemplation of renewal options in the case where renewal is reasonably assured, for

instance, when there is a bargain renewal option. The projected changes would require the lessee

and lesser to assume that the lease term includes all renewal options that are more likely than not

to be exercised. This will greatly increase the use of renewal options in the calculation of leasing

assets and liabilities as well as amplify the amount of subjective judgment in deciding what

renewal options are more likely than not (greater than 50% chance) to be exercised.

What This All Means

The planned changes will affect almost all companies since almost all businesses lease assets

such as real estate, office equipment, vehicles, etc. Leasing companies that base their business on

the leasing of assets to other companies will especially be affected by the changes. Management

of all companies need to understand the implications of the rule changes now since it is likely

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that leases existing at the time the official change in accounting occurs will echo the new

standards and will not be grandfathered in.

Some of the significant implications facing companies if the proposed changes take effect

include the following:

All companies that lease assets will have to capitalize those assets. Balance sheets will be

significantly inflated and companies will appear more highly leveraged.

Lease expense will no longer remain constant through the term of the lease as they were

under operating leases. Lease costs will now be higher in the earlier years of the lease and lower

in the later years because the lease liability will be amortized using the effective interest

method.

A lessee's compliance with its debt covenants may be impacted.

A lessee's EBITDA would likely increase since lease expense will be replaced with

interest and depreciation expense, both of which are not included in EBITDA. The increase in

EBITDA could impact the calculation of certain financial ratios and on bonuses or commissions

that are tied to EBITDA.

Companies may have to provide additional training to their accounting department to

ensure that the company's lease contracts are being accounted for properly. New policies and

procedures may need to be established to ensure there are adequate controls surrounding the

accounting for lease transactions.

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What Companies Should Be Doing

Most companies have not fully evaluated the blow to their financial statements and operations

that will come as a result of the lease accounting changes. Companies need to fully understand

the implications of the changes and begin developing a corporate strategy to address the issue. A

few considerations to be taken include:

Buy or lease? If the asset will now be on the balance sheet anyway, companies need to

consider whether or not it would be more advantageous to purchase the asset as opposed to

leasing the asset. Companies that own that asset will be able to reap the tax benefits of

depreciation through the life of the asset, whereas depreciation on a capitalized lease will only

run through the lease term.

Lease terms. Shorter-term leases will likely result in higher rental rates, but will reflect

less debt on the balance sheet and overall will have less of an impact on the financial statements.

Longer-term leases will likely result in more favourable rental rates, but will increase exposure

on the balance sheet. Impact to corporate agreements. Companies need to review the

ramifications that the change in lease rules will have on corporate agreements such as

compliance with debt covenants and bonus and commission agreements tied to EBITDA.

Consultation with lenders, legal counsel and accounting advisors is advised to determine if

agreements should be amended for changes caused solely by the lease accounting rule change.

Understatement of e-Commerce state tax payments

Fraud activities that are carried out within a company are understating the income and not paying

taxes on the right amount of earned income. Fraud can occur in any company or corporation,

several aspects of e-business present unique risks. The distinctiveness of the Internet-driven

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economy creates pressures and opportunities specific to e-commerce fraud. Many of these fraud

risks are found within organizations. Once theses fraudulent activities are found within the

firewalls and securities checks, it can be much easier to infiltrate the systems, steal money, and

information, and cause damage to the system itself.

There are elements that motivate fraud and they are pressure, opportunity, and rationalization.

Once we reduce these elements then we can reduce or eliminate these opportunities. The lack of

contact can be a factor, because we do not know what they are thinking if they have no contact

with the other people within the organization. We ask ourselves what pressures exist or what

rationalizations crooks are using. There are five different elements traditional business use: (1)

the control environment, (2) risk assessment, (3) control activities or procedures, (4) information

and communication, and (5) monitoring. The attitude of management lies in the essence of

effectively controlled organizations. As long as top management believes that direct control is

important, then others within the organization will respond carefully observing established

controls.

Fraud can be prohibited through direct controlled activities such as adequate disconnection of

duties, proper authorization of activities and business, adequate records and documents, physical

control over records and assets, and self-sufficient checks on performances, but often in e-

commerce business it is not effective enough.

Leases on technology assets seem inflated:

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Under both US GAAP, revenue is not recognized until it is both realized (and realizable) and

earned. FASB requires lessees and lessors to disclosure certain information about leases in their

financial statements or in the notes. These requirements vary based upon the type of lease and

whether the issuer is the lessor or lessee (Kieso, Weygandt, & Warfield, 2007). These disclosure

requirements provide investors with the following information: General description of the nature

of leasing arrangement, the nature, timing, and amount of cash inflows and outflows associated

with leases, including payments to be paid or received for each of the five succeeding years. The

amount of lease revenue and expenses reported in the income statement each period. Description

and amounts of leased assets by major balance sheet classifications and related liabilities.

Amounts receivable and unearned revenues under lease agreements (Kieso, Weygandt, &

Warfield, 2007). The portion of the monthly payments related to future maintenance, service

and supplies should be recognized as revenue later, when the services are actually provided.

Revenue from the lease should be recognized immediately upon delivery of the equipment and

interest cost should be recognized over the lease period. The consequences to the fraudulent

activities include that the revenue will be overstated on the financial statement and the company

could face charges from the Securities and Exchange Commission (SEC) for inappropriately

allocating lease receipts, which affects the timing of income that it reports. If it was to be done

according to SEC guidelines, it would report income in different time periods (Kieso, Weygandt,

& Warfield, 2007). The people that are involved consist of management, board of directors, the

banks, shareholders as well as the lessees. Recommended internal controls would include

frequently conducting internal audits as well as ensuring there is a separation of duties.

Understatement of e-Commerce state tax payments:

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E-Commerce fraud is currently a significant problem, and it’s growing every day. In recent

years, the technology revolution has provided perpetrators with new ways to commit and conceal

fraud and to convert their ill-gotten gains (Strayer University, 2011). US GAAP require entities

to account for both current tax effects and expected future tax consequences of events that have

been recognized (that is, deferred taxes) using an asset and liability approach (Ernest &Young,

2010). Fraudulent activities within the organization would mean that the company is

understating the income; therefore, not paying taxes on the true amount of earned income.

Although fraud can occur in any environment, several aspects of e-business environments

present unique risks. These characteristics of the Internet-driven economy create pressures and

opportunities specific to e-commerce fraud. Just like other frauds, these new frauds are

perpetrated when pressures, opportunities, and rationalizations come together. Many of the most

serious e-commerce fraud risks are found within organizations. Once perpetrators are within

firewalls and security checks, it can be much easier to infiltrate systems, steal money and

information, and cause damage (Strayer University, 2011). Preventing fraud in every business

setting involves reducing or eliminating the elements that motivate fraud: pressure, opportunity,

and rationalization. The lack of personal contact makes it hard to know what pressures exist or

what rationalizations perpetrators are using. True security is found when algorithms and

processes are made public and stand the test of time. One of the best ways to prevent fraud in e-

business settings is to focus on reducing opportunities, usually through the implementation of

appropriate internal controls. In traditional businesses, internal controls involve five different

elements: (1) the control environment, (2) risk assessment, (3) control activities or procedures,

(4) information and communication, and (5) monitoring. The essence of effectively controlled

organizations lies in the attitude of their management. If top management believes that control is

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important, others in an organization will respond conscientiously observing established controls

(Strayer University, 2011). Fraud can also be prevented through control activities such as

adequate separation of duties, proper authorization of transactions and activities, adequate

documents and records, physical control over assets and records, and independent checks on

performance, but often in e- businesses they are not effective (Strayer University, 2011).

Fictitious employees receiving post-employment benefits

Under GAAP, the periodic post-retirement benefit cost under defined contribution plans is based

on the contribution due from the employer in each period. The defined benefit obligation is the

present value of benefits that have accrued to employees through services rendered to that date,

based on actuarial methods of calculation. The rule was not sufficient because they were able

create fictitious employees to pay post-employment benefits. The consequences for this

fraudulent activity lead the company to lose a lot of money. Payment records should be

compared to human resources files periodically to verify that a person is still employed within

the company. Red Flags for fictitious employees would focus on these items: high withholding

exemptions or no withholding for income taxes, no voluntary deductions for health insurance,

retirement, or other normal deductions for the employee population. No vacation, sick, or

personal time charges, no salary adjustments, merit adjustments, or promotions, duplicate bank

account numbers matching to other logical databases, e.g., security access, computer security

access file or company telephone records. Fictitious employees tend to occur in departments

where they would not be evident, and the local manager has a high degree of control over the

hiring process. Audit Strategies for fictitious employees could include the following for each

person, meet the individual and inspect a government-issued identification and search for

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evidence of work performance. This may be as simple as inspecting employee’s work area

(Audit Strategy for Payroll Fraud, 2010). Persons involved in this situation can include payroll

manager, human resources department as well as the employee that is receiving the payments.

Because these payments are tax-deductible, these payments affect the company as a whole, the

contributions that have been made to these fictitious employees, were part of payments that

received tax benefits. Taxes will have to be paid on these payments.

Hiding cash in order to help in future quarters where earnings do not meet analyst’s

expectations:

Over the last three years, SEC investigations have uncovered earnings management practices that

have pushed the boundaries of GAAP, even to the point of out-right fraud. In some instances,

independent auditors were blamed for not catching or correcting accounting irregularities. In

others, it is clear that management intended to deceive outside auditors and audit committees.

Regardless of fault, when earnings management and fraudulent accounting schemes are

uncovered, the monetary losses can be staggering.

Enron’s stock fell from its high of $90.75 to $0.68 after the SEC began investigating Enron’s

accounting practices (www.nysscpa.org). After the collapse in the market value of its stock,

Enron was forced to seek bankruptcy protection, resulting in the largest bankruptcy in U.S.

history. A recent Financial Executives International (FEI) report indicates that the stock market

lost more than $34 billion during the three-day period during which the three most egregious

cases of abusive earnings management in 2000 (Lucent Technologies, Cendant, and Micro

Strategy) surfaced (www.nysscpa.org). While SEC documents indicate that the accounting

irregularities at Lucent, Cendant, and Micro Strategy were primarily “abusive” earnings

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management schemes or outright fraud, all three companies began their abusive and fraudulent

practices by engaging in earnings management schemes designed primarily to “smooth” earnings

to meet internally or externally imposed earnings forecasts and analysts’ expectations

(www.nysscpa.org). Earnings management practices can be designed either to assist managers in

fulfilling their obligations to stakeholders or to deceive investors. The SEC’s concept of

“abusive” earnings management suggests analytical approaches to uncovering such practices. In

addition, the accounting profession has taken steps to educate accountants about earnings

management practices and their effects and consequences. In general, analysts expectations and

company predictions tend to address two high-profile components of financial performance:

revenue and earnings from operations (www.nysscpa.org). The pressure to meet revenue

expectations is particularly intense and may be the primary catalyst in leading managers to

engage in earnings management practices that result in questionable or fraudulent revenue

recognition practices. One FEI study indicates that improper revenue recognition practices were

the cause of one-third of all voluntary or forced restatements of income filed with the SEC from

1977 to 2000 (www.nysscpa.org). Other top managers engaging in improper revenue

recognition practices may do so with the full cooperation of employees that may not understand

the impropriety of their actions. For example, an SEC investigation revealed that premature

revenue recognition practices were such an integral part of operations at one manufacturing

company that MIS personnel wrote a program to automatically freeze the computer date while

the quarter was held open (www.nysscpa.org). In another case, one manufacturer obtained audit

evidence for sales recognized prematurely by shipping legitimate orders to its own warehouses

and holding the products until customer-requested shipping dates in later periods

(www.nysscpa.org). In many cases, managers attempt to meet quarterly expectations by

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prematurely or improperly recognizing revenue for sales that do not meet criteria for recognition

under GAAP but would be legitimately recognized in future periods. Such premature revenue

recognition can go unnoticed if company managers do not consistently engage in such practices

or if the company continues to grow. Nonetheless, because revenue expectations for future

quarters are based primarily on revenues recognized in current quarters, analysts’ expectations

for the quarters following those in which revenue was prematurely or improperly recognized are

typically inflated (www.nysscpa.org). The magnitude of the inflated expectations is usually

compounded by the addition of “growth” factors, rendering the new quarterly expectations

difficult or impossible to achieve without further manipulations or fraudulent accounting

activities (www.nysscpa.org). The seemingly common consequence of improper revenue

recognition practices is that, once started, companies must continue earnings management

activities in order to meet ever-increasing internal sales targets and analysts’ expectations.

Frequently, the earnings manipulations or fraudulent activities involving revenue generate the

need for more complex and sophisticated accounting techniques to ensure analysts’ earnings

expectations are met (www.nysscpa.org). Eventually, companies must engage in more blatant

fraudulent activities by creating artificial reserves, understating reserve liabilities, using creative

acquisition accounting practices, or otherwise manipulating GAAP to perpetuate myths

involving company “growth” (www.nysscpa.org).

Concealing inventory shrinkage because it seems low for the country:

Concealing inventory shrinkage because it seems low for the industry implies that a company is

not reporting the correct numbers. Because most companies in their industry have higher

shrinkage numbers, they wanted to stay within the norm to avoid sending up red flags. But what

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they have done was subjected themselves to inventory fraud rather than reporting the truth.

Reporting the actual shrinkage would have proven that they had good inventory control methods

in place which could have been an example for the other companies in their industry. According

to experts, inventory is the most common area for financial statement fraud. It is the easiest type

of fraud to perpetuate and the hardest for even outside auditors to detect (Wiersema,

2001).Overstating inventory increases the company’s bottom line dollar for dollar. The reason is

that whatever winds up in ending inventory is not a cost against income this period. The cost is

deferred until the indefinite future, which causes a corresponding loss the next year, unless the

overstatement continues. Most managers who have engaged in inventory fraud experience it as

an addiction. The amount of fraud continues to increase for the additional benefits it gives

(Wiersema, 2001). Cost of Goods Sold (COGS) would be overstated as well, resulting in your

net income being overstated, which could possible increase your tax liability. Inventory Control

is the procurement, care and disposition of materials. There are three kinds of inventory that are

of concern to managers: raw materials, in-process or semi-finished goods, and finished goods. If

a manager effectively controls these three types of inventory, capital can be released that may be

tied up in unnecessary inventory, production control can be improved and can protect against

obsolescence, deterioration and or theft (Inventory Control, 2002). Trying to protect your

company from the inside is different. Ultimately, protecting your company depends on having

adequate accounting controls that go beyond physical safeguards. It is important to ensure you

have an adequate internal control system in place according to your needs. For quantities, there is

no substitute for accurate perpetual records that account for every transaction. It essential that the

records leave a permanent audit trail, so they cannot be altered after the fact, this leaves out

many of the cheaper software packages (Wiersema, 2001).Company executives realize that

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effective inventory management may be the difference between operating success and failure. To

enhance inventory management, Wal-Mart has implemented radio frequency identification

(RFID ), a scanning technology similar to bar codes that allows inventory to be tracked from the

supplier to the final consumer, and promises dramatic reductions in inventory costs (Strayer

University, 2011). If there is any incentive pay that is tied to production levels, this could lead to

inventory fraud. Workers are eager for the extra money and collude to over-report production,

which can only be detected by taking an independent physical count (Wiersema, 2001). This

process can be very costly and time consuming for a small business. Similarly, an inflated

inventory value can lead to higher earnings, which, in turn, generate higher staff bonuses or, the

overstated value can hide substantial shortages arising from theft against the company. These are

going to be areas of concerns that will need to be monitored closely (Wiersema, 2001).

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References:

Nikolai/Bazley, ET AL; Mason, OH: Strayer University; (1st custom edition 2011) ACC499

Accounting Undergraduate Capstone; (Cengage Learning).

Strayer University. (2011). ACC 499: Accounting undergraduate capstone. Mason, OH

Cengage Learning.Wiersema, W. H . (2001, April).

Kieso, D. E., Weygandt, J.J., & Warfield, T. D. (2007). Intermediate Accounting, 12th Ed.Wiley.

Alvin A. Arens, Randal J. Elder, Mark S. Beasley; 2010 Auditing and Assurance Services.

AICPA, AU Section 316; Consideration of Fraud in a Financial Statement Audit; revision 2007.

S. Waters; About.com; Retailing; “Top 4 Sources of Shrinkage”; retrieved December 16, 2012 at

http://retail.about.com/od/lossprevention/tp/shrink_sources.htm

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