Companies need to engage in ethical accounting practices. Engaging in ethical accounting practices ensures that the financial reports reflect the true financial position of the company. However, several companies usually engage in accounting malpractices. These companies may conceal or exaggerate certain information to portray a false image of their financial position. Financial scandals have brought to light some of the financial malpractices of various companies. These include Enron and WorldCom. In both cases, the discovery of massive financial malpractices led to the collapse of the companies. This highlights the importance of engaging in ethical accounting practices. Some of the unethical accounting practices include inflating technology leases, understatement of income, and fraudulent cash management.
Technology leases seem inflated
Leasing is one of the most popular methods of acquisition of business property. The popularity of leasing arises from the fact that it offers flexibility and it has various economic advantages over ownership of property. Leasing provides the lessee with 100% financing. On the other hand, traditional credit purchase requires the borrower to make an initial equity investment. Leasing protects the lessee from obsolescence. Leasing provides the lessor with a steady flow of payments, which in most instances are above the commercial lending rates. When the lease elapses, the lessor remains with a residual value (Epstein & Jermakowicz, 2010). The significance of the leased property in business operations necessitates its proper accounting.
Under the US GAAP rules, there are two major classifications of lease contracts. These include capital and operating lease contracts. Capital leases are leases where the lessee bears a substantial amount of the risk and rewards that are comparable to ownership of the leased asset. GAAP rules classify all other types of leases as operating leases. GAAP rules view leased property as purchased property. Therefore, the lessee should treat the leased property as purchased property. In addition, the lessee should treat payments to the leased assets as liabilities of the leased assets. On the other hand, organizations should not treat operating leases as assets or liabilities. Therefore, they do not appear on the balance sheet. Companies should treat operating leases as expenses (Kieso, Weygandt & Warfield, 2010).
Inflating technology leases lead to the statement of false values in the financial statements. This ultimately affects the taxation of the company. Fraudulent activities may make an organization face charges from the Securities and Exchange Commission (SEC). This is because fraudulent activities may affect the timing of incomes in the financial reports of a company.
Customers may be a source of red flags of fraudulent activities. Questions from many customers regarding the billing or equipment may be a red flag for fraudulent activities. Managers, banks, and lessees are the major parties that are involved in fraudulent activities on inflation of technology leases. An organization can minimize fraudulent activities by conducting frequent internal audits. In addition, separation of duties helps in minimizing inflation of the value of leases.
Understatement of e-commerce state tax payments
E-commerce forms a sizeable percentage of most company’s sales. In some instances, it may be the only means of selling the products of a company. Therefore, a company needs to have a proper accounting of all e-commerce transactions. Various companies have taken advantage of developments in e-commerce to conceal their ill-gotten gains. The US GAAP requires entities to have a proper accounting of all transactions that may affect the current and future taxation of the entities (Wells, 2011).
Engaging in fraudulent activities implies that a company is understating its income. This makes the company pay less tax on its income. E-commerce may present opportunities for companies to engage in fraudulent activities. The inability to track e-commerce payments makes it hard for authorities to detect fraudulent activities (Wells, 2011). This is one of the major factors that make e-commerce a suitable method for fraudsters to conceal their activities.
For an organization to reduce fraud must reduce or eliminate factors that motivate people to engage in fraudulent activities. Some of the factors that make people engage in fraudulent activities include opportunity, pressure, and rationalization. It is extremely difficult for an organization to understand the rationalizations and pressures that make employees engage in fraudulent activities. Therefore, organizations should strive to reduce or eliminate opportunities for engaging in fraudulent activities (Wells, 2011). One of the most efficient methods of reducing or eliminating opportunities for engaging in fraudulent activities is the implementation of internal controls.
Companies that understate their e-commerce payments usually have cash flows that do not correlate with earnings. This is one of the major red flags for fraudulent activities. In addition, failure to provide records of all e-commerce transactions may be a red flag for fraudulent activities. Concealing certain records leads to an understatement of e-commerce transactions. In addition, unexplained earnings may be a red flag for fraudulent activities (Wells, 2011). Ideally, an organization should be able to account for all its earnings via e-commerce.
An organization can prevent fraud by ensuring there is the proper authorization of various transactions. Continuous monitoring and control of information and communication are the major internal control measures that help in preventing fraud. In addition, an organization should ensure that there is sufficient separation of the duties of employees. Compliance with Payment Card Industry (PCI) Data Security Standards also helps in reducing fraud (Wells, 2011).
Fictitious employees receiving post-employment benefits
Employers should offer their retired employees post-employment benefits. Usually, employers contribute a certain amount of money towards meeting the costs of their post-employment benefits. According to GAAP, an employer should offer post-retirement benefits that are following the periodic contribution of the employer. The employer uses various actuarial methods to determine the amount of post-employment benefit that it should offer its employees (Singleton & Singleton, 2010).
The GAAP rule on post-employment benefits was not sufficient in preventing companies from creating fictitious employees. Organizations may create fictitious employees and offer them periodic payments. The creation of fictitious employees makes organizations lose huge sums of money. Creating fictitious employees makes employers pay fewer taxes since the contributions are tax-deductible. Therefore, an organization needs to scrutinize the human resource files to determine people who are eligible for post-employment benefits.
Lack of voluntary deductions for health insurance and other deductions that are normal for other employees is one of the most common red flags for fictitious employees receiving port-retirement benefits. In addition, the employer may provide high withholding exemptions for income taxes. The employer deliberately takes this measure since the fictitious employees do not have genuine taxation information. Fictitious employees also have duplicate bank account numbers. Data for the fictitious employee may also match other logical databases in the company. Fictitious employees do not usually receive salary adjustments or promotions (Wells, 2011). This is because scrutiny involved in undertaking salary adjustments or promotions may lead to the discovery of the fictitious employee.
To discover a fictitious employee, the auditors should meet the individual and undertake a thorough inspection of the identification documents issued by the government. In addition, auditors may search for proof of the work performance of the individual. In some instances, this may involve only inspecting the individual’s work area. Audit of the eligibility of employees may also help in discovering fictitious employees. The payroll manager and the human resource department are the major culprits in schemes involving fictitious employees (Wells, 2011). Therefore, schemes involving fictitious employees are common in organizations where these parties have a high degree of control in the process of hiring employees.
Hiding cash to meet analysts’ future expectations
Analysts usually estimate the future earnings of a company. These expectations shape the investors’ perception of the company. Therefore, it is vital for a company to meet the analysts’ future expectations. Failure to meet the analysts’ expectations may have devastating effects on the company. The drastic drop in the share price of Lucent Technologies Inc. shows how analysts’ expectations may affect investor confidence. In January 2000, failure to meet analysts’ expectations on its quarterly profits made Lucent’s share value in the market drop by a staggering $64 billion within three days. This was 30% of the company’s market value. In contemporary accounting practices, companies may hide their income to create a reserve that may help in meeting analysts’ future expectations. GAAP permits companies to create reserves for uncollectable accounts, warranties, and guarantees. In addition, GAAP permits organizations to create reserves that would help in restructuring future income. According to GAAP companies should create reserves when they are uncertain of the circumstances that would necessitate the use of reserves. Therefore, it is wrong for companies to create reserves to meet analysts’ future expectations. GAAP rules are inefficient in preventing earnings management. The SEC and the accounting profession appreciate the fact that various earning management techniques are not fraudulent. Accountants, investors, and analysts believe that managers should have good earnings management techniques (Magrath & Weld, 2002).
Managers engage in earnings management practices to smooth out their income. This is because volatile earnings usually lead to lower market valuation. Therefore, managers believe that they should time their investment, sales, expenditures, and financial decisions strategically. Fraudulent management of earnings usually deceives the financial community. However, the discovery of fraudulent management of earnings may jeopardize an organization’s position in the market. The Discovery of fraudulent accounting practices led to Enron’s bankruptcy (Magrath & Weld, 2002).
It is very difficult for outsiders to detect fraudulent activities in earnings management. This is because people who are responsible for earnings management usually strive to hide their activities. Cash flows that do not correlate with earnings are one of the obvious red flags for earnings manipulation. This is because proper recognition of earnings and cash flows should lead to the completion of the business cycle of an organization. Another red flag for earnings manipulation is receivables that do not correlate with revenue. Lack of correlation between the two entries may be an indication that a company is recording false sales or exaggerating its revenues. Having allowances for uncollectible accounts that do not correlate with receivables is another red flag for earnings manipulation. Unrealistic growth in receivables may also provide evidence of premature recording of revenues. The creation of acquisition reserves for questionable purposes may also provide evidence of earnings manipulation. Ideally, companies should create reserves for engaging in good business practices. Companies may create reserves for warranties, guarantees, or future commissions. However, if there are questionable changes in the reserve accounts, the company may be engaging in earnings manipulation. Meeting analysts’ expectations consistently may also provide evidence of earning manipulation. Companies that engage in earnings manipulation ensure that they meet the growth expectations of analysts (Magrath & Weld, 2002).
To prevent the above red flags from occurring, companies need to understand the difference between good earnings management and fraudulent earnings management. Companies should ensure that their financial reports reflect their true financial position. In addition, auditors and investors should help uncover fraudulent accounting practices by knowing the difference between good accounting and fraudulent accounting practices (Magrath & Weld, 2002).
Concealing inventory shrinkage
Most companies have three major types of inventory. These include raw materials, semi-finished goods, and finished products. The amount of inventory determines the company’s ability to meet its production needs and customers’ orders. Companies should ensure that the amount of inventory would ensure that their operations run smoothly. Different industries have different levels of inventory due to the nature of their activities. Companies may report incorrect values of inventory to conceal shrinkage in the inventory. This would make the inventory levels of the company comparable to the acceptable levels in the industry. Reducing levels of inventory help in releasing capital for other business activities (Singleton & Singleton, 2010).
GAAP requires companies to state and value all their inventory reserves. A company should record the lower value of the inventory according to the cost or market valuation of the inventory. However, this does not deter companies from concealing their inventory. Concealing inventory is one of the most common accounting frauds in the business world. This is because it is easy to manipulate the values of inventory. However, it is very hard for outsiders to detect. Inflating values of inventory increases a company’s bottom line. This is because companies do not account for the inventory during the current financial period. Companies defer accounting for the cost of inventory indefinitely. This makes inflation of inventory one of the most attractive methods of concealing fraudulent financial activities. Inflating values of inventory may conceal the shortages that may arise due to the theft of items by the company’s employees (Singleton & Singleton, 2010).
Altered inventory records are one of the major red flags of concealing shrinkage of inventory. Other red flags of concealing inventory shrinkage include forced reconciliation and false sales and accounts receivables. A company may also use physical padding to conceal inventory shrinkage. Physical padding involves packing empty boxes to make them resemble boxes that contain items. To prevent inventory shrinkage a company should undertake a thorough audit of the inventory (Singleton & Singleton, 2010).
In addition, companies should have accurate records that account for every transaction to prevent managers from concealing inventory shrinkage. Companies should have measures that ensure various parties cannot alter the inventory records. Physical safeguards may also prevent managers from concealing inventory shrinkage. Physical safeguards involve protecting the inventory from theft by outsiders or employees. Companies may also implement methods that help in tracking inventory (Singleton & Singleton, 2010). Radiofrequency identification (RFID) is one of the methods that may help in tracking inventory.
GAAP strives to ensure that companies engage in ethical accounting practices. However, this does not deter companies from engaging in accounting malpractices. Companies engage in unethical practices when it seems to favor them. Companies may provide wrong accounting information or conceal certain information. Thorough auditing would lead to the discovery of the malpractices.
Epstein, B.J. & Jermakowicz, E.K. (2010). WILEY interpretation and application of international financial reporting standards 2010. Hoboken, NJ: John Wiley & Sons.
Kieso, D.E., Weygandt, J.J. & Warfield, T.D. (2010). Intermediate accounting: IFRS edition, Volume 2. Hoboken, NJ: John Wiley & Sons.
Magrath, L. & Weld L.G. (2002). Abusive earnings management and early warning signs. The CPA Journal, 72(8), 50-53.
Singleton, T.W. & Singleton, A.J. (2010). Fraud auditing and forensic accounting. Hoboken, NJ: John Wiley & Sons.
Wells, J.T. (2011). Corporate fraud handbook: Prevention and detection. Hoboken, NJ: John Wiley & Sons.