Question

1. Examine the differences and similarities between the U.S. GAAP and IFRS valuation methods on assets and liabilities.

2. How could these differing methods affect the probability of fraud occurring in valuing assets and liabilities?

3. How do the different valuation methods affect the results of auditing assets and liabilities, and what could be done to improve these auditing results?

Answer 1

A major difference between IFRS and GAAP accounting is the methodology used to assess the accounting process. GAAP focuses on research and is rule-based, whereas IFRS looks at the overall patterns and is based on principle.

With GAAP accounting, there’s little room for exceptions or interpretation, as all transactions must abide by a specific set of rules. With a principle-based accounting method, such as the IFRS, there’s potential for different interpretations of the same tax-related situations.

The following table offers a side-by-side comparison of the two standards.

	US GAAP	IFRS	Impact
Inventory Valuation	Permits LIFO, FIFO, weighted average cost, or specific identification. Inventory carried at lower of cost or market.	Permits FIFO or weighted average cost; LIFO not permitted. Inventory carried at lower of cost or net realizable value.	Companies that use LIFO must revalue inventory, which could result in major tax liabilities due to the IRS’s LIFO conformity rule.
Asset Impairment	Two-step impairment.	Single-step impairment.	Write-downs are more likely under IFRS.
Asset Valuation	Assets can be written down, but not written up. PP&E is valued at historical cost.	Allows upward revaluation when an active market exists for intangibles; allows revaluation of PP&E to fair value.	Book values are likely to increase under IFRS.
Research & Development	R&D costs must be expensed.	Allows capitalization of R&D costs.	Development costs will be deferred and amortized.
Securitization	Allows certain securitized assets and liabilities to remain off a corporation’s books.	IFRS requires most securitized assets and liabilities to be placed on the balance sheet.	May result in very different balance sheet values.
Financial Instrument Valuation	Fair value based on a negotiated price between a willing buyer and seller; not based on entry price.	Several fair value measurements. Fair value generally seen as the price at which an asset could be exchanged.	Financial assets and liabilities will be measured differently.
Depreciation	Methods allowed: straight-line, units of production, or accelerated methods (sum of digits or declining balance). Component depreciation allowed but not commonly used.	Allows straight-line, units of production, and both accelerated methods. Component depreciation required when asset components have different benefit patterns.	Assets with different components will have differing depreciation schedules, which may increase or decrease assets and revenue.

Asset Overstatement/Liability Understatement Schemes

Improper reporting of assets is another way for companies to overstate earnings. A direct relationship exists between overstatement of assets/understatement of liabilities on the balance sheet and the inflation of earnings. The WorldCom scandal for example, exemplifies how expenses improperly capitalized as assets on the balance sheet can serve to inflate income.   In many cases, perpetrators are looking for a place on the balance sheet to place the debit. Overstating an asset or understating a liability usually occurs with this scheme. Accounts such as inter-company and foreign currency exchange gain/loss should not be overlooked as potential places to hide the debit.

Common asset overstatement fraud schemes include:

• Creating fictitious assets;
• Manipulating balances of legitimate assets with the intent to overstate value;
• Understating liabilities or expenses, including failing to record (or deliberately under estimating) accrued expenses, environmental litigation liabilities and other business problems;
• Misstating inter-company expenses; and
• Manipulating foreign currency exchanges.

An auditor can often become alert to the possibility of fictitious or over inflated assets by inquiring as to whether the entity intends to secure financing. If the answer is yes and if that financing is contingent on the value of particular assets such as receivables or inventory, that should lead the auditor to ask more questions and perform additional procedures to verify the existence, and location and value of these assets. As with certain other schemes, the auditor can most often detect these schemes by observing the company’s operations and inquiring as to unusual items.

Inventory Schemes

The original COSO Report found that fraudulent asset valuations comprised nearly half of the cases of financial fraud statements. Misstatements of inventory, in turn, comprised the majority of asset valuation frauds.

Generally, when inventory is sold, the amounts are transferred to cost of goods sold and included in the income statement as a direct reduction of sales. An overvaluation of ending inventory will understate cost of goods sold and in turn, overstate net income.

Inventory schemes can generally fall into three categories:

• Artificially inflating the quantity of inventory on hand;
• Inflating the value of inventory by

1. Postponing write-downs for obsolescence);
2. Manipulating unit of measurement to inflate value;
3. Under-reporting reserves for obsolete inventory, especially in industries where products are being updated or have a short shelf life; and
4. Changing between inventory reporting methods (average costing, last invoice price, LIFO, FIFO, etc.);

• Fraudulent or improper inventory capitalization.  

Following are indicators an auditor can look for to detect possible inventory manipulation:

• A gross profit margin which is higher than expected;
• Inventory that increases faster than sales;
• Inventory turnover that decreases from one period to the next;
• Shipping costs that decrease as a percentage of inventory;
• Inventory as a percentage of total assets that rise faster than expected;
• Decreasing cost of sales as a percentage of sales;
• Cost of goods sold per the books that do not agree with the company's tax return;
• Falling shipping costs while total inventory or cost of sales have increased; and
• Monthly trend analyses that indicate spikes in inventory balances near year-end.

Accounts Receivable Schemes

Companies can manipulate accounts receivable with the same techniques that they can manipulate inventory; that is, by creating:

• Fictitious receivables; and
• Inflating the value of receivables.

Analytics that may assist in detecting overstated receivables include:

• A decrease in the company’s quick or current ratio;
• Unexplained decrease in accounts receivable turnover
• Unexplained increase in days sales outstanding; and
• An increase of the ratio of credit sales to cash sales.

Fictitious Investments

Fictitious investments are similar to the creation of other fictitious assets. Indicia include:

• Missing supporting documentation;
• Missing brokerage statements; and
• Unusual investments (i.e., gold bullion) or ones held in remote locations or with obscure third parties.

Follow up procedures an auditor can conduct include:

• Confirming the existence of the investment by physical inspection or by confirmation with the issuer or custodian;
• Confirming unsettled transactions with the broker-dealer;
• Reviewing the minutes of board of directors meetings and the company’s Treasury policies to ensure that all investments were authorized by the Board and that company policy was followed in the trading of and investment in securities; and
• Reviewing internal controls to ensure that the duties of purchasing, recording, and custody are adequately segregated.