The warning signs
Auditors need to check for warning signs when reviewing the financial statements of a company. There are several red flags that the auditor can check. A large change in the values reported is the first red flag. The second red flag is changing the external auditor. The third one is ambiguities in reporting and changes in footnotes. Similarly, there are a lot of warning signs that auditors need to check.
Recording of revenues before they are earned is the first warning sign. In this case, a company can recognize the whole amount of income expected before the execution of a contract or recording revenue that is more than the contract amount.
The warning sign guides auditors in determining if the revenues reported are earned. The second sign is the record of bogus revenues. In this case, a company can define revenues that lack economic value or inflate revenues. The warning sign aids auditors in ascertaining that all revenues are correctly estimated and that they arise from the permitted transactions.
The third sign is escalating income using activities that cannot be sustained. This entails recording transactions in wrong accounts. It guides the auditors in ensuring that all revenues from unusual activities are entered in the correct book of account and are properly disclosed.
The fourth sign is moving expenses, which relate to the current period, to future periods. This can be in the form of capitalizing operating expenses, failing to write-off valueless assets or increasing the period of depreciation. It guides the auditors in reviewing the cut-off period for expenses.
The fifth sign is “employing other techniques to hide expenses or losses” (Schilit & Perler, 2010, p. 137). This contains failing to record expenses to reduce tax liability. This type of manipulation may be difficult to detect though it guides auditors in ascertaining if all expenses are disclosed.
The sixth sign is recording income that related to current period to future periods, which understates the current income. It guides the auditors in defining the cut-off period. The final warning sign is recording expenses that relate to future periods in the current period. This reduces current earnings and guides the auditors in reviewing the cut-off period for income (Schilit & Perler, 2010).
Earnings manipulation
One way of manipulating earnings of a company is increasing the cash flow from operations using activities that cannot be sustained. This can be achieved by “failing to segregate unusual and non-recurring gains or losses from recurring income” (Schilit & Perler, 2010, pp. 93 – 95). Such income often arises from one a -time sale of an operating business unit or a manufacturing plant.
For instance, in the financial statements for the year 1999 of IBM, the company recorded $4.057 billion as a reduction of the selling, general, and administrative expenses. The gain was received from the sale of Global Network Business to AT&T. The improper recording of this transaction resulted in a decline of the selling, general, and administrative expenses by 11.6% and a corresponding increase in operating income by 30.2% (Schilit & Perler, 2010).
The managers’ motivation in this scheme was to conceal the declining financial performance of the company. During that period, the company’s costs were growing faster than revenue. Therefore, the management wanted to hide the declining performance of the company from various stakeholders. These actions can be detected by the auditor by reviewing the percentage change of different items in the income statement over the years.
For instance, it can be observed that the revenue grew by 7.2% between 1998 and 1999. The cost of sales increased by 9.5% while gross profit increased by 3.4%.
However, the operating profit escalated by 30.2% from the previous year (Schilit & Perler, 2010, pp. 93-95). It is worth noting that there is a large inconsistency between the change in gross profit and operating income. Therefore, by observing the consistency of the values, an auditor will be able to point out the fraud.
Reference
Schilit, H., & Perler, G. (2010). Financial shenanigans: Detecting accounting gimmicks that destroy investment. New York, NY: McGraw Hill Publishers.