Question

Select and discuss an area of financial statement fraud.

Answer 1

Net income can be a very important area of financial statement fraud.

Most cases of fraudulent financial reporting involve making the financial statements rosier than they actually are.There are a number of ways that this can be accomplished:

• Overstating revenues
• Understating expenses

Net income = Revenues - Expenses.

Revenues can be overstated by :

• Recording fictitious revenues:Fictitious revenue can be created by recording sales to customers who do not exist or by recording inflated sales to actual customers
• Premature recognition of revenues: recording revenues even before the revenues have been earned by providing services or selling goods.
• Understating sales returns: If sales returns are understated, or not recorded at all, net sales revenues would be overstated.

Expenses can be understated by:

• Deferring expense recognition : The matching principle demands that costs incurred by the business be recorded as expenses on the income statement in the period in which the related revenue is earned. If the expenses are recorded in an accounting period later than the one in which the related revenues were generated, net income will be overstated.
• Treating revenue expenses as capital expenses: Expenses which benefit the firm for the current reporting period are revenue expenses, while those which will bring economic benefits over a period of time are to be capitalized.Capitalization of expenses has the effect of shifting expenses from the income statement to the balance sheet.If a company is engaged in fraudulent financial reporting, it may decide to capitalize expenses improperly to overstate income.