CPA Hall Talk

Aug 22

Accounting Tricks Used to Inflate Earnings

By Charles Hall | Financial Statement Fraud

Companies can inflate earnings easily with accounting tricks such as cookie jar reserves.

This article explores how businesses inflate profits and sometimes decrease them, depending on the company’s desires.

Today, I show you how fraudsters alter financial statements to magically transform a company’s appearance. Then, you will know how to detect these tricks.

Inflate Earnings

Companies can inflate earnings by:

Accruing fictitious income at year-end with journal entries
Recognizing sales for products that have not been shipped
Inflating sales to related parties
Recognizing revenue in the present year that occurs in the next year (leaving the books open too long)
Recognizing shipments to a re-seller that is not financially viable (knowing the products will be returned)
Accruing projected sales that have not occurred
Intentionally understating receivable allowances

Think about it: A company can significantly inflate earnings with just one journal entry at the end of the year. How easy is that?

You may be thinking, “But no one is stealing anything.” Yes, true, but the purpose of manipulating earnings might be to increase the company’s stock price. Once the price goes up, the company executives sell their stock and make their profits. Then, the company can, in the subsequent period, reverse the prior period’s inflated entries.

Inflate Earnings: Control Weakness

Such chicanery usually flows from unethical owners, board members, or management. The “tone at the top” is not favorable. These types of accounting tricks typically don’t happen in a vacuum. Usually, the top brass demands “higher profits,” often not dictating the particulars. Then, years later, they plead ignorance once the fraud is detected, saying their lieutenants worked alone.

Such possibilities are why the control environment, an entity-level control, is so important. Ethical leadership is foundational to a company’s health. Additionally, controls such as codes of conduct and conflict of interest statements matter.

So, how can companies lessen the risk of earnings manipulation?

Inflate Earnings: Lower the Risk

Transparency is the remedy to someone inflating earnings.

This sentence sounds simple, but transparency usually removes the temptation to inflate earnings. When fraudsters believe they’ll get caught, they usually will not act.

A robust internal audit department can put some fear in the heart of fraudsters and provide additional transparency. The board should hire internal auditors who report directly to them. Moreover, the company’s internal auditors should know that the board has their back.

But what if board members don’t desire transparency such as the WorldCom fraud? Consider removing them, if possible.

Now, let’s consider whether a company might desire decreased earnings.

Deflate Earnings (Cookie Jar Reserves)

Though much less likely, some businesses fraudulently decrease their earnings. Why? The company may want to save current year earnings for future periods, especially if highly profitable in the current period.

For example, what if a company bases bonuses on profits and has high current-year earnings? Then management might defer some of the profits to the following period (to increase the possibility of bonuses in the next year).

Deferring earnings is called a cookie jar reserve.

For example, if a company’s allowance for uncollectible receivables is acceptable within a range (say 1% to 2% of receivables), it might use the higher percent in the current year. The higher reserve decreases current-year earnings (the allowance is credited, and bad debt expense is debited, increasing expenses and decreasing net income). Then, the following year, the company might use 1% to increase earnings (even though 1.75% might be more appropriate).

Such actions are called smoothing.

Inflate Earnings Summary

So, as an auditor, know whether your audit client desires higher or lower profits–or whether they want the numbers to fall honestly.

And be aware of fraud incentives such as management bonuses. Then, audit accordingly.

How to Audit Journal Entries

If you want to know how to audit for potential fraudulent journal entries used to inflate earnings, see Get a Grip on Journal Entry Testing.

Aug 04

Audit or Tax, Which is the Better Job?

By Charles Hall | Accounting and Auditing , Auditing

Should you work in tax or audit?

If you're near graduation, you may wonder, "Which is best for me? Tax or audit?”

In this article, I provide questions and facts for you to consider as you decide. This decision is one of the most important ones you'll make in your career.

Tax and Audit Career Decision

Here are some thoughts about that decision:

1. Do you like subjectivity or objectivity? Audits tend to have more subjective elements like risk assessment. Tax, on the other hand, tends to be more objective (it's compliance-oriented).

2. Are you willing to work long hours for four months each year? Tax season is an annual marathon. Auditing also has busy seasons, depending on the industries your firm services, but you can more easily distribute your workload in audits.

3. Do you like to travel? Audits usually involve some travel. Tax CPAs spend most of their time in the office, though not all.

4. Do you like accounting? If you work in public accounting, you must understand accounting well to do audits (and other A&A work). You also need to understand accounting for tax purposes, but tax work is more compliance-oriented.

5. Do you like saving individuals and companies money? Tax allows you to have a direct impact on taxes paid (and your clients will love you if you can save them money).

6. Do you like short-term or long-term projects? Tax work tends to be short-term, and audit work tends to be long-term. For instance, you might complete a tax return in four or five hours (sometimes less). Audits can take several hundred hours.

7. Do you like technology? Audits can involve technology more than tax work, though this is a generalization. With audits, you might, for example, use data mining software or Excel for advanced purposes.

Tax and Audit Compensation

You may be wondering which field offers the more significant compensation opportunities. I've seen auditors and tax folks make plenty of money through the years. So, you can do well with either. But being in the field best suited to you will enhance your ability to generate income. Why? Because happy people are more productive and effective. That's one reason choosing the right field--tax or audit--is critical.

Tax and Audit Work Hours

If you've worked in public accounting, you've seen tax people working late into the evenings and on weekends throughout tax season. The tax deadlines lead to compressed work schedules, especially in the early part of the calendar year. But tax people usually get relief in the summer or late in the year.

Audit personnel tend to have steadier workloads, though their work can also be seasonal. For instance, if you work with a firm that does governmental audits, there may be a substantial number of engagements with June 30 and September 30 year-ends, leading to increased workloads later in the calendar year. So check with the firms you interview with to see how the audit workloads vary.

Talk to Auditors and Tax Persons

Talking to auditors and tax people with real-world experience will give you more insight than almost anything you can do. Make a list of questions and ask them as you interview prospective CPA firms.

Learn About Auditing

If you want to learn about auditing quickly, check out my book The Why and How of Auditing on Amazon.

Jul 04

Why Accountants Use ChatGPT (or should be)

By Charles Hall | Technology

Accountants use ChatGPT—or if not, they should be. The old way of Googling for information is not the most efficient way to find answers. In this article, you’ll see why.

As an accountant, you’ve used search engines such as Google to look for answers. But you may not have used a chatbot such as ChatGPT.

While search engines are helpful, you can turbocharge your searches for information by using ChatGPT and its plugins (more in a moment). It’s somewhat like conversing with the Internet.

Additionally, ChatGPT was trained with web information, so it can draw upon that knowledge to provide answers to you without even "searching" the Internet. The training cut-off was September 2021. So, if ChatGPT uses only the training information, you may not obtain current information (that was placed on the Internet after September 2021).

But you can supplement the training information with with current information by using ChatGPT plugins such as WebPilot. Below I explain how.

First, I'll start with an explanation of search engines, and then we'll move to how ChatGPT enhances your ability to find accounting answers.

Search Engine

A search engine is a software system designed to conduct web searches, which means searching the World Wide Web systematically for certain information specified in a textual search query. The search engine provides a list of results, often called search engine results pages (SERPs).

Examples of search engines include:

Google
Bing
Yahoo

Crawling the Web

Search engines constantly crawl the web with spiderbots looking for changes, such as a new lease accounting article on my website, CPAHallTalk.com. When a search engine (e.g., Google) finds differences, it updates its index (catalog of all data)--often within hours after the website adds the information.

Accountant's Search Example

Googling involves your reviewing the list of articles that you might visit and your choosing one.

As an accountant, you’ve keyed in Google search terms such as ASC 842, Leases. The search engine provides you with a list of web articles that might be useful. After that (if you're like me), you click several links looking for the information you want, but the results are lacking. For example, you may want the wording for a lease disclosure, but you can't find one.

Chatbots Like ChatGPT

ChatGPT uses its training information and plugins to provide answers to you. It feels more like a conversation (than reviewing a list): you give it a prompt and it provides an answer.

As an example, you might tell ChatGPT:

Please provide an example of an operating lease disclosure using ASC 842, including future payments, discount rates, lease terms, and weighted average information. Also, tell me how to compute the weighted average details.

ChatGPT can provide the requested information (a sample lease note) and respond to your request for information about computing weighted averages.

But how does it do so?

ChatGPT-4: Obtaining Sources with Plugins

When you ask ChatGPT for a sample disclosure, it visits web pages using plugins like WebPilot, asking if the requested information is available. If CPAHallTalk.com's article has a sample lease disclosure, it can leverage that information in providing the example you requested.

If my lease article doesn't explain how to compute weighted average lease information, ChatGPT will search other websites. Once it finds the solution, it includes the computational directions in responding to your request.

WebPilot can provide sources of the information such as URLs, but you may need to tell ChatGPT that you want sources. (Simply say, "provide sources.") Then you can click the source and read the article. (One downside to ChatGPT is it often gives you answers without sources. I want to see the source so I can assess whether it is reliable.)

As an example, I typed "provide a summary of ASC 842 with sources" into ChatGPT-4, using the WebPilot plugin: the answer was as follows:

ChatGPT's ability to provide current information is dependent on the specific web pages it is directed to visit. It does not have the ability to independently search the internet or stay updated with new information.

ChatGPT-4: Obtaining Sources without Plugins

Additionally, ChatGPT-4 can use its training information to respond and provide sources. As an example, I typed "provide a summary of ASC 842 with sources" into ChatGPT-4 without using a plugin: the answer was as follows:

The combination of plugins and ChatGPT-4 is a powerful way for this software to provide you with the answers and sources you need.

In conclusion, while a search engine like Google is a wonderful tool, ChatGPT can provide a more powerful, intelligent, and efficient way of retrieving and processing information.

As always, you want to verify the information you obtain to ensure its integrity and accuracy. Why? Because errors can occur in the responses you receive from ChatGPT.

So, ChatGPT is an aide but not a replacement for traditional research and information verification methods.

ChatGPT Video

To see ChatGPT in use, watch the following basics video.

Jun 24

CECL’s Impact on Private Nonbank Companies

By Charles Hall | Accounting and Auditing

What is CECL’s impact on private nonbank companies?

This article provides an overview of how CECL might impact your nonpublic (private company) financial reporting including your numbers and disclosures.

An Overview of CECL

The Current Expected Credit Losses (CECL) model was introduced by the Financial Accounting Standards Board (FASB) through Accounting Standards Update (ASU) No. 2016-13, "Financial Instruments—Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments."

ASU 2016-13 was issued in June 2016 and it replaced the previous incurred loss impairment methodology with the CECL methodology. The new model requires more timely recognition of credit losses associated with financial instruments.

Effect on Nonbank Entities

Most nonbank entities have financial instruments or other assets (such as trade receivables, lease receivables, and held-to-maturity debt securities) that are subject to the CECL model.

Because financial assets of nonbanks tend to be held for a shorter duration than those of banks, nonbanks will generally be less affected by the new CECL standard.

According to Deloitte, many nonbank entities have disclosed that the impact of the new CECL standard is immaterial to their financial statements or did not disclose the adoption of the new CECL standard at all.

Nonpublic companies may use simpler methods for estimating expected credit losses and making forecasts about the future (as compared to public companies), as long as those methods are reasonable and supportable. They may also have more flexibility in the types of information they consider and the ways they document their estimates.

However, they will still need to comply with the basic principles of the CECL model, including the requirement to estimate expected credit losses over the life of the financial instruments.

Changes in Disclosures

The CECL standard introduces principles-based disclosure requirements, giving entities flexibility to determine the nature and extent of the information to be disclosed.

Entities are required to provide sufficient information to enable users of their financial statements to understand the credit risk inherent in a portfolio, management's estimate of expected credit losses, and changes in the estimate of expected credit losses that have taken place during the period.

Changes in Allowance for Uncollectibles

Under the CECL model, an entity recognizes its estimate of expected credit losses as an allowance, which incorporates forward-looking information and eliminates barriers to the timely recognition of losses under legacy incurred loss models. This is a significant shift from the previous incurred loss model, which only recognized losses when they were incurred.

Effective Dates for CECL Standard

The guidance became effective on January 1, 2023, for private companies. Public business entities that meet the SEC’s definition of smaller reporting companies and have a calendar year-end have the same effective date, January 1, 2023.

Apr 17

Get a Grip on Journal Entry Testing: AU-C 240

By Charles Hall | Accounting and Auditing , Auditing

Journal entry testing is required in all audits. Why? The use of journal entries to manipulate financial statements is always present--even in accounting systems with good internal controls. Thus the journal entry test requirement in AU-C 240, Consideration of Fraud in a Financial Statement Audit.

In this article, I explain how auditors can understand and test journal entries to ensure management is not cooking the books.

Understand the Journal Entry Process

First, auditors should gain an understanding of the journal entry process. Ask questions such as:

Who can post journal entries (see logical access assignments in the software)?
How are journal entries posted?
Who approves journal entries?
Can one person post a journal entry without a second-person approval? If yes, who?
How often are journal entries posted, and for what purpose?
Have there been any unusual journal entries during the year?
Are estimates adjusted or recorded with journal entries? If yes, who makes those entries, and how often?
Does the company have a separate journal entry software package (such as Blackline) that interfaces with the general ledger?
What journal entries are made in creating the financial statements, including those after the trial balance is taken from the accounting package (for example, the company downloads the trial balance to Excel)?
Are all journal entries in the financial statement creation phase reviewed and approved by a second person? If yes, by whom?
Has management asked anyone to override journal entry controls or protocols?

Inspect sample documents and journal entries. Also, observe who is doing what. Then document your inquiries, the records inspected, and your observations as a part of your walkthrough process. Also, document who you talked with and on what date.

Scan a Month's Journal Entries

Consider downloading all journal entries for a particular month and scanning those. Doing so will enable you to see the typical entries made. Most accounting systems differentiate journal entries from other transactions, so it's usually easy to segregate all journal entries for review.

Scanning a month's journal entries is not a required procedure, but one that I suggest.

So, as you scan the journal entries, what are you looking for? What types of entries might imply that fraud is present?

Indicators of Fraud Risk

The following are potential indicators of fraud risk:

Nonstandard journal entries made at year-end, especially those for round numbers
Entries made to seldom-used accounts
Post-closing entries with no explanation
Entries made by persons that seldom do so
Entries made to force accounts to balance without performing proper reconciling procedures

Plan Your Journal Entry Responses

Plan to test journal entries based on your risk assessment procedures. If you notice particular risks, then audit those areas.

Here are examples of risks and responses:

Test more entries if one person records journal entries without a second-person approval. Why? There's more risk.
If you note unusual logical access rights, consider downloading all journal entries and sorting them by persons to see if there are any unusual journal entries.
If significant revenue entries are made in the last month, test those.
If one person consolidates the financial statements in Excel, making adjustments without a second-person review, test that process.

Journal entries may be appropriate throughout the year because they are subject to good controls. Even so, someone might inflate the numbers in the financial statement creation process (after exporting the original numbers to a spreadsheet, for example).

Test Journal Entries in Every Audit

AU-C 240, Consideration of Fraud in a Financial Statement Audit, requires auditors to test journal entries in every audit. Why? There is always a possibility that management might override controls, and journal entries are an easy way to make the company look better than it is. Think about it: one journal entry in the last month of the year can increase revenues and receivables by millions.

Test Entries Late in the Year

It is wise to test journal entries made late in the year. As management approaches year-end, they might realize the company needs to meet specific targets (e.g., a certain level of net income) for them to earn bonuses. If true, management has a potential motivation to manipulate the numbers, especially at year-end.

See my article about management override of controls for more information about manipulation of financial statements and potential theft.

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