FRAUD IN FINANCIAL STATEMENTS

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CHAPTER 1

LITERATURE REVIEW

1.1: OVERVIEW OF ACCOUNTING SYSTEMS

Accounting systems go back thousands of years.  Ancient societies used relatively crude systems, and more sophisticated methods were developed during the reign of the Roman Empire.  Accounting helped bring about the Industrial Revolution, and today, accounting is the underlying foundation (the "language") of business and finance.  Accounting is essential for evaluating the efficiency of a business, and it does this by recording a history of a business's failures, successes, and projections for the future.  Accounting is commonly defined as:

"The art of recording, classifying, summarizing, and interpreting monetary transactions and events of a financial character."

1.1.1: Bookkeeping

Bookkeeping is a system of checks and balances for the recording of expenses and income.  Actually, anything that qualifies as a "transaction" (or exchange of goods and services) should be subject to bookkeeping, but usually anything recordable in terms of dollars and cents is what goes in the "books."  The basic rule of bookkeeping is for numbers to be recorded in the right place, and for this, you need a system of "accounts."  An "account" can be numerical or it can be a description of the category for that account.  For example, if you buy something for your business and get a receipt for it, the receipt may not be itemized, so you write something on the receipt like "Office Supplies - stapler and staples."  This way, your bookkeeper can at least identify the descriptive category for the right account. 

There are two methods of bookkeeping:

The single-entry method; and The double-entry method. 

The single-entry method arranges all financial transactions in chronological order, much like the Register pages of the checkbook that comes with a checking account.  Single-entry is fine for personal finance, especially when automatic deductions and deposits take place, but it doesn't readily classify transactions according to category or type. 1

1 Dixon, R. (1993). The McGraw-Hill 36-Hour Accounting Course. NY: McGraw-Hill.

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The double-entry method requires that every transaction affect two or more accounts.  For example, when you buy an office desk and pay cash for it, two accounts are affected, cash and office furniture.  The account called "Cash" gets a negative entry, called "credit," and the account called "Office Furniture" gets a positive entry, called "debit."  Every transaction must have at least one credit and one debit that perfectly "zero" each other out.  However, various types of transactions may be recorded differently because you didn't pay cash, but instead charged an item, which made it a liability, recorded in accounts payable.  This is just one example, and the following table shows how debits and credits affect different types of accounts, and these rules make up the primary ways the T-account format is used in ledgers.  Various credits or liabilities may incur a finance charge, just as various debits, or purchases, incur some depreciation, so this (along with some other business practices) will most probably require what are called "balancing entries" to keep everything coming out to zero.

Account Type Debit Credit

ASSETS Increases Decreases

LIABILITIES Decreases Increases

EQUITY Decreases Increases

INCOME Decreases Increases

EXPENSES Increases Decreases

There are two recognized methods of recording transactions:

The cash basis; and The accrual basis. 

Under the cash basis, receipts (revenue) are recorded when cash is received, and expenditures (expenses) are recorded when cash is paid out. Meaning that a company which ordered, say, computer paper in December and doesn't receive it until January records the transaction as having occurred in January.  Doctors, dentists, lawyers, and other professionals widely use the cash basis method. 

Under the accrual basis, revenue is recorded when earned, and expenses are recorded when incurred. That is a company would record its computer paper liability in December, and the account called Expenses (for the paper not yet received) might be debited along with balancing entries someplace else (like Assets or Income) that produce the corresponding credits.2

It should be noted that there is a perfectly acceptable third method of recording transactions, called the "hybrid" method.  Under the hybrid method, revenue is reported via a cash basis and expenses are reported via an accrual basis.  The hybrid method is most commonly found in small (contractor) businesses where the "timing" between obligations and payments of expenses is of short duration and most income is handled on a cash basis.  If there is no material distortion of income and expenses, the hybrid method 2 Dixon, R. (1993). The McGraw-Hill 36-Hour Accounting Course. NY: McGraw-Hill.

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is a perfectly acceptable business practice, but most business check with the IRS to see which method they should use.

1.1.2: Accounting

There are basically three things an accountant is expected to do:

(1) Keep original receipts and paperwork in a filing system; (2) Produce periodic summaries (daily, weekly, monthly) of income and expenditures

(called posting to a ledger, but sometimes called keeping the journals); and

(3) Produce periodic summaries (monthly, quarterly, yearly) called financial reports that show, for example, if the business is making a profit or how much the business is worth at a given point. 

While journals consist of multiple books of original entry, a ledger is nothing more than a "big book" containing sheets with single lines where revenues, expenditures or whatever is required to be kept track of are summarized. The ledger can be set up by date (general ledger) or by category (sub ledgers), but it must be posted to at least monthly. Ledger help trace any discrepancy (such as double billing or unrecorded payment).  Finding the origin of any transaction is important in order to verify its accuracy, and general ledger helps us do this. The most popular form of ledgering is The "T-account" format. At the end of an accounting period, the balance of the ledger account (the mathematical difference between the total debit entries and total credit entries) becomes the basis for balance sheet and income statement reports.  An example of the T-account format (where the "debit" and "credit" columns form the T) is as follows:

Financial reports periodically bring together key pieces of information from the ledger to show the "big picture," but accounting systems are also usually automated and make entries along the way.  In fact, an accounting "system" will interact with every stage of the business cycle.  Here's a table of the typical business cycle along with the related accounting entries at each point.3

3 Dixon, R. (1993). The McGraw-Hill 36-Hour Accounting Course. NY: McGraw-Hill

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1.1.3: Financial Statements

During the accounting cycle, accountants track, organize and record the financial dealings of a company. At the close of each period, accountants use the information they've gathered to prepare financial statements. Some common financial reports are discussed in detail. 1.1.3.1: Balance Sheets

Statement is also called a Statement of Financial Condition or Statement of Financial Position.  It is a snapshot of financial condition at the close of business on any given date, usually at a date, which represents the end of an accounting period.  Balance sheets simply consist of everything that comprises assets, liabilities, and equity (the owner's equity and any stockholder's equity).  Assets are anything of monetary value, liabilities are claims of creditors against assets, and equity is the difference between assets and liabilities, but can include partner's capital accounts, stock, and retained earnings.  Retained earnings are the accumulated profits from previous years, and is the category most often used to "zero out" the "books" so the business can start each fiscal year with a clean slate (The fundamental accounting equation is ASSETS = LIABILITIES + EQUITY which is sometimes expressed as ASSETS = LIABILITIES + CAPITAL).  Corresponding adjustments must be made for this equation to be solved; either an asset somewhere must be decreased, or a liability or equity must be increased.  The balance

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sheet, however, is never "zeroed out," but reflects a balance that solves the fundamental accounting equation.  Previous balances in any asset, liability, or equity category are carried over into the start of a new period.  In other words, the ending balances in a quarterly balance sheet for each asset, liability, and equity account become the beginning balances for those categories for the next quarter (see how ending and beginning balances match up in the graphic below).  Managers usually look at balances from year-to-year to see if receivables can be collected more aggressively, if payables can be slowed down a bit, or if some debt is uncollectible.3

 

From a forensic accounting standpoint, one critical issue involves exactly what date the balance sheet is reported.  A balance sheet prepared on Monday the 11th will be different from a balance sheet prepared on Tuesday, the 12th, for example.  It's customary to prepare a balance sheet at the close of business on December 31st, but some organizations have different fiscal years, and an incentive for financial statement fraud exists if the accounting department is ordered to produce balance sheets on different dates to find the most desirable one.  Deliberate timing of the balance sheet to misstate revenue and expense recognition constitutes fraudulent accounting.  In fact, there are seven (7) major "shenanigans" that Schilit (1993) describes as manipulating a financial profile:

Recording revenue before it is earned Creating fictitious revenue Boosting profits with nonrecurring transactions Shifting current expenses to a later period Failing to record or disclose liabilities Shifting current income to a later period Shifting future expenses to an earlier period

A balance sheet does not show the flow of funds in and out of accounts.  It only shows the ending balance on the statement date shown.  Further, not all balance sheets will contain the same categories and sub-categories of Assets, Liabilities, and Equity.  The basic rule is that assets are listed in order of liquidity (using book value or market value, whichever is more important to the decision making process).  Some balance sheets may be very small, and others may be quite long.  The following is an example of what a Balance Sheet looks like in report form:4

4 Eisen, P. (2003). Accounting the Easy Way. NY: Barron's

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1.1.3.2: Income Statements

This is also known as a profit and loss statement or a net income statement.   Managers use these statements to figure out which departments are over budget or under budget.  Income statements are also used to pinpoint unexpected expenditures or dramatic increases in some cost as a percentage of sales (cost variance).  Further, income statements are relied upon to determine tax liability.  Rather than being a snapshot of financial health, the income statement is a video report on the operations of an organization since the attempt is to match all selling that the company does (revenue) with the costs (expenses) of doing business.  The so-called "matching" process set down by Generally Accepted Accounting Principles (GAAP) calls for a showing of revenue when it accrues and matching the expenses required to generate that revenue.  There are simple ways to do an income statement (called the single-step format), but most accountants prefer to use what is called the multi-step format which brings out important subcategories such as gross profit, operating earnings, and earnings before taxes.  An income statement is read downward in a stair step manner usually involving three main steps: a deduction of the cost of goods sold; a deduction of regular operating expenses; and a deduction of other expenses like taxes.  The following is an example of an Income Statement with some sample figures for purposes of better understanding:5

1.1.3.3: Cash Flow Statements

A cash flow statement describes all the changes affecting a company's cash account during an accounting period.  It is primarily used to determine the liquidity (ability to pay

5 Eisen, P. (2003). Accounting the Easy Way. NY: Barron's

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short-term obligations) and solvency (ability to pay debts when they become due) of a business as well as make improvements to the budget process.  They also usually report the effects of fraud, embezzlement, and unexpected events (as well as the impact of internal controls for these) on the organization.  The concept of cash flow is one of the most important pieces of information a financial manager can derive from financial statements, and a cash flow statement is often a requirement before a bank will lend you money.  A cash flow analysis looks at how cash is generated from utilizing assets and how cash is paid to those who finance the purchase of those assets.  You should easily be able to find cash flow statements on the Internet.

Cash is not the same as inventory, or accounts receivable, and neither is it property.  Cash is money in the bank or in the business that might be converted to cash at some point in time.  Profit does not necessarily mean cash.  There are essentially three kinds of cash that an organization needs to "flow" in order to keep the doors open.  The first kind is operating cash, or working capital, and is the cash generated from sales of a product or services.  The second kind is investment cash, or non-operating capital, and includes any returns on investments in buildings, equipment, or other fixed assets.  The third kind is finance cash, which is the external cash given to you by lenders, investors, or stockholders.  Even though you may be successfully pursuing a profit (on paper), you could have cash flow problems because of an inventory backlog, over-extended credit to customers, reduction of credit by suppliers, lump-sum payment of debt, purchase of a major piece of equipment, or any other unforeseen circumstance.  Cash flow statements will highlight these things in a way that income statements will not.  The beginning steps to cash flow analysis are to determine operating cash flow, then investment cash flow, and then finance cash flow.  You start with Net Income After Tax and then add (not subtract) depreciation, as the following example illustrates:

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In practice, there various types of cash flow statements, and each of them has their usefulness.  The following is a list of the most commonly seen cash flow statements in corporate finance, and note there are two ways to calculate CFFA. 

Cash Flow From Assets (CFFA) = cash flow to creditors + cash flow to stockholders

Cash Flow From Assets (CFFA) = operating cash flow - capital spending - change in net working capital

Net Capital Spending (NCS) = ending fixed assets - beginning fixed assets + depreciation

Operating Cash Flow (OCF) = earnings before interest and taxes (EBIT) + depreciation - taxes

Cash Flow to Creditors = interest paid - new borrowing Cash Flow To Stockholders = Dividends Paid - New Equity Raised

1.1.3.4: Net worth Statements

Statement can be produced on an individual or an entity like the stock of a traded company.  If the net worth analysis is done on securities, like stock, the process is generally referred to as valuation, and is usually engaged in for purposes of corporate

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dissolution, merger, diversification, buy-sell agreements, or stock option plans.  Another common scenario involves assessing the net worth of an individual who owns all or part of a family business.  Individual assessments of net worth are needed whenever application is made for a Small Business Loan or other capitalization projects such as Minority Set-Asides.  Net worth analysis is also frequently found in divorce cases as well as (non-resident) disputes with a state or local tax authority (43 states and 12 cities have an individual income tax).6

  In assessing the NET WORTH of something, three methods of valuation are allowed by the IRS: cost (net asset value) analysis, income analysis and market analysis; but regardless of the method chosen, fair market value must be calculated if securities and taxes are involved.  Fair market value can be defined as the price at which property will change hands between a willing buyer and a willing seller, neither party being under compulsion to buy or sell, and both having reasonable knowledge of the relevant facts. In other words, fair market value represents a hypothetical, arms-length purchase price between parties who are not forced to participate in the transaction (as opposed to liquidation value).  The three valuation methods exist because they provide guidelines to determining fair market value, and are summarized below:

Cost (net asset value) analysis -- the value of the cost to reproduce or replace the property is calculated, less depreciation.  Asset-rich companies, like the timber and oil business, primarily use this method

Income analysis -- the value of the enterprise is determined in terms of its net present value projected into the future (usually five years), taking present income streams into account, less a discount rate which represents an appropriate estimate of risk, return on risk, or return on investment.  Financial institutions, like banks, generally prefer this method, but the courts and IRS agents look it upon as speculative.

Market analysis -- the value of property is determined by comparison to comparable property being sold in the marketplace.  Most readers will recognize this method as similar to the process of real estate appraisal.  It is the method overwhelmingly preferred by the courts and in tax case law.

In practice, any company or client with the means (e.g. large accounting department) will have their Net Worth calculated using each of the three methods allowed, since quite different results are produced by each method.  A high Net Worth is obviously desirable if one wants to qualify for certain credit purchases, but a low Net Worth is obviously desirable if one is being sued by creditors or having their assets seized in a criminal action.  There are distinct incentives for personal finance statement fraud.  One recent area of controversy is the valuation of what are called intangibles (or soft assets) such as patents and intellectual property, since sometimes these things are more valuable than hard assets.  Intentional non-disclosure of significant assets or business interests (as well as over-stated ness of indebtedness) can carry serious penalties or at least reflect poorly

6 Eisen, P. (2003). Accounting the Easy Way. NY: Barron's

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on the credibility and reputation of a person.  Personal financial statement fraud is something frequently overlooked by ordinary auditors and accountants.  The following is an example of what a Net Worth statement looks like:

 

1.2: FINANCIAL STATEMENT FRAUDS

The term ``fraud or dishonesty'' shall be deemed to encompass all those risks of loss that might arise through dishonest or fraudulent acts in handling of funds. As such, the bond must provide recovery for loss occasioned by such acts even though no personal gain accrues to the person committing the act and the act is not subject to punishment as a crime or misdemeanor, provided that within the law of the State in which the act is committed, a court would afford recovery under a bond providing protection against fraud or dishonesty. As usually applied under State laws, the term ``fraud or dishonesty'' encompasses such matters as larceny, theft, embezzlement, forgery, misappropriation, wrongful abstraction, wrongful conversion, willful misapplication or any other fraudulent or dishonest acts resulting in financial loss.

Fraud in financial statements usually takes the form of:

Overstated assets or revenue Understated liabilities and expenses

Overstating assets and revenues, say by the inclusion of fictitious assets or revenues, has the effect of suggesting greater financial strength and value to the organization than what it would otherwise have. The understatement of liabilities and expenses, say by the exclusion of costs or financial obligations, has a similar effect. Both result in increased earnings per share and increased equity value and net worth for the company.

To demonstrate these under/overstatements, the schemes have been divided into five

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classes. These are:

Fictitious revenues Timing differences Concealed liabilities and expenses Incorrect or misleading disclosures Incorrect or misleading asset valuations

Because the accounting system is based on double-entry book keeping, fraudulent entries should affect at least two accounts and, therefore, usually at least two areas in the financial statements. While the areas described below reflect general financial statement classifications, the reader should remember that that the other side of the fraudulent transaction exists somewhere, quite probably in another area of the accounts.7

Frauds using falsified financial information have direct connection with accounting standards. False information is either made-up information with no support from actual projects or relates to accounting standards and codes. Since the beginning of reform, China has made progress in improving accounting codes. Apparently, the designing and implementation of accounting codes can influence information truthfulness and give rise to the opportunities to produce false information.  

Accounting codes is a very technical issue. Many think the accounting codes as a “steel ruler” that allows no vagueness. However, the complexity of modern economy has put some areas of accounting subject to discretion and interpretation or even personal preference, which result in a ruler with flexibility. The issue of accounting codes did not attract much attention at the beginning of the reform. It was not until 1993 that reforms were witnessed in corporate accounting and regulations.  During the Asian financial crisis more concrete progress was made in improving the account rules, which should be recognized and valued. At the same time, that more is required to be done to bring our accounting rules up to the international standards. Some people still think in China there are too complicated an accounting system including a corporate accounting system and also distinctive accounting systems for different industries. For instance, some corporate accounting rules require enterprises to build value-loss reserves based on the recoverability of assets. Although accounting rules of different industries have similar requirements, they are all inadequate in terms of soundness comparing to corporate rules. Another issue is that, since there was no luxury of a strong accounting industry and external auditing facilities, when banks assessed the reliability of enterprises financial information, they did not require borrowers to provide external auditing results. In the future, banks may consider acquiring financial information audited by accounting firms and assessment on enterprise’s compliance and borrowing conditions made by law firms, and valuation of collaterals made by evaluation firms and bond classes given by rating firms.  However, it may take years for the above intermediate services to develop, and the expertise, reputation, brand-name, service quality also take tens of years to build. Are the audited statements trustworthy? It really depends and relates to the expertise and internal control of the firms. The development of intermediate financial service providers is

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affected by market liberalization as well. If all of these issues cannot be dealt with effectively, probability of enterprises’ providing false information and engaging in financial frauds will continue to be high. 

This situation is not about stock valuation, product quality or whether or not Microsoft has monopoly power in its markets. Nor is it part of a pro or anti-Microsoft movement.  This situation is instead a shining example of financial fraud and corruption enabled by bad government policy.  Even the best are manipulating the financial statements. This is the reason why it is important to stop manipulation of financial statements.

There are many reasons why individuals dishonestly manipulate their organizations’ financial statements. It may be to look company’s earning better. It may be also to cover up the misappropriation of company money and other management frauds. Some of the most common reasons why employees commit financial statements frauds are:

To encourage investment in the company To demonstrate increased earnings per share, thereby encouraging increased

dividend payments To cover negative cash flows To obtain new finances or to obtain it in more favorable terms than would

otherwise be provided To obtain higher purchase price in takeover To demonstrate compliance with financing covenants To meet company goals and objectives To receive performance related bonuses

It should be noted from this list that the motivation for financial fraud does not necessarily involve personal gain. Fraudulent financial statements often arise from the pressures either the organizations or its managers to ‘perform’ together with the belief that the fraud will not be detected. These pressures may act as “red flags” to the auditor and fraud examiner.8

Examples of such pressures are:

Sudden decreases in the company’s sales or market share Unrealistic budget pressures, particularly for short term results Financial pressures arising from bonus plans that depend on short term

economic performance.

1.3: FRAUD DETECTION USING FINANCIAL STATEMENTS

As a forensic accountant, you may not always have to reconstruct financial statements, but you should not take the ones given on face value.  It's more a mindset than a method. 

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The analysis of accounting records without such a mindset is called auditing. Looking for signs of deception is forensic accounting. An auditor, however, may help provide an investigative lead by discovering the absence of a business purpose for a transaction.  Or, an auditor might find an insufficient amount of documentation for a transaction. All these inconsistencies and out-of-ordinary transactions will be part of any standard audit report.  Forensic accountants will be looking further into these matters for "suspect" transactions, and may very well start with the journals or ledger to scrutinize the "Explanation" section of books. For example, a capital investment account might mention the name of someone external to the organization (e.g., "Loan from Malik Bashir"), and securitization of the books might establish that Malik Bashir is also heavily involved in cash disbursements for supplies or subcontracted services. The investigation then proceeds from securitization to comparison, looking for comparable vendors or subcontractors to see from such benchmarking if something is out of the ordinary with him.  The original source documents (cancelled checks) written to him might be analyzed to see which bank they were cashed at.  Those source documents might reveal that the bank transferred the deposit to another account or name that was on the State Department's Entities list. 

Fraud is usually discovered when several small events, taken together, point to a possible pattern of deception, and the following indicators are the classic "red flags", according to the IRS (1999), which relate to fraud through financial statements and accounting systems:

Maintaining two sets of books and records (and/or destruction of books and records)

Concealment of assets (altered entries in asset categories) Large or frequent cash transactions (or frequent use of cashier's checks) Payments to fictitious companies or persons false invoices or billings (excessive billing discounts or double billing) purchase of over-valued assets (excessive spoilage or defects) Large company loans to employees or other persons Using photocopies of source documents instead of originals Personal expenses paid with corporate funds Payee names left blank on checks and filled out later Second or third-party endorsements on corporate checks Unnecessary use of collection accounts Excessive use of exchange banks or clearing accounts

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The fundamental problem is that Microsoft is incurring massive losses and only by accounting illusions are they able to show a profit.  Specifically, Microsoft is granting excessive amounts of stock options that are allowing the company to understate its costs. What would happen to Microsoft's stock price if the public suddenly realized that they lost $10 billion in 1999 rather than earning the reported $7.8 billion?  If 80 percent of its stock value or roughly $400 billion is the result of a pyramid scheme, one might also ask what kind of effect this could have on the retirement system. It is also important to note that this is a relatively new situation that did not occur before 1995.  Microsoft has always been a highly valued stock and that might have been justified prior to 1995.

There are many underlying reasons for financial risks. First, the rapid global economic, technological and financial development has made it difficult to address new problems with existing theories and experiences. Among these are the uncertainties in financial stability. Second, in the transition from planned to market economy, some aspects of institution building is still in a vague, non-planned and non-market, or conflicting stage. Third, reality has proved that all kinds of problems in the economy are reflected in the workings of the financial system, which was particularly evident during the Asian financial crisis. Financial risks, if not addressed in a timely manner, could continue to grow and develop into economic and financial crisis. We must put more emphasis on understanding the financial risks and the uncertainties involved. Only by taking timely

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measures, could potential risks be removed. It is a worldwide experience that the longer the risks are left unattended, the harder it is to solve them. 9

9 Microsoft Financial Fraud Update.htm

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CHAPTER 2

METHODS OF COMMITING FRAUD THROUGH FINANCIAL STATEMENTS

Fraud includes the improper usage of resources and the misrepresentation of facts to receive gain. It is related to the misallocation of resources, or the distorted reporting of the existence and availability of resources. Fraud is a parasite that maims and eventually kills an organization. After a while, its contagious effect would find its way to another host organization.

It erodes the bottom lines and in the end or ultimately the very existence of any organization is negatively impacted. Whatever an organization is, be it non-profit or profit/business in nature, it cannot remain healthy to survive and be competitive if fraud continues to go undetected and unchecked because obviously any organizational resource that is misallocated or "misused" threatens the continued existence of an organization. Some of the methods through which financial frauds are committed are mentioned below:

2.1: Fictitious revenues

Fictitious or fabricated revenue involves the recording of the sale of goods or services that did not occur. Fictitious sales usually involve fake or fictitious customers, but they may involve legitimate customers. For example, a fictitious invoice may be prepared for a legitimate customer where the goods are not delivered or the services are not rendered. At the start of the next accounting period, the sale is then reversed. Another method of using legitimate customers' accounts is to alter invoices to include higher amounts or quantities than are actually sold.

Profit and revenue recognition is based upon the following criteria:

Definition Measurability Relevance Reliability

The term 'revenue' is not defined either in the Companies Acts or in any current accounting standard. The nearest reference to it is in SSAP2 concerning the prudence concept:

'... revenue and profits are not anticipated, but are recognized by inclusion in the profit and loss account only when realized in the form either of cash or of other assets the ultimate cash realization of which can be assessed with reasonable certainty; provision is made for all known liabilities (expenses and losses) whether the amount of these is known

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with certainty or is a best estimate in the light of the information available' (para 14).

More than one scheme may be used simultaneously in order to overstate sales. In the following example, the company used fictitious sales, premature or early recognition of revenue.

EXAMPLE

A person wanted to raise its financial standing and engineered fictitious transactions over a period of more than seven years. Its management used shell companies to make a number of fictitious sales. The sham transactions also involved the payment of money for assets to the shell companies that would be returned to the parent company as payment for fictitious sales. The scheme went undetected for so long that profits were inflated by more than £50 million. However, the fraud aroused the suspicions of the internal auditors. The scheme was uncovered and the perpetrators prosecuted in both the civil and criminal courts.10

A book keeping entry is made to record the purchase of fictitious fixed assets. This debits fixed assets for the amount of the purchase and credits cash for the payment in the usual way. A fictitious sales entry is then made for the same amount as the false purchase, debiting debtors and crediting sales.

To cover the fictitious sale, the cash payment to cover the purchase of assets is returned as payment for the sales. For instance:

Debit Credit

Fixed Assets 350,000Cash 350,000

Debtors 350,000Sales 350,000

Cash 350,000 Debtors 350,000

The effect of this completely fabricated sequence of events is to increase both the company's assets and revenue.

Pressures are placed on owners and top management to perform by bankers, shareholders, and even families and the community. The following examples are instances in which they succumbed to the temptation to manipulate the numbers.

EXAMPLE

In a similar case, a publicly traded textile company engaged in a series of false transactions designed to improve its financial profile. Receipts from the sale of shares

10 [Joseph T. Wells, "Occupational Fraud and Abuse" (Obsidian, 1997)].

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were paid to the company purporting to be sales. The management even went so far as to record a bank loan as profit. By the time the scheme was uncovered, the company books had been overstated by £30,000, in this case a material amount3.

The pressures to commit fraud sometimes come from within the organization. Departmental budget requirements including profit and profit goals also encourage financial statement fraud.

EXAMPLE

The accountant of a small company misstated financial records to disguise its financial problems. He designed a series of book keeping entries to meet budget projections and to cover up losses on the pension fund. Also, because of poor financial performance, he consistently overstated profit. To hide this, he debited liability accounts and credited the shareholders' equity account. The accountant finally resigned, leaving a letter of confession but was later prosecuted in criminal court.3

2.2: Uncompleted sales

These involve sales that are made on certain conditions that have not been met, or not completed, by the end of the accounting period and ownership has not yet passed to the purchaser. They should not be recognized as revenue until completed. The most common examples of this are conditional and consignment sales.

EXAMPLE

ABC person sells products that require further engineering before they are acceptable to customers. However, it records these as revenue before this has been done. In some cases, it may take weeks or even months. In other cases, the sale is specifically contingent upon the customer's trial and acceptance of the goods.

The revenue account would require correcting to comply with the revenue recognition criterion. Debit Credit

31/12/00 Debtors 17,000 Sales - Project C 17,000

Being sales re Project C

Additionally, a provision needs to be made for the unearned sales on Project C. An entry needs to be made on the debit side of the Sales account to reduce the sales for the period by £17,000 and carried down as a credit balance to represent unearned sales. This balance should then cancel the £17,000 debtor on the balance sheet.

In January, the project is started and completed. The entries below show the correct

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recording of the £15,500 of costs associated with the project:

31/1/01 Cost of Sales - Project C 15,500 Stock 13,500 Wages 2,000

Being the costs of Project C in the form of stock and wages

The effect of these book keeping entries is to recognize revenue and expenses for the period to which they actually relate, i.e. January, thereby matching them. This example illustrates how easily the non-adherence to the matching principle may cause a material misstatement in yearly Profit and Loss Accounts.11

Premature revenue recognition and the problem of long term contracts

Generally, revenue should be recognized in the accounting records when a sale is complete; that is, when title is passed from the seller to the buyer. The transfer of ownership completes the sale and is usually not final until all obligations surrounding the sale are complete.

This raises the problem of long-term contracts, especially construction contracts. A contract which extends for more than one year will usually require to be accounted for as a long term contract under SSAP 9 (para. 22). Here, turnover should be ascertained in a way both appropriate to the stage of the contract and to the industry in which the business operates (para. 28). For instance, if the outcome of a long-term contract can be assessed with reasonable certainty before its conclusion, the reported profit should be the difference between the reported turnover and the related costs for the contract (para. 29).

No definition of turnover is given in SSAP9. It merely states that turnover is ascertained in a manner appropriate to the stage of completion of the contract, the business and the industry in which it operates. It is left to individual firms to decide according to their own circumstances. However, the amount of profit taken in an accounting period would normally relate to separate or measurable parts of the contract completed within that period.

Hence, although accounting for long-term contracts represents an exception to the usual definition of sales (their occurrence being determined by the passing of ownership), it is based on conservatism and sound judgment leading to true and fair financial reports. Misrepresentation occurs when these principles are not applied.

The following example illustrates how early recognition of revenue not only leads to financial statement misrepresentation but also encourages further fraud.

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EXAMPLE

The management of a retail chemist chain began recognizing profit before it was earned. The impression given was that the chain was much more profitable than it actually was. When this came to light and was investigated, several embezzlement schemes, fictitious expense schemes and cases of credit card fraud were also uncovered.3

EXAMPLE

Time Energy Systems, Inc. developed, promoted, and marketed energy conservation systems including hardware and software for managing power supply use in buildings. The company formed limited partnerships to raise capital for its operations. Interests in the limited partnerships were sold to provide the funds to purchase equipment from Time Energy. Time Energy needed to report good profits: (1) to encourage investment in the limited partnerships and (2) to obtain bank loans. As the limited partnerships were Time Energy's primary customers, there were few sales from which it could otherwise generate profitability. It decided to create fictitious profits by charging management fees for research and development work to the limited partnerships. These were charged before the services were performed. Time Energy also failed to make a provision in its accounts for the costs it would incur in providing the services.

There are many reasons for premature recognition. Profit may be just one reason for recording profit before it is actually received.

EXAMPLE

The chief executive of a charity attempted to maximize donations by manipulating its books. As future donations were dependent upon its success so far, he recorded promised donations before they were actually received. The scheme had been in existence for more than four years before it was discovered3

Recording expenses in the wrong period

The correct recording of expenses is often influenced by pressures to meet budget projections and goals. This may be facilitated by lack of proper accounting controls. The charging of costs to periods other than the one in which they actually relate may cause them not to be matched against the profit that they have produced.

EXAMPLE

Here supplies were purchased and charged against the current year's budget, but were actually to be used in the following accounting period A manager at a publicly traded company completed 11 months of operations remarkably under budget. He therefore decided to get a 'head start' on the next year's expenditures. He bought £30, 000 of unneeded supplies and charged them against the current year's budget.

The internal auditors noticed the increase in expenditure and investigated the situation.

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The manager explained that he was under pressure to meet budget goals for the following year. Because he was not attempting to defraud the company for personal gain, no legal action was taken.

The correct recording of the above transactions would be to debit stock for the original purchase and subsequently charge the items out of that account as they are used. The example journal entries below show the correct treatment by charging the supplies over time.

31/12/01 Stock 50,000 Creditors 50,000 Being the purchase of goods.

In period used

Cost of Goods Sold 2,000

Stock 2,000 Being the use of goods costing £2,000

Similar entries should be made as the supplies are used.

2.3: Concealed liabilities

As discussed earlier, understating liabilities and expenses is one of the ways in which financial statements may be dishonestly manipulated to make a company appear more profitable or more valuable than what it would otherwise appear. Understating liabilities has a positive effect on the balance sheet, in that the equity and net assets are increased by the amount of the understatement. Understating expenses, on the other hand, has the effect of inflating net profit. Overstated profit has the effect of overstating shareholders' equity.

Concealed liabilities and expenses can be difficult to detect because often there is no audit trail. There are three common methods for concealing them: liability and expense omissions, capitalized expenses, and failure to disclose warranty costs and liabilities.

2.4: Liability and Expenses Omissions

The easiest method of concealing liabilities and expenses is simply not to record them. They may or may not be recorded at a later time, but this does not change the fraudulent effect on the financial statements.

Because they are easy to conceal, omitted liabilities are probably one of the most difficult to discover. A thorough review of all balance sheet date transactions, such as increases

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and decreases in creditors, may help in the discovery of omitted liabilities in financial statements.

Often, perpetrators believe they can perpetuate the fraud into future periods. They often plan to compensate for the omitted liabilities with other profit such as increased profits from future price Increases.

EXAMPLE

The owner of a publicly traded retailer falsified financial statements by concealing liabilities and inflating stock. The objective was to increase profitability, thereby attracting new investors. He planned to conceal the fraud by increasing selling prices when the expenses were charged. However, a tip-off by an employee to the company's audit committee caused an investigation.3

2.5: Fraudulent Capitalization of expenses

The distinction between capital and revenue expenditure arises out of the matching concept. Capital expenditure is expenditure that produces benefits to the company over a future accounting period (probably more than one). Manufacturing equipment costs are an example. Revenue expenditure, on the other hand, is expenditure matched with current revenue whose benefits only extend to the current accounting period. An example of this is wages, which are costs for work done in the current accounting period, which is either billed during the period or carried forward with stock as work in progress.

Capitalizing revenue expenditure is a way of increasing profits and assets as it is charged against future profits rather than immediately. The effect is that profit for the current period is overstated and for subsequent periods, it is understated.

Often generally accepted accounting principles are not always clear about the capitalization of costs so abuses may occur. The fraud examiner should be diligent in ascertaining whether it is appropriate to capitalize expenditure and consult relevant accounting standards.

2.6: Fraudulent charging of capital expenditure against profits

Just as capitalizing expenses is wrong, so is charging to the Profit and Loss Account costs that should be capitalized. A company may want to minimize its net profit for to tax reasons. Charging against profits an item that should be depreciated over a period of time may help achieve lower net profits and, therefore, less tax to be paid. Internal budget constraints also put pressure on accounting staff into misallocating capital items as revenue costs.

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2.7: Fraudulent accounting for returns, allowances and warranties

An incorrect liability for these will occur if the company fails to properly account for potential product returns or repairs. It is inevitable that a certain proportion of products sold will, for one reason or another, be returned. It is the job of management to try to accurately estimate what this will be and make provision for it.

In warranty liability fraud, the liability is either omitted altogether or substantially understated. A similar case is accounting for the liability arising from defective products (product liability).

EXAMPLE

A manufacturing company produced government armaments. Some did not meet specifications and the company was liable for resolving this. Management decided to recognize the cost as items were returned and the work was performed which would be conducted over a considerable future period.

Failure to estimate and record the total warranty cost resulted in a material understatement of costs and overstatement of profits for the periods in which the contract revenues were received and the liability was not recorded.

2.8: Misleading disclosure

As was discussed earlier, accounting principles require that financial statements and related notes include all the information necessary to prevent the user from being misled. Management has an obligation to disclose all significant information in an appropriate way. If not disclosed in the financial statements, the necessary information should appear in the footnotes or elsewhere in the report.

The information that is disclosed should also not be misleading. Fraud through incorrect or misleading disclosure usually involves one of the following: liability omissions, significant event omission, related-party transactions, and accounting changes.

2.9: Liability omissions

Typical omissions include the failure to disclose loan covenants or contingent liabilities. Loan covenants are agreements, in addition to, or part of, a financing arrangement, which a borrower has promised to keep as long as the financing is in place. Contingent liabilities are obligations a firm may be required to pay, for example, a pending lawsuit. The company's potential liability, if material, must be disclosed and explained.

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2.10: Fraudulent treatment of significant events

These are events that, if not disclosed, may mislead the reader. Examples include the impact of new products or technology. Obsolescence of goods or manufacturing methods should also be reported if relevant

EXAMPLE

Milbury pIc, a publicly quoted company, collapsed in 1988.. It was controlled by a controversial entrepreneur, Jim Raper, through St Piran Ltd which had a majority share holding. When Milbury encountered severe financial losses it decided not to make a payment on a loan from St Piran. The consequence of this was that the ownership of Mil bury's main assets would transfer to St Piran. The small shareholders in St Piran did not know that this would be the effect of such a minor default on the loan. Milbury's accounts merely stated that the loan was 'secured'. (P.Bames, 'Raper report cites inadequate controls', Accountancy, January, 1989.

2.11: Related-party transactions These occur when an officer of the company has a financial interest in a transaction that has an economic effect on the company. They may take a variety of forms. Many of them include transactions in the normal course of business; for example, the purchase or sale of goods. Others include:

Transferring fixed assets. The transfer may be at a fair value on an arm's length basis or itmay be at book value or some other amount that differs from market value. . Outright gifts and capital contributions. Provision of accommodation or management services. These may be charged at a fair and reasonable amount for the services provided. Alternatively, they may be unrelated to market value, either excessively high or low.

In the case of companies, the provisions for their disclosure are contained in the Companies Act, 1985, sections 231-234 and the 5th, 6th and 7th schedules. In the case of quoted companies, the Stock Exchange Listing Requirements add certain matters. FRS 8 is intended to complement these.

The Companies Act does not use the term 'related party'. The provisions in Part II of Schedule 6 to the Act require disclosure of certain transactions with directors and persons connected with directors. A person connected with a director falls broadly into the following categories:

A director's spouse or children who are minors, A body corporate in which a director owns at least 20 per cent of the shares or

which is controlled by a director or any persons connected with him are beneficiaries,

A partner of the director (or a person connected with the director) in his capacity as partner.

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The principal areas the Act addresses are:

Loans and similar transactions with directors and officers, . Transactions in which a director has an interest,

Directors' share interests.

FRS 8 requires the following information to be disclosed in a reporting entity's financial statements concerning its related parties:

The name of the party that controls the reporting entity and, if different, the name of the ultimate controlling party (whether or not any transactions have taken place with those parties),

Details of material transactions between the reporting entity and any related parties,

Details of balances due to, or from, related parties at the balance sheet date. Under the

Standard, two or more parties are related parties when:

o One party has direct or indirect control of the other party; oro The parties are subject to common control from the same source; oro One party has influence over the other party; oro The parties are subject to influence from the same source.

FRS 8 sets out four criteria for establishing whether certain parties are related parties as

follows:

"Two or more parties are related parties when at any time during the financial period.

One party has direct or indirect control of the other party; or the parties are subject to

common control from the same source; or one party has influence over the financial and

operating policies of the other party to an extent that the other party might be inhibited

from pursuing at all times its own separate interests; or the parties, in entering a

transaction, are subject to influence from the same source to such an extent that one of

the parties to the transaction has subordinated its own separate interests. "

2.12: Changes in accounting policies

Changes of accounting policy arise when a choice is available between two or more alternative accounting treatments. A 'change' does not occur if there is change of accounting treatment because the transactions or events are different from what they were previously.

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A change of policy must be adequately explained and justified in the financial statements. The Companies Act 1985 requires that where there is a change of accounting policy (that is, a departure from the consistency principle) the financial statements must disclose "particulars of the departure, the reasons for it and its effect" [4th Schedule].

2.13: Misleading asset valuation

The cost principle requires that assets be recorded at their original cost. However, the prudence principle overrules this by requiring a market valuation to be used if it is lower than historical cost. The best example is stock, which is required to be reported at the lower of cost or net market value (Le. after selling costs). With the exception of property (which may be stated in the balance sheet at a valuation if there has been a permanent valuation change), it is rare for asset values to be increased. This may only be done for permanent changes and not merely for current market values.

Sometimes, it is necessary to use an estimate with the hope that it is near the true value. For example, estimates are used in determining warranty costs, salvage value, and the useful life of a depreciated asset. Whenever estimates are used, there is an additional opportunity for fraud.

Intentionally misleading valuations are sometimes referred to as "window dressing." Often, these are done to improve (i.e. inflate) the current ratio (current assets/current liabilities) which is important to financial institutions that base their lending decisions on certain liquidity ratios.12

Many misleading asset valuation schemes involve the fraudulent overstatement of stock or debtors. Other misleading asset valuations include the misclassification of fixed and other assets, the treatment of start-up costs and the incorrect capitalization of costs.

2.14: Misleading stock valuation

Stock must be valued at the lower of purchase price or production cost and net realizable value. Consequently, obsolete stock should be written down or written off altogether if it has no value. Failure to write down stock results in the overstatement of asset values and the mismatching of the cost of the goods sold with revenue. Stock can also be incorrectly reported by the manipulation of stock count, failure to adjust the stock account for the cost of goods sold, and by other methods. The following example shows a stock valuation scheme may be perpetrated by tampering of the stock count.

EXAMPLE12 UK’s fraud manual

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During the audit of a publicly traded pharmaceutical manufacturer, a misstatement affecting the value of its stock was discovered. It was measured in metric volumes and, as the count was taken, an employee moved the decimal unit to the right. The discovery forced the company to restate its financial statements by writing down stock by more than £1 million.

One of the most popular methods of overstating stock is by adding fictitious items.

EXAMPLE

A small private company was owned by its chairman (who was also CEO) and three other investors. The latter took no active part in the management of the business. Over a period of years, he consistently made adjustments to falsely increase stock, thereby reducing the cost of goods sold and increasing reported profit. When the auditors discovered the fraud, he argued that he did not benefit directly from it. Instead, his primary purpose was to give the impression of success to the other owners, his family and the community.

Most perpetrators of stock fraud have more pecuniary motives and by increasing profit they may increase their own income.

EXAMPLE

During a systems control review at a large tinning and product wholesaler in the USA, a Certified Fraud Examiner (CFE) observed a forklift truck driver constructing a large heap of finished stock in the corner of a warehouse. The area was cordoned off and a sign indicated that the stock was earmarked for a national food processor. The wholesaler was apparently holding the stock until it was requested by the customer. When the CFE investigated, he discovered that the stock was later resold to a national fast-food supplier.

A review of the debtor schedule indicated sales of approximately £.8 million to the food processing company in recent months. Analysis of the account showed that these had been paid for. An analysis of closing stock failed to reveal any impropriety and the appropriate transfers to cost of sales had been made.

Copies of all sales documents sent to the food processing company were then requested. Goods had been sold FOB and title had passed but bills of lading indicated that only £120, 000 of stock had been delivered. There should have been £.6 million of finished goods for the food processor. A comparison of bin numbers on the bills of lading with the sales documents revealed that the same goods had been sold twice.

The corporate controller was notified and the plant manager questioned. He explained that he was just doing as he was told. The heads of marketing and operations both knew of the situation but they felt there was "no impropriety." The financial director and CEO felt differently and fired the two heads. The company eventually was forced into

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liquidation.

Fictitious stock schemes usually involve the creation of false documents such as goods received notes. In some instances, an accomplice claims to be holding stock for the company in question. It is also common for individuals to insert fraudulent stock sheets or change the quantities on them during the stock count.

2.15: Manipulating debtors

Debtors are subject to manipulation in the same way and in some cases the schemes are conducted together. The most common schemes are:

Fictitious debtors and Failing to write off accounts as bad debts (or failure to make proper

provisions). Fictitious fixed assets Capitalizing non-asset costs Misclassifying assets

EXAMPLE

The manager of a publicly traded company kept two versions of sales ledger. One set accurately showed the age of the accounts. The other set was manipulated to show a more favorable picture as his remuneration was based thereon. Late accounts were re-dated and write offs were made to other accounts. As a result of the discovery of this, the manager was demoted.3

2.15.1: Fictitious debtors

These are common amongst companies with financial problems as well as with those whose managers receive a commission based on sales. The typical entry under fictitious debtors is to debit (increase) debtors and credit (increase) sales. Of course, these schemes are more common at the end of the accounting period.

2.15.2: Failure to write down or write off of bad debts

Companies are required to write off bad debts or provide for them in full. Companies struggling for profits will often choose not to do this because of the negative impact on profit.

2.15.3: Fictitious fixed assets

Fictitious fixed assets can be created by a variety of methods and schemes. Some of the most common schemes are recording fictitious assets, misrepresenting asset valuations and improperly capitalizing stock and start-up costs.

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One of the easiest methods of asset misrepresentation is in the recording of fictitious assets. This affects the company's balance sheet totals and the shareholders' equity account benefits.

Because company assets may be found in many different locations, this fraud may be easily overlooked. One of the most common fictitious asset schemes is simply to create fictitious documents. In other instances, the equipment is held but leased and not owned, and this is not disclosed during the audit.

As with other assets, fixed assets should be recorded according to the historical cost principle. Estimated values of assets should not usually be used. Misrepresented asset values frequently goes hand in hand with other schemes.

Occasionally, it is advantageous to understate assets. For instance, in certain government-related or regulated companies additional funding is often based on asset amounts. This understatement can be done either directly or through increased depreciation.

EXAMPLE

The management of a government-controlled company wanted to avoid cash contributions to a central capital asset acquisition account. In order to achieve this, they increased the provision for depreciation of fixed assets by £2 million over a six-month period.

2.15.4: Capitalizing non-asset costs

Interest and finance charges incurred in the purchase of fixed assets should be excluded from capital costs. For example, a company finances a capital equipment purchase by paying for it by monthly payments. Only the original cost of the asset should be capitalized. The subsequent interest payments should be charged to the Profit and Loss Account and not added to the cost of the asset. The fraud examiner should check the accounting treatment of such transactions.

EXAMPLE

An investor in a private company applied to the Court for the rescission of purchase of shares in the company, alleging that they had been made on the basis of misleading financial information. A fraud examination revealed that assets were overvalued due to capitalization of interest expenses and other finance charges. It was also discovered that one of the owners had understated revenue by £100,000 which he had embezzled. The parties subsequently settled out of court.

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2.15.5: Misclassifying assets

In order to meet budget requirements, and other reasons, assets are sometimes misclassified in the nominal ledger. For instance the manipulation of asset accounts in order to distorting financial ratios and thereby meet borrowing requirements.

The following is an example of an employee who intentionally misclassified the purchase of stock to hide deficiencies in his purchasing ability.

EXAMPLE

A buyer employed by a retail jeweler’s feared censure for some bad purchases. Instead of taking the blame, he attempted to cover them up by charging delivery costs to individual stock accounts. This was not successful as the company's accountant detected the fraud after initiating changes to control procedures. When the accountant created a separation of duties between the buying function and the costing activities, the dishonest employee was discovered and dismissed.

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CHAPTER 3

THE DETECTION OF FRAUDULENT FINANCIAL STATEMENT SCHEMES

The following example illustrates how an analysis of accounting records and procedures may reveal a fraud:

EXAMPLE

Jackson Hardware Supply is a medium-sized plumbing and electrical wholesale distributor. An anonymous note had been received which suggested the cashier had been stealing cash from the company. He had been seen driving a new BMW and had taken expensive vacations. The chairman of the company wanted to investigate the allegation. Although the cashier was a long and trusted employee, he asked a fraud examiner to ascertain if the cashier has been stealing.

Although there were several ways for him to proceed, the fraud examiner decided to use his accounting knowledge and first compare the salary charge in the last Profit and Loss Account to 31 December with that of the previous year. He thought that if the cashier were dishonest, he may be concealing the theft in the salaries expense account. Past experience has taught the fraud examiner to look in the most obvious place first. The examiner noted that the balance of £220,000 in the salary expense account was significantly larger than the £180,000 for the previous year. He asked the chairman if there had been an increase in the number of employees and how large the pay rises were that year. He discovered that the workforce had not increased and all employees, including the chairman had received pay rises of 10 percent. He estimated what the salaries charge should be by increasing the previous year's salaries by 10 percent i. e. £198,000 (£180,000 x 1.10 = £198,000). He concluded that the excess had been misappropriated.

The next step was to follow the overstatement in the salaries account back from the Profit and Loss Account to the source documents-the payroll payments in this case. He found that there were twelve entries in the wages book for John Doe, an employee who left in January last year. He investigated further to find that these payments had not been made to John Doe but to someone else. Armed with this evidence, he interviewed the cashier who confessed to having stolen the £22,000 by making payments to a bank account over which he had control.

Obviously, this example is relatively simple; but most fraud schemes are, especially for an examiner who understands concealment techniques and accounting. Other detection techniques are available for investigating if a wages cashier is stealing. These include obtaining a computer list of all employees who do not make pension contributions and other payroll deductions (deductions for fictitious employees create concealment problems for perpetrators), checking National Insurance numbers of all employees.13

13 UK’s fraud manual

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3.1: FINANCIAL STATEMENT ANALYSIS

The comparison of financial statements provides important information for the fraud examiner. Absolute values in the accounts provide only a limited amount of information. The conversion of these numbers into ratios or percentages allows the examiner of the statements to examine relationships between accounting numbers and facilitate comparisons with data for other companies of a different size. Accounting ratios adjusts for differences in size as the denominator is usually a measure of size.

In fraud detection and investigation, the determination of the reasons for the relationships between accounting numbers and changes in these may be important. These are possible red flags that may point an examiner in the direction of a fraud. If large enough, a fraudulent misstatement will affect the financial statements in such a way that relationships between the numbers become questionable. Many schemes are detected because the financial statements, when examined closely, cannot be supported.

On the other hand, some management frauds may involve a complete cover-up in the financial statements and an analysis of the reported aggregated data will not provide any indication of fraud.

In cases where financial statement analysis may suggest areas for investigation by the fraud examiner, he should adopt one of the two approaches:

An inductive approach: This involves a complete analysis of the financial statements in an attempt to identify inconsistencies and anomalies in the reported data that may suggest fraud.

A deductive approach: This assumes that the fraud investigator has received a suggestion of fraud. As a result, he may be able to hypothesize as to how the financial statements should be affected if the fraud has been perpetrated. His task is simply to test the hypothesis.

Financial statement analysis includes what are known as:

Vertical analysis Horizontal analysis Ratio analysis

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Percentage analysis

There are traditionally two methods of percentage analysis of financial statements: vertical and horizontal analysis.

3.1.1: Vertical analysis

It is a technique for analyzing the relationship between the items on the financial statements (the Profit and Loss Account, Balance Sheet, or Statement of Cash Flows) by expressing components as percentages. This method is often referred to as "common sizing". In the vertical analysis of a Profit and Loss Account, turnover is assigned 100%; for a Balance Sheet, total assets are assigned 100%. All other items in each of the sections are expressed as a percentage of these numbers.

Vertical analysis emphasizes the relationship of statement items within an accounting period. These relationships can be used with historical averages to determine anomalies in the accounts.

3.1.2: Horizontal analysis

It is a technique for analyzing the percentage change in individual financial statement items from one year to the next. The first period in the analysis is considered the base, and the changes to subsequent periods are computed as a percentage of it. As with vertical analysis, this technique will not work for frauds involving small amounts of money.

It is important here to consider the amount of the change as well as its percentage. A 5% change in a very large item in the accounts may actually be greater than a 50% change in a much smaller item.14

14 UK’s fraud manual

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PROFIT AND LOSS ACCOUNT Vertical Analysis  Horizontal Analysis

  Year One   Year Two   Change% Change

Net sales 250,000 100% 450,000 100% 200,000 80%

Cost of goods sold 125,000 50% 300,000 67% 175,000 140%Gross profit 125,000 50% 150,000 33% 25,000 20%Operating Expenses        

Selling Expenses 50,000 20% 75,000 17% 25,000 50%

Administrative 60,000 24% 100,000 22% 40,000 67%Expenses        

Net profit / (Loss) -15,000-6%

-25,000-6%

-40,000-267%

     

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Vertical analysis – Discussion

In the above example, we see that creditors are equivalent to 54% of net assets in year one and 143% in year two. Although this change over the two years may be explained by an increase in sales, it may be a starting point for a fraud examination. Source documents should be examined to determine the increase.

Another major change is the decline over the two years of selling expenses as a percentage of sales from 20% to 17%. Again, there may be a bona fide explanation for this e.g. because of increased sales. But closer examination may point a fraud examiner to uncover fraud e.g. fictitious sales, as there was not a corresponding increase in selling expenses.

Horizontal analysis - Discussion

In the above example, it is obvious that the 80% increase in sales is accompanied by an even greater increase in the cost of goods sold, which rose 140%. Because of its size and generality in nature, this account is sometimes used to hide fraudulent expenses, withdrawals, or other improper transactions.

3.1.3: Financial ratios

Ratio analysis is a means of measuring the relationship between two items in the financial statements. It is the principal method of examination of financial statements and financial data. In order that they may be understood they are usually compared with a norm such as an industry average. Although they are traditionally used to assess performance, they can be very useful in detecting "red flags" for a fraud examination.

If the financial ratios show a significant change from one year to the next, it may be that there is a problem. Specific changes may often be explained by changes in the business situation. If it cannot be explained in this way and fraud is suspected, the appropriate source accounts should be examined in detail.

Many different kinds of financial ratios may be computed and different industries have their own important ones. The use of financial ratios in a fraud context is more specialized and the standard explanations for changes in the ratios may not be appropriate. Therefore, some of the main financial ratios are discussed below in a fraud context.

3.1.3.1: Current ratio

This is the ratio between current assets and current liabilities and is probably the most used ratio in financial statement analysis a quick measure of financial strength. It measures a company's ability to meet present obligations from its liquid assets. Obviously, if this ratio falls below unity, there is a prima facie suggestion that the firm

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may not be able to pay its debts as they fall due and it is insolvent. However, averages and norms vary widely across industries and this may not be the case. For instance, large supermarkets may have ratios of below unity simply because they have few debtors and stock compared to the credit they extract from their creditors.

This ratio can be a useful indicator in fraud detection and the manipulation of financial statements. All kinds of schemes may cause it to decrease (embezzlement and cheque tampering are just two because they involve the loss of cash). On the other hand, liability concealment will cause it to increase. It should also be remembered that:

Companies may manipulate their accounting numbers in order to improve it,

The frauds that may arise from management indicate that the company is about to fail.

In the example in Fig 3 above, the drastic change in the current ratio from year one (2.84) to year two (1.70) should cause the fraud examiner to look at its components and reasons the change in more detail.

3.1.3.2: Quick ratio

The quick ratio (or acid test ratio) is an alternative to the current ratio if some of the Current assets are not easily turned into cash, i.e. they are not liquid. For instance, building contractors and ship building firms may carry large amounts of stock and work in progress in current assets but it may be some time before these are turned into cash. The quick ratio compares assets that can be immediately liquidated with Current liabilities. It will not include stock and work in progress if they are not liquid.

Again, this ratio is useful in a fraud context. It is not that the quick ratio will identify other fraud schemes. In some cases, the Current ratio is not the best measure of a firm's liquidity position and the quick ratio may be better at identifying these (and the fraud schemes which may occur as a result) and liquidity problems which have been brought about by fraud.

In the example given in Fig 3 above, the quick ratio of2.05 for year one falls to 1.0 in year two. This is a considerable change and there should be an explanation for it.

The fraud examiner should also consider whether the liquidity ratios suggest that the firm is no longer a going concern. An adverse trend in these ratios may suggest forthcoming insolvency. There have been many cases in which failure was accompanied by fraud and looting of the remaining assets of the firm. He should be on his guard for this.

Debtor turnover or average collection periodThe relationship between sales and debtors is an important one because it measures how much is owing to the firm relative to how much has been sold. Debtor turnover is defined as net sales divided by debtors. It measures the number of times debtors is 'turned over'

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during the accounting period. This relationship may also be measured as debtors divided by sales and multiplied by 52 to express the average collection period (or average credit given) in terms of the number of weeks. (Alternatively, it may be multiplied by 12 to express it in terms of months; or 365 in terms of days).

The fraud examiner may use this ratio as a first step in detecting many occupational fraud schemes such as fictitious debtors, fictitious or unrecorded sales, and theft and skimming schemes. Normally, this ratio will stay fairly constant from year to year, but changes in billing policies or collection efforts may cause a shift and changes in the ratio should be interpreted in this context.

The example above shows a reduction in the collection ratio from 31 weeks at the end of year one to 23 weeks at the end of year two. This means that the company was collecting its debts quicker at the end of year two than it was at the end of year one for which there should be an explanation. It is only if general business explanations fail to stand up to critical examination that changes in the ratio may be interpreted in terms of the effect of fraud.

3.1.3.3: Stock turnover

This is the relationship between a company's cost of goods sold and average stock. It is expressed as the number of times stock is sold during the period and is a good determinant of purchasing, production, and sales efficiency. In general, a higher stock turnover ratio is considered favorable.

Significant changes in the stock turnover ratio are good indicators of possible fraudulent stock activity if there is no valid managerial or economic explanation. For instance, if the cost of goods sold has increased due to theft (closing stock has declined but not through sales), then this ratio will be abnormally high. In the example above, stock turnover increased in year two, signaling the possibility that embezzlement may be buried in the stock account if there is no other explanation.

Inconsistency or a significant change in the ratio is a red flag for the fraud examiner. He may use this ratio to examine stock accounts for possible theft schemes. He should look at the changes in the components of the ratio to decide what next should be investigated.

3.1.3.4: The net profit margin

This is defined as net profit divided by sales and expressed as a percentage. It shows not only the effects of gross margin changes, but also the effect of sales and administrative overheads.

If fraud is committed, net profit will be affected. For instance, fictitious expenses and fraudulent disbursements will cause an increase in overheads but it is not possible to generalize about the direction of impact of fraud on the ratio. However, over time, this ratio should probably be fairly consistent and if there is a large change there should be an explanation for it.

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3.1.3.5: The gross profit margin

This is gross profit divided by sales. Again this should be fairly consistent over time unless there is a fundamental change, e.g. pricing policy or manufacturing change. It should be affected by large skimming schemes involving unrecorded or partially recorded sales. See the chapters on asset misappropriation.

Financial statement analysis points the fraud examiner in the right direction to follow up an allegation of fraud. The next stage is to select samples in the relevant accounts and examine the source documents. If a large overstatement is suspected, it should be reflected in the financial statements. If, however, an understatement is suspected, the examiner may decide to begin with an examination of the source documents. This rule of thumb is particularly effective in the area of omitted of liabilities, such as litigation, contingent liabilities, leases, and product warranties.

It is likely that most of the well-known financial ratios may be useful for identifying fraud. The P/E ratio (share price/earnings per share) may even be. It is unjustifiably high, this may suggest a share rigging operation (as in the early days of Polly Peck) in order to push up the share price and make it appear an attractive investment.

3.1.3.6: Tax Return review

Tax returns are good sources of additional and comparative financial information if they are available. A comparison with the financial statements may provide information unknown to the fraud examiner and reveal unexplained discrepancies. Unfortunately, the lack of properly prepared and promptly filed tax returns may be a method of stalling or not providing the required information. Most fraudsters are reluctant to continue the deception and falsify a tax return. Extensions and filing of late tax returns may be a device to cover up financial statement and tax return differences.

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CHAPTER 4

MINIMIZING FRAUD RISK

Just because a fraud remains undiscovered, it does not mean that it isn't costing significant sums. No, a company should protect itself by putting in place those mechanisms that will minimize the risk of fraud in the first place or allow for early identification when a fraud does take place.

Many of these mechanisms are easy and cost-effective to implement. When it comes to fraud, is it stealing stationery, fiddling expenses or accepting a bribe from a supplier, there are three types of people: those who will never do it, those who will always do it and those who will do it if the circumstances allow. The goal then, is to avoid employing staff in the second category and for those who are employed and everyone in the third category, to reduce the opportunity and perception of success.

Pre-employment screening can help to weed out those who would commit fraud against you. It may be the reason why they left previous jobs. They might also be inclined to falsify details on their CV to obtain a job with you in the first place. One in four of all job applications contain a material misstatement15

By developing a fraud-aware culture, the overall appreciation of what fraud is, what it means, what it costs and how it manifests itself will be increased. Fewer people will be inclined to commit fraud because they will see it is wrong and fewer will be inclined to commit it because they will know that everyone around them will think it wrong and will be alert to it.

Introducing policies to cover areas such as conflicts of interest, gifts from third parties and disclosure of confidential information can not only discourage transgression but also provide you with a tool to take corrective action if necessary.

Operational controls covering issues such as supplier vetting, supplier tenders, segregation of duties and authority sign-off levels will reduce the opportunity for fraud and will also provide a means of identification.

A free-to-call whistle blowing line for employees to report suspected cases of fraud is also highly recommended.

All of these measures are low-cost and in combination can be extremely effective in combating fraud.

Notwithstanding the above, even those companies that do all of these things still suffer from fraud some or perhaps much of it goes undetected. How then, can a company

15 Source: Control Risks Group's Pre-Employment Screening Division, based on many thousands of screens over the past 4-5 years.

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determine whether they are or might about to be a victim of fraud? The answer is to be proactive and to go looking for it.

4.1: Organizational Fraud Deterrence Program

One of the most difficult issues facing the profession is that there are no auditing procedures that can provide absolute assurance in detecting all fraudulent financial reporting. As a result auditors have historically attempted to avoid, albeit unsuccessfully, the responsibility for fraud detection. In the current environment, the public holds expectations of auditors with respect to fraud that simply cannot be fulfilled. The auditing profession could be better served by adopting a more holistic approach to the deterrence of fraud.

The concept, called the Model Organizational Fraud Deterrence Program, employs a “best practices” approach to fraud prevention. Using this model, researchers would identify the factors present in organizations—both accounting and otherwise—that affects occupational fraud. They then would develop a model deterrence program based on those factors. Thereafter, instead of opining that the entity is essentially free of material fraud, the auditor would disclose the client’s degree of compliance to the model. 16

Factors Affecting Occupational Fraud: A Partial List

Financial condition of the organization. Pressure to show profits in the marketplace.

Internal accounting controls.

The state of the economy.

Integrity level of corporate leaders and employees.

Commitment to the organization’s value system.

Personal traits and characteristics of executives and employees.

Reward systems for ethical behavior.

Organizational culture and dynamics.

Peer pressure.

The perception of detection.

The swiftness, certainty and severity of punishment16 New Approaches to Fraud Deterrence.htm

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Although this is a shift in the way audits are conducted, it has three distinct advantages.

It would move the emphasis away from an unsinkable strategy of detecting fraud to an achievable one preventing it.

It would encourage entities to adopt prevention strategies.

It could solve the liability dilemma that plagues the auditing profession

But we don’t have to wait until we have all the answers in order to do something different. Two ideas are worth debating now:

The use of antifraud specialists on public audits, and Financial transparency for executives.

4.2: ANTIFRAUD SPECIALISTS

Accepting that fraud deterrence and accounting are related but distinctly different disciplines, the auditing profession could utilize the unique skills of antifraud specialists on public audits. Virtually all of the major accounting firms currently employ such specialists. However, they are now being used reactively instead of proactively.

Rather than using their talents exclusively to investigate allegations of fraud once they have been reported, antifraud specialists also should be involved during the audit itself to help identify key risk areas, which then can be furnished to the auditors for further consideration. Moreover, the mere presence of antifraud specialists during audits could have a significant impact on increasing the perception that illegal activity will be detected. This is similar to the strategy of reducing crime by putting more cops on the beat. Although punishment after the fact doesn’t work very well, criminologists have thoroughly documented that more vigilance to stop crime before it happens is the most effective deterrent. 17

EXAMPLE

A videotaped an interview with legendary fraudster Barry Minkow while he was serving an eight-year sentence in a federal prison in Colorado. (Minkow, a high school dropout with no accounting skills, fooled his independent auditors in a $100 million financial statement fraud scheme.) When asked how auditors could cope with his sort, Minkow said: “I’ll tell you what I would do: I’d send in trained fraud examiners before the auditors arrive. And I’d tell the client, ‘You know, I really want your business, but I want to make sure you’re not committing fraud, too. So I’m sending the examiners in first. They’re going to be looking at everything and asking the tough questions.’ Would that stop a lot of fraud, or what? It certainly would have stopped me.”

17 New Approaches to Fraud Deterrence.htm

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4.3: FINANCIAL TRANSPARENCY

From the study of a long list of financial statement frauds, beginning with the classic Equity Funding fraud in the 1970s and continuing through today’s multibillion dollar accounting scandals, a distinct pattern has emerged: Corporate managements—executives, insiders and board members—have lined their pockets at the expense of the shareholders. Their methods vary and are often cloaked behind complex transactions not readily apparent to the entity’s auditors.

But the profits from these illegal schemes nearly always find their way into the personal finances and spending habits of those involved EXAMPLE

Prosecutors accused Dennis Kozlowski and Mark Swartz of Tyco of stealing another $140 million from the company. Their salaries, respectively, were $106 million and $54 million.

Andrew Fastow, former CFO of Enron, funneled $30 million to himself from off-balance-sheet partnerships that he created. Another $17 million was paid to his wife, Lea.

Federal prosecutors say that Adelphia founder John J. Rigas and two of his sons used the company as their “personal piggy bank, purportedly looting over $300 million, which included more than $50 million in cash advances, money for luxury apartments and a $13 million golf course.”

A jury determined that Mickey Monus, responsible for the $500 million Phar-Mor fraud, embezzled at least $10 million to fund the now-defunct World Basketball League.

In some situations the same firm that conducted the audit, albeit by different personnel, prepared the individual tax returns of insiders. That was the case in the $300 million ESM Government Securities fraud of the 1980s. Although the financial fraud was concealed on the company’s books, the insiders had declared huge illegal profits on their own personal tax returns. Had the auditors examined the tax returns of the principals (which they did not) the scheme would have been obvious.

This illustrates a fundamental tenet of fraud examination: Follow the money. There are but two ways that this can be accomplished. Illicit transactions can be traced from an insider to the organization or vice versa. The former approach is invariably easier than finding funds from the company to the insider, which often are disguised in a variety of ways.

Corporate insiders have a fiduciary duty to act in the best interests of the shareholders. A part of this duty should include their financial transparency. Auditors could be given access to any financial information that bears on this issue. That would include, but not be limited to, personal tax returns and detailed banking records. By having such access,

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two important objectives could be accomplished. First, it would make it more difficult for insiders to conceal ill-gotten gain. Second, financial transparency could be a significant and powerful deterrent.

CAHPTER 5

CHANGES IN GLOBAL ACCOUNTING STANDARDS

Investors have clamored for change. And now, many of the nagging issues that not long ago looked hopelessly stuck in the status quo -- accounting for stock-option compensation, among them -- finally seem on the fast track to change. Nowhere has that transformation in attitude been more evident than at the Financial Accounting Standards Board, where proposals that once gathered dust for years in some cases are getting pushed through in mere months.

Here's an update on some high-profile, hot-button issues. Some stem directly from the scandals, others more from the resulting push to wipe out appearances of just about anything that smells of poor earnings quality. To be sure, every wave of financial scandal historically has been followed by a wave of reform, which is then followed by a new wave of scandal that the reform proved ineffective at heading off, followed by more reform. Cheats will be cheats and will find new ways to plump their profits. There is world wide irregularities in major companies in the world.18

Dwindling options for stock options: Finally, it looks as if the accounting-rule makers have summoned the courage to mandate that companies record stock-option compensation as an expense on their income statements, not just in their footnotes. Already, the FASB has required quarterly -- instead of merely annual -- footnote disclosures of companies' estimated option expenses. And unlike the last time the board tried to go the distance with this proposal back in the mid-1990s, nowadays the politicians don't appear inclined to intervene and risk appearing to be advocates of bad accounting. What's fair isn't always fair: If companies are required to expense stock options, this big question looms: How are companies supposed to figure out how much these options are worth? It turns out that Wall Street's vaunted Black-Scholes mathematical model makes options on highly volatile stocks look unduly valuable, even where the stocks have

18 Johnathon Weil (2003), Accounting standards boards take on hot button issues, Article

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crashed. The estimates fed into these models also reduce the models' reliability.

Of course, companies rarely object when the discretion they're given to make estimates produces extra income, rather than expense. Corporate balance sheets now sport trillions of dollars worth of the financial instruments known as derivatives, many of which are thinly traded and not easy to value accurately. The collapse of the energy traders, led by Enron Corp., exposed an industry whose valuation methodologies too often were optimistic at best, and fraudulent at worst.

As a result, securities regulators and accounting-rule makers say they intend to cast a more skeptical eye on any so-called fair-value techniques, including those for valuing derivatives, which leave too much discretion to companies' management. Expect a lot of hand-wringing on this front in 2003, maybe even some regulatory calls for greater disclosure of valuation methods and assumptions, but not much more than that.

That probably won't change soon. Pension accounting isn't on the FASB agenda yet. But the board did signal recently that it is receptive to new proposals. One relatively easy fix would be to improve the frequency and display of information. Some investors are pushing for quarterly, rather than annual, disclosure of pension plans' effects on corporate performance, possibly shown on the income statement itself. The idea has at least a shot of passing this year -- if enough investors demand it.

Cookie jars: This is one of the oldest tricks in the book. A company announces a "restructuring" plan, say, for coming layoffs or plant closings. Next, it takes a big charge to earnings -- which it advises investors to ignore as a "special" or "one-time" item -- to reserve for the costs of executing the plan by setting up liabilities on its balance sheet. Then, lo and behold, the restructuring costs turn out lower than originally forecast, allowing the company to reach into the corporate "cookie jar" and reverse part of the reserves, resulting in a boost to net income.

That game is mostly over, thanks to a new standard passed by the FASB last year. Now when companies make plans to exit from or dispose of a business line, they aren't allowed to set up liabilities to reserve for the future costs. Instead, they must recognize the costs over time as they're actually incurred. Without restructuring reserves, there can be no cookie-jar reserves. Problem solved? Not quite.

As it turns out, the new standard didn't address the accounting for restructuring plans undertaken in connection with a merger or acquisition. So, for the time being, companies still can set up large reserves for acquisition-related restructurings. That option won't be around for long, though. Expect new FASB guidance this year forcing companies to recognize acquisition-related restructuring expenses as they are incurred.

Since the news of Enron broke, US accounting professionals have been distracted by the many corporate scandals that have come to the fore, which have left less time for focusing on international standards issues. More important, the US Securities and Exchange Commission was ambivalent about the IASC but is somewhat more

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enthusiastic about the IASB and international standards, although the movement toward convergence has been praised in several speeches over the past three or four years by a steady stream of senior SEC officials. The SEC's concern is it does not want to endorse international standards if they will corrupt the integrity of US capital markets. That could happen if international standards allow into the United States companies whose numbers are more difficult to decipher, unclear or harder to verify than those of companies headquartered in the US. In short, the SEC wants international accounting standards to be as strong or as stringent as those written with US GAAP.19

5.1: Financial Reporting and IAS-12

International Accounting Standard number 12 was and is the most misunderstood International Accounting Standard in the financial reporting history of Pakistan, apart from International Accounting Standard 32 and 39. The prime reason of this conceptual misunderstanding is the three-dimensional Income Tax Ordinance, 2001 and Sales Tax Act, 1990. The purpose of this article is to cover International Accounting Standard 12 within the context of three-dimensional Income Tax Ordinance, 2001, impact over corporate financial reporting, removal of doubts raised in different articles and lacunas or shortcomings of International Accounting Standard 12 and Companies' Ordinance, 1984.

Normally the accounting profit before tax figure appearing in the financial statements of corporate entities differ from the taxable profit showed in income tax return. Such a difference may be categorized as permanent difference or temporary difference. Permanent difference arises due to permanent factors while temporary difference arises due to temporary factors.

Permanent factors include inadmissible expenditure mentioned in section 21 of Income Tax Ordinance, 2001, for instance entertainment expense in excess of limit prescribed in rule 10 of Income Tax Rules, 2002. Income exempt from tax mentioned in second schedule of Income Tax Ordinance, 2001, for instance, clause 131 of part I of second schedule of Income Tax Ordinance, 2001.  Nothing can be done about that, and the increased [due to inadmissible expenditure] or decreased [due to exempt income] tax charge just has to be accepted. Now we can conclude that if an expense in the profit and loss account is not allowed for tax purposes or an income is not recognized for tax purposes, permanent difference arises.

A temporary difference arises when an expense [temporary factor] is allowed both tax and accounting purposes, but the timing of the allowance difference. Temporary factors include deemed income subject to reversal in subsequent years or treatment difference of depreciation, amortization etc. for instance, if the depreciation rate is higher for tax purposes than the depreciation rate in Financial Statement, the tax charge will be lower in the first year than it would have been if based on accounting profit, but in subsequent year the tax charge will be higher. In order to fully understand the situation, let’s consider an example.

19 Lawrence Richter Quinn (2003),Closing the GAAP, Article

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EXAMPLE

A Company bought plant and machinery for Rs. 200,000.00. The useful life of the asset is five years and is to be depreciated on straight-line basis. 

For tax purposes, the initial depreciation rate is 50% and 25% in subsequent years on WDV. The tax relevant tax rate is 43% throughout the period.

 TAX ACCOUNTS

 

YEARCOST / OPENING BALANCE

DEP'N WDVCOST / OPENING BALANCE

DEP'N WDVDIFFERENCE

1200,000 180,000 20,000 200,000 40,000 160,000 140,000

220,000 5,000 15,000 160,000 40,000 120,000 (35,000)

315,000 3,750 11,250 120,000 40,000 80,000 (36,250)

411,250 2,813 8,438 80,000 40,000 40,000 (37,188)

58,438 2,109 6,328 40,000 40,000 - (37,891)

               

  254,688 193,672   600,000 200,000   (6,328)

The WDV of Rs20,000 is the tax base [amount attributed to the asset or liability for tax purposes] of plant and machinery. While the accounting WDV of Rs 160,000 is the carrying value of plant and machinery.

From the above chart it is apparent that due to the difference in depreciation rates, the company’s depreciation expense, for tax purposes, increased by Rs 140,000.00 in year 1. Alternatively, we could also say that the WDV of the asset has increased by Rs 140,000.00. Hence, we can conclude that the effect of depreciation or WDV has started reversing from year 2 till year 5 and will continue thereafter till the exhaustion of the cost of asset under diminishing balance method, that is, year 35.

It is worthwhile here to note that depreciation expense reduces tax payments. The very impact difference in above referred chart is over the tax payments and can be analyzed as follows.

 TAX ACCOUNTS

DIFFERENCE

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YEAR DEP'NReductionin TaxPayment

DEP'NReductionin TaxPayment

 

1180,000 77,400 40,000 17,200 60,200

25,000 2,150 40,000 17,200 (15,050)

33,750 1,613 40,000 17,200 (15,588)

42,813 1,209 40,000 17,200 (15,991)

52,109 907 40,000 17,200 (16,293)

From the above chart it is apparent that due to the difference of depreciation rates or more appropriately due to difference in tax and accounting WDV/depreciation expense has resulted in reduced tax payment of Rs 60,200.00 [deferred tax] (140,000 X 43%) in year 1. The difference arose during year 1 has start reversing from year 2 till year 35.

Deferred tax can be defined as ‘The estimated future tax consequences of transactions and events recognized in the financial statements of the current and previous periods’.

As stated earlier, tax saving of Rs 60,200 in year 1 is not an actual tax saving but primarily tax liability is effectively deferred to the extent of useful life of the asset. Now let’s analyze the concept of difference arose in the above referred chart through tax accounting, to the extent of year 5. This can be illustrated as follows.

 TAX ACCOUNTS

YEAR CURRENT 

TOTAL CURRENT DEFERRED TOTAL

1- -            - 34,200 60,200 94,400

24,150 23,285 30,866 34,200 (15,050) 19,150

354,863 23,591 31,272 34,200 (15,588) 18,613

455,397 23,821 31,576 34,200 (15,991) 18,209

555,798 23,993 31,805 34,200 (16,293) 17,907

             

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  220,207 94,689 125,518 171,000 (2,721) 168,279

One must not confuse with the negative aggregate balance of Rs 2,721.00, this will be reversed in 35th year. The most important point is that why should we recognize deferred tax? It is worthwhile here to note that if an entity fails to recognize deferred tax, it eventually fails to recognize a liability or asset, which will ultimately lead to distortion of the post tax profit. Hence, it can be concluded that it is basically the accrual concept, which requires its recognition. Failing to recognize deferred tax may lead to over/under optimistic dividend payment based on inflated or understated profit, distortion of EPS and PE ratio and above all shareholders will be misled.

There are two main methods of accounting for deferred tax, Deferral method [the original amount set aside for deferred tax is retained without alteration for subsequent changes in tax rate] and the liability method [the deferred tax balance is adjusted as the tax rate change in order to maintain the actual liability expected to arise].

The liability method is sub-divided into two methods, Income statement liability method [focuses on difference between taxable profit and accounting profits timing difference] and balance sheet liability method – IAS 12 preferred [calculation is made by reference to differences between balance sheet values and tax values of asset and liabilities temporary differences].

It is worthwhile here to note that as per division II of part I of 1 st schedule of Income Tax Ordinance, 2001, the tax rates are continually decreasing till tax year 2007, that is, 35%. Hence, if an entity adopts the liability method, it must consider the falling tax rates in advance, that is, during the 1st year of recognition of deferred tax. Although International Accounting Standard 12 is silent over the issue of continually reduced tax rates, but in order to incorporate a transparent, crystal clear and objective recognition of deferred tax asset or liability, it is of utmost importance.

Whatsoever the method a corporate entity adopts for deferred tax, still International Accounting Standard 12 gives a choice in respect of extent of the provision. The extent of the provision may be nil provision [no provision is made – flow through method], Full provision – IAS 12 preferred [provision is made for the tax effect of all temporary differences] and partial provision [provision is made to the extent that expected liability will actually arise].

The nil provision, or flow through basis ignores the taxation effects of timing differences completely. Tax is accounted for as it is assessed on the basis that taxation is an appropriation of profits by the government, and so is not relevant as a performance indicator. A theoretical justification for this argument is that the only tax liability that satisfies the statement of principles’ definition of a liability (an obligation to transfer economic benefits out of past transactions and events) is current taxation.

The full provision is based on the view that every transaction has a tax consequence and it is possible to make a reasonable estimate of the future tax consequences of transactions

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that have occurred by the balance sheet date. If this basis of deferred tax accounting is adopted, the computation of the deferred taxation figures is a relatively straightforward arithmetical exercise. The approach of International Accounting Standard 12 to tax accounting under the full provision approach is commonly known as the valuation adjustment approach. This approach recognizes deferred tax on all differences between the carrying values of assets and liabilities in the financial statements and their tax base. An alternative approach to deferred tax accounting under the full provision basis is the incremental liability approach. This approach recognizes deferred tax only when it could be regarded as meeting the definition of an asset or a liability in its own right.

Like the full provision basis the partial provision basis is based on the premise that the future reversal of a timing difference gives rise to a tax liability (or asset). However, instead of focusing on the individual components of the tax computation the partial provision basis analyses the components as a whole in a single net assessment. To the extent that timing differences are expected to continue in future (by the existing timing differences being replaced by future timing differences as they reverse) the tax is viewed as being deferred permanently. The computation of deferred tax balances under the partial provision basis is rather more complicated than under the full provision basis because of the need to use forecasts of future transactions to estimate the incidence of future timing differences.

Professional accountants must keep an eye over the three dimensional Income Tax Ordinance, 2001 – Minimum tax, Presumptive tax regime and normal tax on profit. One may think that Minimum tax needs to be adjusted in deferred tax provision. It is worthwhile here to note that minimum tax is a dead tax and have nothing to do with the future adjustment of losses due unabsorbed depreciation. Although care need to be taken, in subsequent years, where the losses are converted into profits after the audit under Income Tax Ordinance, 2001. This situation may require adjustment of deferred tax, recognized in earlier years, through International Accounting Standard 8, before continuing with the current year provision. As far as presumptive tax regime is concerned, decision of either to make a provision of deferred tax or not, lies over the conclusion drawn from the future budgeted activities of the corporate entity. Similarly, a proportionate return requires careful consideration.  

It is worthwhile here to note that under the balance sheet liability method, deferred tax is calculated by reference to the tax base [amount attributed to the asset or liability for tax purposes]. The tax base of an asset is the amount that will be deductible for tax purposes against any future taxable benefit derived from the asset, hence, where the benefit will not be taxable [e.g. Income is exempt] the tax base of an asset is equal to the carrying amount. The tax base of a liability is the carrying amount less any amount that will not be deductible for tax purposes [e.g. advance revenue on account of exempt income] in respect of liability in future period.

The problem lies in identifying whether the deferred tax is an asset or liability, that is, figure of Rs 60,200.00 in the chart. It is worthwhile here to note that deferred tax liability needs to be recognized for all taxable temporary difference [where carrying value is

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greater than tax base or Carrying value > tax base] while deferred tax asset needs to be recognized for all deductible temporary difference [where tax base is greater then carrying value or Tax base >Carrying value].  Care need to be taken where an item is neither an asset nor a liability, for instance, research cost.

In our above-referred example the difference arose due to the difference in tax base and carrying value. The tax base of the asset is Rs 20,000.00 while the carrying value is Rs 160,000.00. In this case, the carrying value is greater than the tax base [taxable temporary difference], hence, it can be effectively concluded that Rs 60,200.00 is a deferred tax liability.

Apart from other issues, creation of deferred tax asset on tax losses is the most critically appraised hot topic. In order to understand the spirit of the problem, let’s go through an example.

EXAMPLE

A (Pvt.) Ltd sustained a loss of Rs 100,000.00 in year 1. In order to identify the reason of sustaining the loss, the auditor has obtained the reason of loss and budgeted profit and loss account for next five year. The reasons were found satisfactory and the budgeted data is as follows.

Tax yearPROFIT/LOSS

DEFERRED TAX

 

2003 (100,000) (37,400) 37.4%

2004 20,000 8,200 41%

2005 20,000 7,800 39%

2006 20,000 7,400 37%

2007 20,000 7,000 35%

2008 20,000 7,000 35%

The auditor allowed the creation of deferred tax asset to the extent of Rs 37,400.00. It is worthwhile here to note that a deferred tax does neither extract cash nor insert cash into the accounts of the company. The amount of Rs 37,400.00 credited to Profit and loss account will subsequently reverse in future years and Rs 8,200.00, Rs 7,800.00 and so on in subsequent years, will debit profit and loss account. This will ultimately save the interest of shareholder and serve as a deterrent to the intention of the management to show inflated profit after taxation in subsequent years and deceive prospective investors.

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A management may increase the EPS ratio through creation of deferred tax asset but same EPS ratio will also be kept in line with normal practice in future years just because of deferred tax. Deferred tax is normally recognized on all timing differences that have originated but not reversed by the balance sheet date. However, deferred tax is not recognized on permanent differences.20

5.1.1: Global Convergence on IAS-12

The evolutionary development of IAS 12 “Income Taxes” has covered a long way and also inspired several reporting frameworks all over the world. The reporting of income tax in the financial statements of an entity has always been a much debatable issue under different financial reporting frameworks including international scenario developed by IASB. Since its inception, it has covered a journey from flow through accounting leading to partial provision and at last to full provision accounting. The reporting aspects of income tax and specially deferred tax were and even today are by hook or by crook different under several financial reporting frameworks specifically under FRSs, the reporting framework in UK, issued by ASB. The main focus in Pakistan and international scenario is IAS 12 “Income Taxes” but the study of most accomplished frameworks prevailing since the very beginning is of much import to understand the current sketch of IAS 12. These proficient reporting frameworks are mainly FRSs, standards issued by AASB and US reporting standards conventionally known as SFASs or GAAP. 

The entire accountancy world is going to converge and is on way to synchronization of reporting frameworks as much evidenced by adoption of IASs by various countries including those members of SAFA and most of the member countries of EU by the year 2005 for consolidated financial statements through EC directives and the recent changes in AASB Standards in parity with IASs/IFRSs. All these changes have resulted in the international consensus of shifting focus on “temporary” rather “timing” approach. However a few exceptions in the shape of FRSs still prevail in the world, founded on timing approach and constituting the main reporting framework in England and the Republic of Ireland. While others have already gone to complete underlying conceptual change from timing to temporary well after the revised IAS 12 issue. The major example is Accounting Standard AASB 1020 “Income Taxes” which superseded Accounting Standard AASB 1020 “Accounting for Income Tax (Tax effect accounting)” and was later itself amended by Accounting Standard AASB 1020A “Amendments to Accounting Standard 1020” and Australian Accounting Standard AAS 3. At last a refined accounting standard AASB 1020B, under pending status, has been finalized for application from 1st January 2005 in Australian reporting environment.

The concept of temporary difference, as opposed to timing difference, was evolved in Australian Accounting Standard AASB 1020 “Income Taxes” in December 1999. The International Accounting Standard 12 (original) was issued in 1979 named “Accounting for taxes on Income”. This was later lagged by IAS 12 (reformatted 1994), IAS 12 (revised 1996), and the latest IAS 12 (revised 2000) “Income Taxes”. The concept of timing difference was presented by the original IAS 12 in 1979 while this idea was

20 Mohammed Ashraf (2003), Financial reporting and IAS-12, Article

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shifted to complete change in 1996 by IAS 12 (revised) through conceptual basis of temporary differences. The same phenomenon was adopted by Australian Standards in 1998 in an attempt to be intact with global velocity.

However in some examples like FASB Statements of Accounting Standards, the concept of temporary instead of timing difference has ever been present since the issue of FASB Statement 96 “Accounting for Income Tax (tax effect accounting)”. The same ideas win through after a long time on international consensus.

IAS 12 revised in the year 2000 deals with reporting issues regarding income tax. IAS 12 bifurcates tax issue under current tax and deferred tax. The accounting and reporting treatment of current tax is the same under different frameworks. However the deferred tax has been differently treated under differing frameworks. Deferred tax liabilities and assets for the future tax consequences of events and transactions already recognized in an enterprise's financial statements or tax returns have to be accounted for and this issue leads to the two main streams of timing and temporary differences. In order to fully grasp the deferred taxation, a comprehensive study is first to be made about the incurrence of deferred tax. What is deferred taxation? How does it arise? What are the essential accounting treatments to reflect the true financial position and performance of the entity? How does the accounting treatment under IAS 12 differ from that described for well established English and Irish reporting environments? And most importantly, the impact of IAS 12 approach on performance appraisal and transparency of financial statements must be studied.

One reason to study FRSs and other frameworks together with IASs is to visualize the proficient frameworks existed well before the very beginning of harmonization of reporting aspects all over the world by IASB. The International Accounting Standards later developed by IASB still envisage many basic rules and principles the FRSs, previous SSAPsand US GAAP were founded on in view of international accord. There was even a time when IASs were alleged to be espoused from the American culture.

“The main argument is that, while IASs closely resemble US GAAP, [but] they don’t necessarily accommodate or reflect the business culture of the rest of the world”  - Ramona Dzinkowski (Eminent Canadian Economist)

IAS 12 before revision in 1996 was founded on the concept of timing differences instead of temporary differences but treated most of temporary differences in the same way as timing differences. The same rules, with a little bit divergence, were adopted by FRS 19 “Deferred Tax” issued in December 2000 in continuance of its old approach established by SSAP 15. Even today, the exact reporting framework as established by IAS 12 (original) exists in the shape of GAS10. While studying timing and temporary differences, there seems to be no difference between the two but the very differences, which have to be visualized, cause the complete diversion from income statement to balance sheet for the identification and reporting of deferred taxation.

EXAMPLE

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Singora Enterprise has an asset with carrying value and tax base of $1000. The asset is revalued at $1500 and it causes a temporary difference of $500 and the resulting deferred tax liability of $150 (500 x 30%) assuming 30% tax rate.

Before revaluation, the depreciation charge for the year was $100 (assuming 10% rate applicable on straight line method) but now it has increased to $150. The difference of $50 appearing in the income statement is not an admissible expense, neither now nor in future (permanent difference). However, the amount of $500 (difference between the tax base and carrying value) would be credited to the retained earnings when the asset is sold or utilized internally to avail benefit.

In this case, while adopting timing difference approach no deferred tax is recognized concerning revaluation of asset. Timing approach escapes such liability where temporary approach does not.

EXAMPLE

Singora Enterprise acquired a foreign subsidiary classified as foreign entity under IAS 21. The earnings of acquired entity are *FC 800 for year. Its net assets (unremitted earnings) are FC 1,250 and FC 2,050 at the end of years 1 and 2, respectively.

The foreign currency is functional currency (FC). For year 2, translated amounts are as follows:

 Foreign Currency

Exchange rate Rupees

       Unremitted earnings, beginning of the yr 1,250 FC1 = Rs.2.00 2,500Earnings for the year 800 FC1 = Rs.1.50 1,200Unremitted earnings, end of year 2,050 FC1 = Rs.1.80 3,690

A Rs.10 translation adjustment (2,500 + 1,200- 3,690) is cumulative translation adjustment account in shareholders' equity for year 2.

The parent expects that all of the foreign subsidiary's unremitted earnings will be remitted in the foreseeable future and a deferred tax liability is recognized for those unremitted earnings.

The parent accrues the deferred tax liability at a 20 percent tax rate (that is, net of foreign tax credits, foreign tax credit carry forwards, and so forth). An analysis of the net investment in the foreign subsidiary and the related deferred tax liability for year 2 is as follows:

  Net Investment (in Rs.)Deferred Tax Liability (in Rs.)

     

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Balances, beginning of year 2,500 500Earnings and related taxes 1,200 240Translation adjustment and related taxes

(10) (02)

Balances, end of year 3,690 738

For year 2, Rs.240 of deferred taxes are charged against earnings, and Rs.02 of deferred taxes are credited directly to the cumulative translation adjustment account in shareholders' equity.

* (all figures in millions)

5.1.2: IAS 12 & Temporary Difference Anomaly      

Even after a shift from timing to temporary, there are also many differences between the tax base and book values of assets and liabilities on which the recognition of deferred taxation caused inappropriate reporting. IAS 12 several times reverts back to nullify such anomaly inherent in the definition of temporary differences. The nullifications of such anomalies are embarked upon by IAS 12 in following ways:

1. Non recognition of deferred taxation for goodwill not deductible for tax purpose.2. Non recognition of deferred taxation on temporary difference arising on initial

recognition, not in case of business combination, of an asset or liability. 3. Non recognition of deferred taxation on temporary difference arising on

recognition of exempt government grant where the government grant is accounted for as deferred income under IAS 20.

4. Temporary differences arising on the existence of undistributed profits of subsidiaries, branches, associates and joint ventures where the enterprise controls the timing of reversal and the differences are not expected to reverse in foreseeable future.

However, the recognition of deferred taxation is quite in accordance with the definitions of asset and liability. These definitions are described in somewhat the same manner under all frameworks as the asset being a resource controlled by an enterprise as a result of past event and the liability being present obligation as a result of past event. The emphasizing words here are past events. The transactions or other events obligating the entity constitute past events and cause deferred tax liabilities or assets to be recognized due to temporary differences. However a prudent approach for the recognition of asset is required as per the Framework.

The US GAAP visualizes the approach of temporary differences in line with international consensus. However the incremental liability approach also made the way in ABP Opinion 11 prior to SFAS 96 and its successor SFAS 109. SFAS 96 was first issued in 1987 while IAS 12 adopted temporary difference terminology and the resulting changes in 1996 and emulated much of SFAS 109 (1992) with some distinctions by requiring the use of liability method instead of deferred method (ibid; para 60).  But there is still a major difference in respect of deferred tax asset which is to be recognized for all

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deductible temporary differences and furthermore a valuation allowance is to be created where the non-recovery of asset is more likely than not. The FASB of US has now signed a memorandum of understanding with IASB to streamline its standards with IASs/IFRSs, which is another step towards harmonization and adoption of International Accounting and Reporting Standards on global lines.

In this way IAS 12, after much debate, has succeeded in achieving greater transparency in the financial statements of an entity. The matter of recognition, measurement and presentation of deferred taxation is at last in conformity with the basic rules developed by the framework and all this is leading to the true and fair presentation and financial performance appraisal. The performance and position appraisal requires the completeness and accuracy of assets, liabilities, income, expenses and equity of an enterprise in terms of recognition, measurement and even most importantly the reporting.

5.1.3: IAS 12 & Performance and Position Appraisals

Not surprisingly, the deferred taxation assets and liabilities substantially affect the financial position and performance of an enterprise where the amounts are much material in relation to pretax profit, assets and liabilities. One can think of the consequences of inappropriate financial appraisals where the amount of deferred taxation exceeds millions in case of large scale business and in turn affecting EPS, gearing, ROCE and other ratios which are at the heart of performance and position measurement techniques used all over the world. The shift to temporary differences is an indispensable step towards transparency of financial statements and the recognition of deferred liabilities and assets in line with the basic concepts underlying the framework.

The evolutionary development of IAS 12 also elucidates the calculation of deferred taxation, which is another effort towards true and fair presentation while still avoiding the complexity. e.g.:

1. Use of future expected tax rate based on substantially enacted tax rates by the balance sheet date for computation of deferred taxation

2. The expected pattern of utilization of assets or liabilities for the calculation of deferred taxation (e.g. disposal of an assets or its use in business)

3. The prohibition of use of discounting (though not in accordance with the general concept of discounting long term items) of deferred taxation

4. Deferred taxation related to items charged or credited directly to equity 5. Offset provisions relating to deferred taxation

The requirement of IAS 12 as described in (c) is quite contradictory to the norms of accounting and reporting but the sacrifice in this respect is sought to avoid undue complexity of financial statements.

The accounting and reporting rules under IAS 12 appear to be complex, but they do accomplish the objective of keeping tax and financial accounting separate and independent of one another. The different purposes for each accounting system must

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always be kept in mind. Tax Regulations in any country are designed to raise revenue, regulate business activity, encourage investment, and redistribute income between various social groups. Tax regulations are in a constant state of flux and are the result of legislative compromises. Thus Income Tax returns have little relevance for potential investors since they simply reflect how aggressively the taxpayer has utilized the tax laws to report as little income as possible for taxation purposes. Accounting rules for deferred taxation under IAS 12 are developed to reflect the economic reality of a firm by providing relevant financial statements so that users can make informed decisions about a firm. Accounting does not change as frequently as tax regulations. The two accounting systems are completely separate. A change in accounting rules has no impact on taxable income while a change in tax rules will only affect the amount of tax expense reported for financial purposes. For these reasons, the accounting and reporting aspects of deferred taxation have been developed in such a way to accommodate the recognition of assets and liabilities pursuant to completeness concept described in the framework and all this has been achieved after over 60 years of debate.21

5.2: The Sarbanes-Oxley Act

Without a doubt, the Sarbanes-Oxley Act is the single most important piece of legislation affecting corporate governance, financial disclosure and the practice of public accounting since the US securities laws of the early 1930s. And, it is clear that public companies and the accounting profession have made tremendous progress in meeting the rigorous requirements of this legislation.

The furthest reaching of these regulations is the Sarbanes-Oxley Act, which requires companies to comply with challenging new standards for the accuracy, completeness and timeliness of financial reporting, while increasing penalties for misleading investors. The Act, which applies to all companies (and their subsidiaries) on the US public markets, protects the interests of investors and serves the wider public interest by outlawing practices that have proved damaging, such as overly close relationships between auditors and managers. The law includes stiff penalties for executives of companies that are non-compliant including fines of $5m dollars, and up to 20 years in prison per violation.

5.3: Basel II

Basel II, the forthcoming protocol for the financial sector, is designed to replace the 1988 Capital Accord. It recognizes that managing and controlling financial risk and operational risk, such as IT, is an integral part of corporate governance and, as such, obligates companies to assess their vulnerability and make it public.

Basel II is based on three main areas that allow banks to effectively evaluate the risks financial institutions face:

21 Yasir Khan (2003), Global Convergence on IAS-12: Why Temporary and not Timing difference?, Article

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Minimum capital requirements, Supervisory review of an institution’s capital adequacy, and

Internal assessment process and market discipline through effective disclosure to encourage safe and sound banking practices.

Financial organizations that do not provide appropriate details must set a side 20 per cent of their revenue in order to cover loses or risk being prevented from trading. The first phase of Basel II will come into effect at the end of 2006, with the more advanced elements planned for implementation at the end of 2007.

5.4: Companies Act

The forthcoming Companies (Audit, Investigations and Community Enterprise) Act is designed to help UK firms avoid the much-publicized accounting and auditing problems experienced by companies such as Enron, WorldCom and Parmalat. The Bill, which made mention in this year’s Queen’s speech and will be debated in this session of Parliament in order to come into force early next year, will impose new measures to ensure that data relating to trades, transactions and accounting throughout an organization is fully auditable.

With reference to the Companies Act, Department for Trade and Industry minister Jacqui Smith has said: “We want the UK to have the best system of corporate governance in the world. There is no denying that financial markets around the world have been badly shaken by the corporate failures of the last few years.

“This Bill completes a comprehensive package of measures aimed at restoring investor confidence in corporate governance, company accounting and auditing practices here in Britain. Its aim is to raise corporate performance across the board and beyond.

“The Bill tightens the independent regulation of the audit profession and strengthens the enforcement of company accounting, both concerns highlighted by the Enron and WorldCom scandals. It gives auditors greater powers to get the information they need to do a proper job, and increases company investigators’ powers to uncover misconduct.”

5.5: Security

Basel II, the Sarbanes-Oxley Act and the Companies Bill all highlight the fact that board directors and executive management have a duty to protect the information resources of their organizations. As such, network security – preventing unauthorized access to information and data – is of the utmost importance, and the most effective way of achieving this is by deploying an effective provisioning solution that allows the enterprise to determine who has access to which applications and when.

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However, implementing an identity and access management program that ensures the correct level of security and internal controls over key information and data can be a difficult task for many large organizations.

Often, systems and access policies in use today were developed many years ago when security was not necessarily the highest priority. Not only are these legacy systems now unsuitable for use, but, since being implemented, many of the policies associated with them have not been reviewed, and access is granted either manually or by way of ‘home grown’ development.

Furthermore, many of the systems were not developed to cater for temporary changes such as the provisioning and de-provisioning of contract workers or account for a member of staff on leave. Adding to the problem is the fact that, often, companies have myriad systems and access policies, which have merged with another organization’s policies, systems and architectures.

These issues are now major problems that need to be addressed urgently. As well as the need to comply with corporate governance regulations, the situation has also given rise to an increased security threat; a fact highlighted by the Financial Services Authority’s Financial Crime Sector Report: ‘Countering Financial Crime Risks in Information Security’.

CAHPETR 6

PAKISTAN ACCOUNTING AND AUDITING STANDARDS

The Institute of Chartered Accountants of Pakistan (ICAP) plays the major role in setting accounting standards in Pakistan. On the receipt of an Exposure Draft from the International Accounting Standards Committee (IASC), ICAP advises its members of the contents of the Draft either through a publication in “The Pakistan Accountant” (the

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official journal of ICAP) or by newsletter. Comments are invited from members on the Draft. If considered important enough, the draft Standard is debated at a conference or seminar before a decision is made as to its acceptance. Most International Accounting Standards (IAS) is accepted in full and some are accepted with slight amendments to suit the needs of Pakistan. When the draft is finalized, an order is issued by the Securities and Exchange Commission (SEC) directing that the International Accounting Standards will be followed in regard to the accounts and preparation of Balance Sheet and Profit and Loss Accounts of listed companies and subsidiaries of listed companies. The authority for the issue of this Order is conferred by subsection (3) of section 234 of the Companies Ordinance, 1984 (XLVII of 1984), read with clauses (a) and (c) of section 43 of the Securities and Exchange Commission of Pakistan Act, 1997 (XLVII of 1997).

6.1: DEVIATIONS FROM IAS-33

The following IASs have all been adopted by the national accounting bodies and have also been adopted by SEC for mandatory application to listed companies and subsidiaries of listed companies.

The following Standards have been adopted:

IAS 1 Presentation of Financial Statements IAS 2 Inventories IAS 7 Cash Flow Statements IAS 8 Net Profit or Loss for the Period, Fundamental Errors and Changes in

Accounting Policies. IAS 10 Contingencies and Events Occurring After the Balance Sheet Date IAS 11 Construction Contracts IAS 12 Income Taxes (effective in Pakistan after 1-1-2001) IAS 14 Segment Reporting IAS 16 Property, Plant and Equipment IAS 17 Lease IAS 18 Revenue IAS 19 Employee Benefits IAS 20 Accounting for Government Grants and Disclosure of Government

Assistance. IAS 21 The Effects of Changes in Foreign Exchange Rates IAS 23 Borrowing Costs IAS 24 Related Party Disclosures IAS 25 Accounting for Investments IAS 26 Accounting and Reporting by Retirement Benefit Plans IAS 27 Consolidated Financial Statements and Accounting for Investments in

Subsidiaries IAS 28 Accounting for Investments in Associates IAS 30 Disclosures in the Financial Statements of Banks and Similar Financial

Institutions IAS 31 Financial Reporting of Interests in Joint Ventures

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IAS 32 Financial Instruments: Disclosure and Presentation IAS 33 Earnings Per Share IAS 34 Interim Financial Reporting IAS 35 Discontinuing Operations IAS 36 Impairment of Assets IAS 37 Provisions, Contingent Liabilities and Contingent Assets IAS 38 Intangible Assets IAS 39 Financial Instruments: Recognition and Measurement

6.1.1: ACCOUNTING AND AUDITING STANDARDS

The following standards have not been adopted:

IAS 15 Information Reflecting the Effects of Changing Prices – Has been classified as non-mandatory by IAS Committee and has not been adopted by Pakistan

IAS 22 Business Combination – is being considered for adoption. IAS 29 Financial Reporting in Hyperinflationary Economies – Not relevant in the

Pakistan context and has not been considered for adoption. IAS 40 Investment Property – Is being considered for adoption. IAS 22 and IAS 35 to IAS 39 have been adopted by ICAP but not yet notified

by the Securities and Exchange Commission. Most IASs have been adopted in full; however, some minor deviations occur in the following: ( i ) IAS 1 – Not mandatory for banks and insurance companies. The accounting requirements for banks are covered in the Banking Companies Ordinance 1962 and insurance companies are required to have separate classes of insurance accounts under the Insurance Ordinance 2000. Only minor deviations occur from IASs.

IAS 12 – Becomes effective on 1 Jan 2001, until then the original IAS is applicable and not the 1996 revision.

IAS 16 – Allows for a revaluation of an asset to be offset against the devaluation of another asset, i.e., the offset is not restricted to the same asset in accordance with IAS.

6.1.2: PUBLIC SECTOR ACCOUNTING STANDARDS BOARD

ESTABLISHMENT

The Pakistan Consortium on Governmental Financial Management (the Society) was established on 28 August 1999. It is now an incorporated body with the registered office situated in Islamabad. The sponsors of the Society are ICAP, ICMA and the Auditor-General of Pakistan and the governing body consists of 12 members, four from each sponsoring organization.

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Any person who is a member of ICAP, ICMA or any officer of the Auditor-General’s Department holding a post of B-17 or above may be admitted by the governing body as a member of the Society. The main objectives of the Society are as follows:

6.2: FINANCIAL MANAGEMENT AND GOVERNANCE ISSUES IN PAKISTAN 34

To promote and establish the Pakistan chapter of the International Consortium of the Governmental Financial Management to promote a better understanding of the professional financial management among public officials, at all levels of budgeting, data processing, debt administration, social safety net administration, tax administration and treasury management.

To improve public financial management system by encouraging participation and affiliation of individuals and groups concerned with various specialized areas of activity of interest within a broad field of public financial management.

To promote exchange of programs, information, documents and ideas relating to public financial management of systems nationally and internationally and develop and disseminate guidelines for professional public financial management.

To provide a permanent organizational structure and mechanisms with national and international organizations, institutions and other bodies.

To encourage sponsors, conduct or collaborate in appropriate research and publish results thereof, provide a clearing house of information relevant to financial management; undertake consultancy work both nationally and internationally and establish liaison with those organizations which are capable of promoting the objectives of the society.

To promote understanding of public financial management as a basic responsibility of all public officials at all levels and providing a forum for discussion of common public financial management problems.

To collaborate in the development of programs nationally and internationally involving sophisticated technologies, ensure professional quality and uniform criteria and provide quality control.

To accept grants of money, sponsorships, donations, fees, securities or property of any kind, on such terms as deemed fit by the governing body.

To provide help and assistance to Standing Committees of Senate, National Assembly and other committees whenever required.

To organize training courses, seminars, workshops, technical meetings and other professional development events directed towards improving public financial management.

6.3: ACCOUNTING AND AUDITING STANDARDS 35

To develop uniform, financial reporting formats, which ensure greater transparency, permit comparability and increase utilization of financial management information.

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To develop a code of ethics for establishing and maintaining high standards of integrity, honesty, morality, ethics and character among financial managers and staff members.

To emphasize importance of professional management of scarce public financial resources and increase economy, efficiency and effectiveness of public sector activities, projects and programs.

To send experts and representatives to other countries and invite representatives and experts of foreign countries, bodies, societies, institutions etc., having the same aims as the Society to attend conferences (local or international), meetings and functions to deliver lectures, etc.

To make arrangements and take all necessary steps including entering into agreements with the governmental, national, provincial, local or municipal, or foreign institutions or individuals or other authorities at any place in which the Society may have interests and to carry on any negotiations or operations for the purpose of directly or indirectly promoting the purposes of the Society.

The Society is in the establishment stage and Pakistan Audit Department is currently being used as the Registered Office and Secretariat. Arrangements are currently being made to hold an international seminar on one of the following topics:

1. Asset management and asset accounting in the Public Sector.2. Towards a more efficient regulatory mechanism for the industrial sector.3. Managing the transition towards a market economy. It is recommended

that the Society be used as the vehicle to create the Public Sector Accounting Standards Board.22

CHAPTER 7

FRAUD CONTROL THROUGH AUDITING

22 ICAP

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7.1: COMMON AUDIT PROBLEMS AND SOLUTIONS

The most common problem—alleged in 80% of the cases—was the auditor’s failure to gather sufficient evidence. In some instances, this failure was pervasive throughout the engagement; in other instances the allegations were more specific. For example, many of the cases involved inadequate evidence in the areas of

- Asset valuation. The auditor did not obtain evidence to support key assumptions.- Asset ownership. The auditor did not obtain evidence to indicate the company

owned certain assets.

- Management representations. The auditor did not corroborate management responses to inquiries.

Some cases involved the auditor’s failure to examine relevant supporting documents (for example, examining a draft, instead of a final, sales contract) or failure to perform steps listed in the audit program. Overall, this failure contributed to management’s success in overstating assets, the most common fraud technique.

Due professional care: The SEC claimed that auditors failed to exercise due professional care in 71% of the enforcement cases and to maintain an attitude of professional skepticism in 60% of the cases. In general, this failure on the auditors’ part can be found throughout the sanctioned audit engagements.

Applying GAAP: In almost half of the cases, the SEC said the auditors failed to apply or incorrectly applied GAAP pronouncements. Many of the GAAP violations related to unusual assets with unique accounting valuation issues (often described in the lower levels of the GAAP hierarchy).

Audit program design: Planning the audit engagement is crucial to its success. Deficiencies in audit planning were cited in 44% of the cases. Specifically, the auditor failed to

- Properly assess inherent risk and adjust the audit program accordingly.- Recognize the heightened risk associated with non-routine transactions.

- Prepare an audit program (or inappropriately reused one from prior years).

Audit evidence: Another common deficiency the SEC alleged, present in 40% of cases, involved over reliance on inquiry as a form of audit evidence. The agency cited auditors for failing to corroborate management’s explanations or to challenge explanations that were inconsistent or refuted by other evidence the auditor had already gathered.

Failure to obtain adequate evidence relating to the evaluation of significant management estimates was present in 36% of the cases. The SEC claimed auditors failed to gather

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corroborating evidence and to challenge management’s assumptions and methods underlying the development of those estimates.

Accounts receivable: The SEC cited numerous deficiencies in confirming accounts receivable (present in 29% of the cases). These deficiencies included

- Failure to confirm enough receivables.- Failure to perform alternative procedures when confirmations were not returned

or were returned with material exceptions.

- Problems with sending and receiving confirmation requests (for example, failing to corroborate confirmations received via fax or allowing the client to mail confirmation requests).

Related parties: Another common problem (in 27% of cases) was the auditor’s failure to recognize or disclose transactions with related parties. The auditor was either unaware of the related party or appeared to cooperate in the client’s decision to conceal a transaction with this party. Such transactions often resulted in inflated asset values.

Internal controls. In 24% of the cases, the SEC alleged the auditors over relied on internal controls. It said that they typically had failed to expand testing in light of identified weaknesses in the client’s internal controls. In other cases, the auditors seemed to implicitly assume the presence of a baseline level of internal controls, even though the auditor documented that the client essentially had no controls in place.

Based on the deficiencies the SEC found, there are a number of areas that warrant specific attention from audit firms that do audits and from individual auditors themselves.

Audit issue: The three most common deficiencies all reflect engagement management problems affecting many areas of the audit:

A failure to gather sufficient, Competent evidence, lack of due care and

Lack of professional skepticism. In many cases

The best remedy for such problems is for auditors to develop a properly designed and executed quality control system. Such a system creates a culture that encourages all members of the audit team to maintain a baseline acceptable level of performance, regardless of perceived day-to-day engagement and firm pressures.

Audit firms should evaluate their own quality control systems to ensure policies and procedures emphasize the importance of proper audit planning, supervision and review, including timely involvement by engagement and concurring partners. Additionally, firms should reexamine existing quality control procedures to make sure they are detailed enough to assure firm leaders that audit teams are examining appropriate documentation

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(final documentation, not drafts) and that teams complete all audit program steps. Those procedures should emphasize that auditors should corroborate management representations with additional evidence and not overuse management inquiry as a form of audit evidence.

The firm’s “tone at the top:” Another means of reducing office-wide audit problems is to address the attitudes at the firm’s highest levels. Here are some values an audit firm’s managing partners should clearly communicate to their employees. Firms should

-    Define “client” to include not only management but also the entity’s board of directors, audit committee, stockholders and the investing public to ensure the audit team considers all affected parties throughout the engagement.

-    Signal to their audit teams that providing high quality audit services is a top priority and that the firm does not view such services as a commodity. A firm can do this by emphasizing the importance of audit quality in training programs and annual performance reviews.

-    Encourage all personnel to maintain an attitude of professional skepticism that focuses on the importance of the auditor’s role in protecting the public interest and maintaining strong capital markets. A firm can accomplish this by conducting periodic engagement-wide team meetings to discuss concerns about management integrity issues and by highlighting for staff members the risks of not being skeptical.

Performance measurement and compensation: Audit firms can benefit from closely examining their performance measurement and compensation systems. In many of the fraud cases, it appeared auditors simply chose not to pursue identified audit issues, perhaps fearing the time spent investigating those issues would hinder career advancement or result in penalties during salary and bonus reviews because they ran overtime budgets or missed client-imposed deadlines.

A clear message should be part of all personnel decisions (hiring, retention and promotion) that the firm values high quality audit services and that all other considerations—including time budgets, firm administration, development of nonaudit services and other practice development issues—are secondary. Firms also need to carefully evaluate whether fee and deadline pressures will have an impact on the audit team’s ability to deliver a high quality audit.

GAAP violations: Audit firms that perform audits can take a number of steps to reduce the incidence of GAAP violations among audit personnel, including

- Requiring specific internal firm consultation with technical A&A partners or industry specialists when certain accounting issues arise.

- Expanding the coverage of technical accounting topics and industry-specific requirements in firm-sponsored training courses to ensure audit personnel

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understand the nuances of GAAP, particularly those involving unique industry issues.

- Ensuring that firm personnel understand the provisions of SAS no. 69, The Meaning of Present Fairly in Conformity With Generally Accepted Accounting Principles in the Independent Auditor’s Report [GAAP hierarchy]. Implementing this recommendation might require the firm to develop or purchase guidance on implementing GAAP’s more obscure aspects.

Audit planning: Auditors can best remedy audit planning deficiencies by promoting more extensive and timely involvement by partners—both engagement and concurring—and managers in planning the engagement. Such involvement increases the likelihood the auditor will correctly assess risks (both inherent and control) and modify the firm’s audit approach (nature, extent and timing of tests) as appropriate. Involving the audit team partner and manager during the planning phase will help ensure that audit plans emphasize careful scrutiny of non routine transactions, particularly those recorded near yearend—when management sometimes records inappropriate transactions.

Management estimates: At a minimum, auditors need to carefully review the underlying data, assumptions and methods a company’s management used to develop financial statement estimates. An adequate review hinges on auditors with an appropriate level of both general and industry-specific expertise being involved. In cases of particularly complex or unusual estimates, specialists may be needed.

Confirming accounts receivable: Audit firms need to ensure their audit teams are effectively handling the confirmation process. Firms should remind team members to

- Confirm accounts receivable (unless conditions under SAS no. 67, The Confirmation Process, suggest confirmations would not be effective).

- Confirm an adequate portion of the receivables.

- Maintain control of the confirmation process.

- Employ alternative procedures when confirmations are not returned or exceptions exist.

Related-party transactions: To increase the likelihood of detecting related-party transactions, the auditor should:

- Prepare a list of related parties, continually updating it throughout the engagement and distribute it to all audit team members.

- Make inquiries of management regarding the existence of related-party transactions.

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- Confirm with the counter-party the nature and existence of material or unusual client transactions, including whether a relationship exists between the counter-party and the client or its management.

Once the auditor uncovers a related-party transaction, he or she has two additional responsibilities: 1) closely examine the transaction to make sure that it occurred and is correctly valued and 2) ensure the GAAP requirements (see FASB Statement no. 57, Related Party Disclosures) are satisfied.

Reliance on internal controls: In the SEC cases, auditors sometimes relied too much on internal controls by either failing to expand testing after discovering internal control weaknesses or assuming a baseline level of internal control existed even in the absence of any controls testing. This finding has implications for firm policy and quality control procedures, which should explicitly note the prohibition in professional standards against placing any reliance on controls unless they have been adequately tested. In addition, firms should more closely link internal control evaluations to substantive audit testing (the nature, timing and extent of such tests).23

7.2: BETTER AUDITS, LESS FRAUD

As financial and economic pressures tighten for corporate executives, it is more important than ever for auditors to develop sound fraud-detection audit techniques. The audit deficiencies alleged by the SEC between 1987 and 1997 are, in our view, issues the profession and individual firms can effectively address. The solution presented below may help firms reduce the chance of undetected material financial statement fraud as they strive to continually improve fraud risk assessment tools. The audit deficiencies the SEC identified also have important implications for standard setters as they seek to strengthen professional standards related to the auditor’s fraud detection responsibilities.

Security problems are on the rise—but that's not news. What is newsworthy, however, is the exponential nature of this increase. The Computer Emergency Response Team (CERT) says there has been an annual twofold increase in the number of vulnerabilities and security incidents reported. These numbers signify quite clearly the necessity of security management for all IT decision makers.

Knowing where a company stands currently on security practices is the first step in proactive security management, and a full security audit is the best way to achieve this goal. A security audit is a systematic way to test for vulnerabilities or weaknesses in the IT systems, policies, and procedures. When completed, an audit will provide a firm with a comprehensive picture of its security status. This will help assess current level of compliance or risk, and compare these levels with where the firm need or want security to be.

23 Summary of responsibilities of Pakistani auditors is given in annexure 1.

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Most failures can be attributed to poor compliance with practices and procedures. A recent audit of federal government agencies found that the major failing points were poor password control, end-user security practices and policies, and access controls.

CHAPTER 8

ETHICS IN ACCOUNTING

Accounting programs have become largely technical in nature, suggesting that instruction in ethical behavior has gone by the wayside. Part of this assertion is valid. The Accounting Principles Board (APB) averaged only two Opinions per year during its existence (1958-1973), but the Financial Accounting Standards Board (FASB) has generated 147 Statements, not counting Interpretations, and the SEC has issued a plethora of regulatory pronouncements.

Many of the recent culprits who have disdained ethical behavior occupy influential positions, such as CEO, CFO, and senior partner. They appear to have adopted actor Michael Douglas's infamous words, "Greed is good," in the movie Wall Street. And they seem to have no qualms about taking unethical steps, disregarding the harm to employees, investors, their profession, or even themselves during their pursuit of wealth and prosperity. Accounting programs have become largely technical in nature, suggesting that instruction in ethical behavior has gone by the wayside. Part of his assertion is valid.

Let's not omit two institutions that must share some blame in the Enron disaster. We cannot save harmless the SEC, our regulatory body, from the Enron/Andersen debacle. The SEC feigned being understaffed while knowing that problems existed at Andersen and that earnings at Enron, an Andersen client, grew exponentially. The SEC wasn't being alert as the public watchdog. And now the FASB seems to have divorced itself from the "substance over form" premise its predecessor (the APB) observed. The failure of the FASB to require the full consolidation of Special-Purpose Entities (SPEs) when the parent entity clearly exercises control is unforgivable. The FASB provided Enron with the allowable accounting treatment to accomplish its objective-increase earnings while not disclosing material debt guaranteed by the controlling entity.

Finally, we must look at the profession itself. Both the SEC and the AICPA found no fault with CPA firms providing lucrative consulting services to their audit clients. The value of an unqualified audit opinion seems to have virtually eroded to that of a commodity, while the largest fees are generated by a variety of consulting services provided by CPA firms. The profession and even many in academia booed when Abe Brilloff said that CPA firms should limit their scope of services to audit clients lest they face a conflict of interest.

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The unqualified audit opinion must again be elevated to the highest level of reverence. And the reader of the audit report must be able to rely on the integrity of that report and the firm that issues the report. The profession must return to the cornerstones that gave it the respect of the financial community-independence, integrity, and objectivity.

This restoration can only be achieved by the mutual collaborative efforts of the profession, the private and regulatory communities, and the academic community. While the Sarbanes/Oxley Act isn't perfect, we have to accept it as a starting place to begin working together to restore the financial community's confidence in our profession.24

All these, have contributed to the disregard for ethical values.

24 Roland L. Madison (2003), Is failure to teach ethics the causal factor?, Article

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CHAPTER 9

RECOMMENDATIONS

Now days the extent of financial fraud is increasing considerably. Basically by exploiting the loopholes in the exercised financial principles and policies. Audit cases due to negligence and misfeasance have occurred throughout the last 150 years or so and so-called corporate scandals committed in 2001 and onward like Enron and WorldCom are red signals for other similar events which we could come across if the practiced principles are not soon revisited in the light of the present financial requirements to restrict their fraudulent use. The loopholes thus found should be eliminated or at least steps should be taken towards this process.

Some times the reason for these fraudulent activities is that the employees don’t know what is actually unethical. They do follow the legal requirements but fail to fulfill their ethical duties. The organizations should introduce training programmes, booklets, contractual agreements in which employees are specifically told and trained about what is acceptable by the company; over and beyond the legal requirements. To bring about a shift in the accounting and financial practices overall, ethic’s courses should be introduced as a part of all finance and accounting degrees and the courses should be molded specifically to financial and accounting practices. So that the future finance and accounting experts know how to deal with in these boundaries and more importantly what these boundaries are.

The fraudulent accounting practices get by more easily when internal and external auditors are the same. Basically the auditor’s opinions help the investors in deciding about the authenticity of the financial reports. In cases where the external and internal auditors are the same the reports are manipulated as per company requirements or mistakes are overlooked which through the double check (In cases where external and internal auditors are different) would have come forward. So it should be made essential for firms to have separate internal and external auditors.

Although the responsibilities of an auditor are many as stated above and the stakeholders, who include shareholders, investors, creditors, regulators, tax and other authorities, employees, debtors, general public etc., have great expectations from the auditors. There is no doubt that the auditors’ opinion enhances the credibility of financial statements by providing a high, but not absolute, level of assurance that such financial statements are free from material misstatement. Absolute assurance in auditing is not attainable as a result of such factors as the need for judgment, the use of testing, the inherent limitations of any accounting and internal control systems and the fact that most of the audit evidence available to the auditors is persuasive rather than conclusive in nature. And the entire process should be more transparent for better understanding of the conclusion reached or figures presented.

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There is a high risk that financial statements which have been audited and have not been printed and published by incorporating the annual report, have no direct or indirect link with the relevant auditors’ report as auditors sign the auditors’ report only with the strong belief that the responsibility for the preparation and presentation of attached financial statements are that of the management of the company. The stakeholders are not comfortable with this attitude of the auditors because the financial statements, which are attached with auditors’ report, may be changed by the management when submitted to the stakeholder e.g. creditors etc, with incorrect numbers and disclosures. This attitude of the auditors and the decision of ICAP is the big departure from the core responsibility by loosing credibility and creating rooms for occurrence of corporate scandals in Pakistan.

I recommend that stakeholders of such type of companies, who do not print and publish annual reports, should be asked by SECP to get audited financial statements along with auditors’ report, in original directly from office of the auditors against payment of stationary charges legally. It should be made compulsory for the companies like Dewan Farooq who do not publicly issue their financial statements to do so in the interest of the investors.

The ideas contained here are not the complete solution. Even if all of them would be adopted in some form, we still would have to recognize that there is no mechanism that could prevent all financial statement fraud. Still, traditional accounting approaches have failed so far to solve these difficult problems. But if we do what we’ve always done, we’ll get what we’ve always gotten.

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CONCLUSION

In this paper I have discussed what are the frauds are committed through financial statements how they are committed and what procedures are followed to unveil them. All this information not only helps us to know that their fraudulent practices being carried out there (which I won’t follow my self after knowing the way to do them) but also what are the gaps in the present financial principles.

The thing to notice is these gaps can be removed to prevent and restrict these fraudulent practices but it is not being done and the fraud through finance and accounting is increasing.

All I can say is that the companies them selves should induce ethical practices in their culture to nip the problem in the bud. We know it is possible that the honest man not grow rich so fast as the dishonest one; but the success will be of the truer kind, earned without fraud or injustice. And even though a man should for a time be unsuccessful still.

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