Forensics Journal - Stevenson University 2015

FORENSICS JOURNAL sale securities is the method by which each investment is recorded. Trading securities are recorded at fair value on the balance sheet, and the changes in fair value are recognized as gains and losses on the income statement. Available-for-sale securities are recorded at fair value on the balance sheet; however, gains and losses are only recorded once these securities are sold. Therefore, a corporation practicing earnings management may prefer to record its equity securities as available-for-sale and benefit from recording the sale of these securities at a later time (Ketz, 2003, p. 56). For instance, a corporation may decide to sell its available-for-sale securities to meet consensus earnings, which will reflect an increase on its income statement. However, earnings of this nature can be classified as a nonrecurring item, which financial statement readers may remove from net income to obtain a better measure of periodic financial performance (Mulford & Comiskey, 2002, p. 75). Nonrecurring items are not representative of normal business activities; consequently, they do not aid in providing creditors or investors with the corporation’s true financial position. lower debt-to-equity ratio because the corporation’s ratio portrays a promising investment/return option with minimal risk. Although a corporation may have less than 50% ownership in a company, it can still have total control over the company’s operations; and therefore, it must consolidate both operations in its financial statements (Ketz, 2003, p. 70). An effective auditor must evaluate the corporation’s procedures for identifying and properly accounting for investment transactions. It may be necessary to request the names of all joint ventures from appropriate management personnel, and determine if the corporation controls the operating, investing, and financing decisions of the company by examining executed copies of agreements, contracts, invoices, cash receipts, and bank statements. The auditor should obtain independent third party confirmations with banks, guarantors, agents, and attorneys, to discuss and verify the accuracy of significant information for a better understanding of each transaction. If the corporation has employed the equity method when accounting for any joint ventures, which it clearly controls, then the auditor must determine if the corporation was hiding the subsidiary’s debt in order to keep it off the balance sheet instead of consolidating the operations. To determine the impact of utilizing each accounting method, the auditor will need to obtain financial statements for each company to consolidate the financial results of the operations. To determine whether there are any financial risks for the given period, the auditor can calculate the debt-to-equity ratio using the corporation’s financial results under the equity and consolidation methods. The auditor may also perform a horizontal analysis of operating revenues, cost of goods sold, gross profit, and operating expenses to determine whether the implications of the differences suggest that the parent company is hiding debt with the equity method. A corporation may own less than 20% of a company, yet exercise significant influence over the company. If so, the equity method must be applied. The equity method requires a corporation to record its investment income (or loss), which is its proportional share in the company’s earnings, and deduct compensated dividends in its investment account on the balance sheet (Ketz, 2003, pp. 56-57). To avoid recording losses on its investment, a corporation may argue the equity method is not applicable because it does not own between 20 to 50%. Therefore, a corporation may prefer to manage earnings by recording its equity investments as availablefor-sale securities to control the environment in which the gains and losses are recorded for these investments. As a result, the corporation does not report its investment losses on the balance sheet, and effectively hides its financial risk from creditors and investors. In, “How Leases Play a Shadowy Role in Accounting” a Wall Street Journal review of annual reports for companies in the Standard & Poor’s 500-stock index reveal a total of $482 billion in off-balancesheet operating-lease commitments out of $6.25 trillion reported as debt (Weil, 2004). Accounting for leases represents an opportunity for corporations to mislead creditors and investors. The two types of leases are operating and capital. An operating lease represents a rental for a short period. In contrast, a capital lease ultimately represents a purchase through the method of financing over the life of the lease (Ketz, 2003, p. 73). Corporations may seek to structure their leases to appear as operating leases for the purpose of hiding debt; however, certain aspects of leases clearly distinguish the two types. Conversely, a corporation may prefer to apply the equity method instead of consolidating the subsidiary’s financial results with its financial statements.1 To avoid consolidation a corporation will deliberately develop an affiliate with ownership slightly below 50% to avoid consolidation (Ketz, 2003, p. 64). Under the equity method, the investment account reflects a net amount consisting of the company’s assets and liabilities. If the company’s assets are greater than their liabilities, then essentially the company’s liabilities will be hidden (Ketz, 2003, p. 70). Therefore, the corporation will not report the liabilities of the company on its balance sheet, and essentially lower its debt-to-equity ratio. Creditors and investors favor a The investee is classified as a subsidiary under the consolidation method. 1 7

Forensics Journal - Stevenson University 2015 | Page 9