[md27]

Hi All,

I’ve been studying for AUD, which raised some questions for me about the assertions. 1) We know a huge risk for asset accounts is the existence assertion as they’re more likely to overstate assets than to understate them. 2) We know a huge risk for expenses is completeness as they’re more likely to understate expenses than overstate them. My question is how would a company conceal this without causing reconciliation issues with the TB?

[NebCPA]

I’m not too sure what you mean by reconciliation issues with the TB. Are you saying that the financials would not reconcile to the TB? The TB would be incorrect which would drive the financials being incorrect.

If you wanted to misstate the financials, the asset you would choose is some type of receivable. That way you increase revenue and the asset account, and it’s not tied to an account which is typically confirmed or has a third-party statement (i.e. cash and investments). You can send confirmations to customers, but this is not typically done unless there is a customer which makes up a large majority of the A/R balance. A JE would increase both the receivable account and revenue account so the TB would be incorrect but everything would tie. You would reconcile the AR subaccount ledger to the G/L, but these would tie since you made a JE.

For expenses or liabilities, what you would want to do is understate accruals. In this case, the TB would just not include the transactions so would tie to everything. What you’re looking for is that year-end payroll, IBNR, legal outcomes, etc. are properly accrued and expensed. Any expenses paid in cash would not as large of a risk since the cash accounts would need to be reconciled each month. The completeness risk lies with not including a JE for accrued expenses.

[md27]

Wow.. great explanation @NebCPA. Makes sense now as I got caught up thinking that only the asset account would get changed, and not the AR AND revenue accounts for example. Because ultimately if it's literally only the asset account being overstated, then there would be TB issues as a TB should always equal $0 (Assets = Liabilities + Equity).

[md27]

Would you only need to accrue for payroll if they use a bi-weekly system?

[NebCPA]

You are correct that if only the asset account were increased then the TB would not balance. This seems unlikely as most accounting software would require a JE to net to $0 before the system would allow for the transaction to be posted. This would mean that the accounting system would either need to be paper based or the financials were created outside of the accounting software, which you won’t find in larger companies.

Payroll expense needs to be accrued for all days where employees worked but have not been paid out yet at year-end, so no, it is not limited to only bi-weekly payroll. If a company pays monthly on the 1st, then they would need to accrue for the entire month on Dec 31. The only time you would not find a payroll accrual would be if payroll was processed on Dec 31 of each year.

If the company chooses not to accrue for payroll, the amount would generally be small relative to the financial statements, so would not be material. The net effect on the financials would actually be current year accrual for December less last year’s accrual, since that would be recognized in January of the current year, because an accural was not performed last year, which would make the misstatement even smaller. An auditor would chalk it up to an immaterial non-GAAP policy.

[md27]

Thanks @NebCPA. Lastly, going back to overstating AR and revenue, this is simply to boost the ending balances to make the financials look better right (also could be to boost commission, etc.), so in the following year they will have to eventually write that bad debt off. So ultimately in the following year financials, you're just going to pay for that fraudulent activity from PY when you have to eventually recognize the bad debt expense and decrease in AR?

[md27]

A question that comes to mind is whether commission is paid when the sale is recorded or when payment from the customers are received? Wouldn't waiting till payments are received be appropriate to discourage fictitious sales to receive commission?

[Tim]

@mbell

After reading several of your posts I think you need to take a step back and look at the bigger picture and the auditor's responsibilities rather than trying to understand every possible way people can commit fraud and the minute details of how they go about doing it. The steps on how fraud is detected are more important than how the fraud is perpetrated. i.e. sampling documents and tracing them to the ledger and doing the reverse of tracing entries in the ledger to the supporting documents. Also ratio analysis, inquiry, observation, confirmation, etc.

[NebCPA]

A little long since you asked a couple questions:

If a company inflated its A/R and revenue in order to overstate its earnings for the year, then yes, in theory it would be detected the next year through the A/R aging report and the company would have to write the A/R off to bad debts the next year according to the company’s policy for bad debts.

Of course, if the company is willing to create fictitious journal entries, then there is no reason why it wouldn’t try to keep the scam going. The company could use lapping to apply new cash receipts to old accounts and keep its A/R aging low. The more aggregated its A/R accounts and cash deposits are the easier this would be. This is why segregation of duties is so important in fraud prevention. An auditor may be able to catch it through revenue testing by tying cash receipts to invoices, but cash deposits are typically aggregated into a single deposit and may contain thousands of transactions; furthermore, payments from other companies can often be for more than one invoice or a partial payment. An analytic may detect the fraud, but if the company is smart they will keep the fraud at less than 5% of the balance, so it doesn’t blow-up any analytic. Of course, while all fraud is material, if the company is keeping the fraud to below 5% and materiality then one could argue that the financials are not materially misstated and as such auditing techniques aren’t designed to find the fraud.

The A/R balance would, eventually, start increasing because new cash receipts would not be enough to cover the older fraud amounts that are accumulating, but if the company is growing this would take some time and the company could just take out debt and use a JE to hide the funds as receipts.

To quote Barry Minkow: “Accounts receivable are a wonderful thing”

For your commissions question, expenses are recognized in the same period as the revenues to which they relate, so when the sales event occurs and is measurable, the commission expense would be recognized by the company.

When the physical payment would occur would depend on the company. A company may pay out commission with each payroll run or may have a separate system which processes payments the 1st of each month. Since the company would be using accrual accounting, it may be easier to payout commissions when the revenue is recognized in the accounting system versus when cash is received, but the sales system may be different than the G/L so commissions may be ‘earned’ by the employee when the sales system is updated.

It really depends on the size and nature of the company and their internal policy, but the company would want a claw-back policy for any sales that eventually fall through, but that would be on the company and would be more of an operating provision. Typically for companies with a large number of commission employees, depending on size, the sales system would automatically net the commission inflows and outflow and payout the appropriate amount and the employee would get a commission statement to review each month which details their pay.

[Author]

Replies