1.

Manipulating Timing

The matching principle in accounting provides guidelines for when transactions should
be recognized and recorded. In its most basic form, revenues and expenses should
be recorded in the period in which the transaction occurred or the period in which the
benefit is obtained and, where possible, the expenses associated with a revenue item
should be recorded in the same period.

There are two ways of manipulating timing. Both methods make the current period
look good, but will cause problems in the next period.

(i) The early recognition of revenues – bringing revenues from a later period into the
current period, increasing revenues for the current period.
(ii) Postponing expenses – delaying booking expenses to the next period, decreasing
the expenses and raising profits for the current period.

The alternative is to reverse these methods to make the current period look worse and
the next period look better.

(i) Early Recognition of Revenues

Businesses will have a policy stating when revenue (sales) should be recorded. The
early recognition of revenues is achieved by manipulating these policies to either
record sales that were made in the early part of the next period in the current period,
or record transactions that should not yet be recognized as sales.

Sales may be recorded when stock is shipped to customers, so some schemes involve
shipping stock to customers when that stock has not been ordered and knowing that
it will be returned. The sale is recorded when the stock is shipped, and reversed when
the stock is returned early in the next quarter, but the earlier period has been closed
and the results reported. If you cannot ship the stock directly to the customer – for fear
or raising suspicion – you may ship it to a third party warehouse to ‘hold’ for the
customer. It can stay there almost indefinitely.

A sale may be recorded when the invoice is issued. To be able record a sale early, an
invoice is issued early, even when there is no sale and no transfer of stock. Sending
the invoice to the wrong address, so that it will be returned to you some days later, or
holding it in a bottom draw, will save sending the invoice to the customer. This is
commonly used when the stock is to be delivered in a later period, but someone wants
the sale recorded in this period.

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A sales may be recorded when an order is received even if the order is not to be filled,
and the actual sale will occur, until a later period.
If the recording policy cannot be manipulated, the fraudster may simply record a sale
based on some other action. The more common approaches are:

(a) recording a sale when there are still items or services to be provided;
(b) recording a sale before the sale contract has been finalized and before shipment
to customers:
(c) recording a sale when items are sent on consignment, on approval, or with a right
of return;
(d) recording a sale to associated parties; or
(e) recording a sale when an order is received
(f) issuing invoices for non-existent sales and recording the transaction.

(ii) Postponing Expenses

Recording expenses in a later period is just as simple. Accounting standards state that
expenses should be recognized in the period in which the related benefit is recognized.
Expenses and their associated liabilities should be recorded when a legally binding
obligation has been created. Most businesses will also have policies about when
expenses should be recorded and paid.

The fraud involves postponing the recording of expenses until the next period. The
business may only record expenses after the invoice arrives from the supplier. To
postpone the expenses, the receipt of the invoice is not recognized. It may be held in
an Inbox until the start of the new period.

Expenses may be recorded when the expense is finally paid, in which case the
expense is not paid until the next period and recorded at that time. Large expenses
may be improperly capitalized and written off over a period instead of being expensed
in the current period, or capitalized expenses may be written off (depreciated or
amortized) over a longer period than appropriate. This lessens the amount recorded
as expenses in the current period and puts some of the expense is later periods.

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These actions raise the profits in the current period. Doing the scheme in reverse
(delaying recording sales and recording expenses early) lowers a profit in order to
reduce a tax liability.

2. Falsifying Entries

Schemes that manipulate the timing of recording transactions affect real transactions.
The schemes detailed in this section involve and produce false entries on either real
or fictitious assets or liabilities. They commonly fall into the following areas:

(i) Fictitious revenues

(ii) Manipulating liabilities and expenses
(iii) Valuing assets

(i) Fictitious revenues

Fictitious revenues can be created by:

(a) inventing sales transactions; or

(b) classifying other incomes or gains as sales.

A business may enter into transactions that on paper appear to be sales, but when the
whole transaction is considered, they either lack any substance or do not create any
gain. The method used may depend of the trigger used to record sales. If that trigger
is the shipment of stock, you ship stock to someone and record a sale, albeit that the
stock was never ordered and will be returned. The account receivable associated with
that sale will be reversed at some later stage. Recording the return of the stock as an
expense and not against sales will maintain the high sales level.

If sales are recorded when orders are placed by suppliers, fictitious orders may be
created. Stock may be sent on consignment, but booked as a sale. Issuing fictitious
invoices for sales that never happened can create recordable sales in the current
period. They can be reversed in a future period.

Entire transactions may be invented that give the illusion of a transaction that creates
revenue. Small nonpublic companies do not have the regulatory bodies look at their
records. A entry into Sales (Cr) and Debtors (Dr) as an end of period adjustment
makes the company look healthier. This is usually done when the company needs to
send information to a financier to support loan applications. This is easier in a service
industry company, as there is no movement of stock in any transaction.

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Other non-revenue gains may also be recorded as sales. Investment income, capital
gains on the sale of assets and other onetime gains may be recorded as sales revenue
to make the core business appear healthy. Items like discounts and rebates from
suppliers and other non-revenue injections of money from loans etc. may also be
recorded as sales.

(ii) Manipulating liabilities and expenses

Manipulating or falsifying liabilities and expenses is done for the same two reasons as
the other schemes:

1. to make the company look better to increase share prices or for investment
purposes; or
2. to reduce the tax liability.

This can be done in a variety of ways.

 Moving a short term liability to long term liability improves the working capital
figures on the balance sheet. It is also used to indicate solvency when that may
not be the fact.
 Capitalizing expenses and writing them off slowly creates an asset that does
not exist and reduces the expenses in the current period. These capitalized
 expenses can then be written off over an extended period spreading the
expense.
 Not writing off assets when appropriate – usually debtors that become
uncollectible, or investments, stock or other assets that will depreciate or
fluctuate in value – keeps an ‘asset’ in the balance sheet when it has no or little
worth. These assets should be expensed when their value decreases.
 Moving reserves from the balance sheet reduces expense accounts on the
profit and loss account.

Understating provisions for contingent expenses makes a balance sheet appear

healthier. A business must either calculate various provisions (for bad debts, sales
returns, employee entitlements, tax etc.) and make allowance for them in the balance
sheet; or allow for known provisions that will cover more than one accounting period
(e.g. rectification work on a capital project, ongoing Court actions etc.).

These schemes may be used in reverse if the aim is to reduce a tax liability.

(iii) Valuing assets

There are many ways of inflating the values of or creating assets. The ones mentioned
below are just a few of them.

Inventory

Inventory can be the major asset owned by a business and can be one of the easiest
to manipulate. There are a few ways of doing this.

1. Value the inventory at a higher price than appropriate (at an inflated selling or cost
price) and count the correct amount.
2. Value the inventory at the correct amount and inflate the number of items.
3. Do both.

There may be some limitations on placing very high values on physical items of
inventory. Generic items would have a recognizable value. Valuing work in progress
has less limitations.

Gaining extra inventory for stock takes is done by either counting empty boxes stacked
high on shelves, moving inventory between warehouses so that it is counted multiple
times, obtaining inventory from a supplier on consignment or under some right of
return, or borrowing inventory from a friendly supplier.

Assets or expenses may be manufactured to hide money that has been

misappropriated, or ‘investments’ in other entities may disguise loans to various
parties. This is not done to manipulate the financial position of the company, but to
hide the real nature of certain transactions.

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Accounts Receivable
Accounts receivable are amounts that are due to the business, and that are expected
to be paid. This makes it a flexible concept as the expectation of payment is subjective.
Some businesses have debtors that have been with them for years. In fact, the debts
have never been written off as uncollectible. This practice improves the balance sheet
as the asset stays on the balance sheet and the bad debt expenses is not recorded.

Creating debtors and sales is a simple credit sales / debit debtors entry. This has the
same effect. Small businesses that do not have their accounts audited may be able to
get away with is when seeking finance. Creating false sales will usually have the effect
of increasing debtors.

Alternatively, writing off good debtors at the end of a period creates an expense and
lowers profits. You can simply write them back on when collected.

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Lessons to be Learned

The role of auditing was created so that an independent person could look behind the
financial statements and discover whether they were accurate. This is not an exact
science and the cost of an audit can be large. As costs constraints make test sample
sizes smaller, the chances that misstatements will slip through the examination
increases.

Financial statement frauds are committed within the business, not on the business.
The best way of preventing or detecting these frauds is a strong internal and
independent audit function. Internal and independent can seem contradictory, but it is
an idea that must become a reality.

Some of these frauds have originated from the pressure to get short term results. If
the consequences of not getting the results are too great, improper or illegal behavior
will increase. Corporate ideals have a large role to play in deterring these activities, by
making them unnecessary.

Financial Statement Fraud

 Falsifying, altering, or manipulating financial records, supporting documents, or

business transactions

• Recording fictitious transactions or transactions

that lack economic substance

 • Intentionally omitting or misrepresenting

information about transactions or events

• Intentionally misapplying generally accepted

accounting principles (GAAP)

These red flags include the following:

 Aggressive revenue recognition practices, such as recognizing revenue in

earlier periods than when the product was sold or the service was delivered
 Unusually high revenues and low expenses at period end that can’t be
attributed to the season.
 Growth in inventory that doesn’t match growth in sales
 Improper capitalization of expenses in excess of industry norms
 Reported earnings that are positive and growing but operating cash flow that’s
declining
 Growth in revenues that’s far greater than growth in other companies in the
same industry or peer group
 Extensive use of related companies
 Sudden increases in gross margin or cash flow as compared with the
company’s prior performance and with industry averages
 Unusual increases in the book value of assets, such as inventory and
receivables
 Invoices that go unrecorded in the company’s financial books
 Loans to executives or other related parties that are written off

1. Kenneth Boyd, Lita Epstein, Mark P. Holtzman, Frimette Kass-Shraibman,

Maire Loughran, Vijay S. Sampath, John A. Tracy, Tage C. Tracy, Jill Gilbert
Welytok

Part of Accounting All-In-One For Dummies Cheat Sheet