C IMPROPER ASSET VALUATION

1
C- IMPROPER ASSET VALUATION

• It is often necessary to use estimates in
  accounting. For example, estimates are used in
  determining the residual value and the useful
  life of a depreciable asset, the uncollectible
  portion of accounts receivable, or the excess or
  obsolete portion of inventory. Whenever estimates
  are used, there is an additional opportunity for
  fraud by manipulating those estimates.

2
C- IMPROPER ASSET VALUATION

• Many schemes are used to inflate current assets
  at the expense of long-term assets. The net
  effect is seen in the current ratio. The
  misclassification of long-term assets as current
  assets can be of critical concern to lending
  institutions that often require the maintenance
  of certain financial ratios. This is of
  particular consequence when the loan covenants
  are on unsecured or under-secured lines of credit
  and other short-term borrowings. Sometimes these
  misclassifications are referred to as "window
  dressing.

3
C- IMPROPER ASSET VALUATION

• Improper asset valuations usually take the form
  of one of the following classifications
• Inventory Valuation
• Accounts Receivable
• Business Combinations
• Fixed Assets

4
INVENTORY VALUATION

• Since inventory must be valued at the acquisition
  cost except when the cost is determined to be
  higher than the current market value, inventory
  should be written down to its current value, or
  written off altogether if it has no value. Other
  examples
• Failing to write down inventory results in
  overstated assets and the
• mismatching of cost of goods sold with
  revenues.
• Manipulation of the physical inventory count,
  inflating the unit costs
• used to price out inventory, failure to
  relieve inventory for costs of goods
• sold, and by other methods.
• The creation of fake documents such as
  inventory count sheets, receiving
• reports, and similar items.
• Companies have even programmed special computer
  reports of inventory
• for auditors that incorrectly added up the
  line item values so as to inflate
• the overall inventory balance.

5
INVENTORY VALUATION

• A friendly co-conspirator claims to be holding
  inventory for the company
• in question.
• Large value of inventory in transit is created,
  perhaps conveniently in the
• middle of the Pacific Ocean where it is hard
  for auditors to observe it.
• "Bill and hold" items that have already been
  recorded as sales might be
• included in the physical inventory count, as
  might goods owned by third
• parties but held by the company on
  consignment or for storage.
• Companies have even made up pallets of inventory
  with hollow centers,
• placed bricks in sealed boxes instead of high
  value products.
• Shuttled inventory overnight between locations
  being observed by auditors
• on different days, so as to double count the
  inventory.

6
ACCOUNTS RECEIVABLE

• Accounts receivable are subject to manipulation
  in the same manner as sales and inventory, and in
  many cases, the schemes are conducted together.
  The two most common schemes involving
• Accounts receivable are fictitious receivables.
• Failure to write off accounts receivable as bad
• debts (or failure to establish an adequate
• allowance for bad debts).

7
BUSINESS COMBINATIONS

• Companies are required to allocate the purchase
  price they have paid to acquire another business
  to the tangible and intangible assets of that
  business. Any excess of the price over the value
  of the acquired assets is treated as goodwill.
• Changes in goodwill accounting have decreased the
  incentive for companies to allocate an excessive
  amount to purchased assets, to minimize the
  amount allocated to goodwill that previously was
  required to be amortized and which reduced future
  earnings.
• However, companies may still be tempted to
  over-allocate the purchase price to in-process
  research and development assets, in order to then
  write them off immediately. Or they may establish
  excessive reserves for various expenses at the
  time of acquisition, intending to quietly release
  those excess reserves into earnings at a future
  date.

8
FIXED ASSETS

• Bogus fixed assets can be created by a variety of
  methods. They are subject to manipulation through
  several different schemes. Some of the more
  common schemes are
• Booking Fictitious Assets.
• Misrepresenting Asset Valuation.
• Improperly Capitalizing Inventory and Start-up
• Costs.

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Examples of fixed assets manipulation

• Create fictitious documents.
• Assets are leased, not owned, and the fact is not
  disclosed during the audit of fixed assets.
• Reporting of fixed assets at market values
  instead of the acquisition costs
• It is advantageous to understate assets this can
  be done directly or through improper
  depreciation.
• Capitalizing non-assets cost, a company finances
  a capital equipment purchase, monthly payments
  include both principal liability reduction and
  interest payments.
• Assets are sometimes misclassified into general
  ledger accounts in which they don't belong. The
  manipulation can skew financial ratios.

10
IMPROPER ASSET VALUATION RED FLAGS (1)

• Recurring negative cash flows from operations or
  an inability to generate cash flows from
  operations while reporting earnings and earnings
  growth.
• Significant declines in customer demand and
  increasing business failures in either the
  industry or overall economy.
• Assets, liabilities, revenues, or expenses based
  on significant estimates that involve subjective
  judgments or uncertainties that are difficult to
  corroborate.
• Non-financial management's excessive
  participation in or preoccupation with the
  selection of accounting principles or the
  determination of significant estimates.
• Unusual increase in gross margin or margin in
  excess of industry peers.

11
IMPROPER ASSET VALUATION RED FLAGS (2)

• Unusual growth in the number of days sales in
  receivables.
• Unusual growth in the number of days purchases in
  inventory.
• Allowances for bad debts, excess and obsolete
  inventory, etc. that are shrinking in percentage
  terms or are otherwise out of line with industry
  peers.
• Unusual change in the relationship between fixed
  assets and depreciation.
• Adding to assets while competitors are reducing
  capital tied up in assets.