assignment 4
DESCRIPTION
CapstoneTRANSCRIPT
Assignment 5
Code of Professional Ethics and Conduct
Dawna Berry, Rochelle Morton, Jose Pinto
ACC 499 – Undergraduate Accounting Capstone
Professor Dr. M. Austin Zekeri
December 12, 2012
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Leases on technology assets seem inflated
Current lease accounting standards have come under criticism for not meeting the needs of users
of financial statements. In response, the Financial Accounting Standards Board (FASB) and the
International Accounting Standards Boards (IASB) issued a joint discussion paper on March 19,
2009 titled Leases: Preliminary Views.
Existing lease accounting standards require lessees to classify their lease contracts as either
capital leases or operating leases. Capital leases are those leases that transfer to the lessee
substantially all the risks and rewards accompanying to ownership of the leased asset. All other
leases are operating leases. Under a capital lease, the lessee recognizes in its balance sheet the
leased asset and a requirement to pay rentals. The lessee depreciates the leased asset and
allocates lease payments between a finance charge and a reduction of the outstanding liability.
Under an operating lease, the lessee does not identify the asset or liability associated with the
leased asset, but rather recognizes lease payments as an expense. As for lessors, current
accounting guidance requires that lessors distinguish a lease as one of the following: sales type
lease, direct financing lease, leveraged lease or operating lease.
The current lease accounting model has been the subject of criticism for many years. Financial
statement users have argued that certain operating leases give rise to assets (the right to use the
leased asset) and liabilities (the obligation to pay rentals), thus users have attempted to capitalize
the asset when analyzing a company's financial statements and projecting forecasts. Criticism has
also been made that the current lease rules are too complex. The bright line tests are too difficult
to apply and similar transactions can be accounted for differently, thus reducing comparability
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for users. Furthermore, arguments have been made that the existing standards provide
opportunities for companies to structure leases so as to achieve a particular lease classification.
The US Securities and Exchange Commission (SEC) recognized that the current lease
accounting model is conceptually flawed in its June 2005 report, report and recommendations
pursuant to section 401(c) of the Sarbanes-Oxley Act of 2002 arrangements with off-balance
sheet implications, special purpose entities, and transparency of filings by issuers and
recommended that the FASB undertake a project to reconsider the leasing standards, preferably
as a joint project with the IASB.
Proposed Changes to Lease Accounting Standards
The projected changes will eliminate the difference between capital and operating leases and
basically require lessees to treat all leases as capital leases. The FASB and IASB believe that
upon entering a lease contract, a lessee has acquired an asset through its right to use the asset and
assumed a liability through its commitment to pay rentals. The new approach would require a
lessee to record an asset signifying its right to use the leased item for the lease term and a
liability for its obligation to make rent payments. As for initial dimension, it was tentatively
decided that the lessee would record its right-of-use asset at cost, which would come to the
present value of the lease payments discounted at the lessee's incremental borrowing rate. The
requirement to make rent payments would be recorded at the present value of the lease payments,
discounted at the lessee's incremental borrowing rate.
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Regarding changes to lessors accounting, the FASB and IASB deferred consideration of lesser
accounting in the discussion paper, but have been deliberating lesser accounting in subsequent
meetings. The Boards have decided to adopt the performance obligation approach to lesser
accounting. Under this approach, a lesser would identify an asset representing its right to receive
rental payments and identify a liability representing its performance obligation under the lease
(its obligation to permit the use of its asset). No revenue would be known at inception of the
lease but would be recognized over the lease term.
Another projected change is the treatment of options to renew a lease. Current standards only
allow contemplation of renewal options in the case where renewal is reasonably assured, for
instance, when there is a bargain renewal option. The projected changes would require the lessee
and lesser to assume that the lease term includes all renewal options that are more likely than not
to be exercised. This will greatly increase the use of renewal options in the calculation of leasing
assets and liabilities as well as amplify the amount of subjective judgment in deciding what
renewal options are more likely than not (greater than 50% chance) to be exercised.
What This All Means
The planned changes will affect almost all companies since almost all businesses lease assets
such as real estate, office equipment, vehicles, etc. Leasing companies that base their business on
the leasing of assets to other companies will especially be affected by the changes. Management
of all companies need to understand the implications of the rule changes now since it is likely
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that leases existing at the time the official change in accounting occurs will echo the new
standards and will not be grandfathered in.
Some of the significant implications facing companies if the proposed changes take effect
include the following:
All companies that lease assets will have to capitalize those assets. Balance sheets will be
significantly inflated and companies will appear more highly leveraged.
Lease expense will no longer remain constant through the term of the lease as they were
under operating leases. Lease costs will now be higher in the earlier years of the lease and lower
in the later years because the lease liability will be amortized using the effective interest
method.
A lessee's compliance with its debt covenants may be impacted.
A lessee's EBITDA would likely increase since lease expense will be replaced with
interest and depreciation expense, both of which are not included in EBITDA. The increase in
EBITDA could impact the calculation of certain financial ratios and on bonuses or commissions
that are tied to EBITDA.
Companies may have to provide additional training to their accounting department to
ensure that the company's lease contracts are being accounted for properly. New policies and
procedures may need to be established to ensure there are adequate controls surrounding the
accounting for lease transactions.
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What Companies Should Be Doing
Most companies have not fully evaluated the blow to their financial statements and operations
that will come as a result of the lease accounting changes. Companies need to fully understand
the implications of the changes and begin developing a corporate strategy to address the issue. A
few considerations to be taken include:
Buy or lease? If the asset will now be on the balance sheet anyway, companies need to
consider whether or not it would be more advantageous to purchase the asset as opposed to
leasing the asset. Companies that own that asset will be able to reap the tax benefits of
depreciation through the life of the asset, whereas depreciation on a capitalized lease will only
run through the lease term.
Lease terms. Shorter-term leases will likely result in higher rental rates, but will reflect
less debt on the balance sheet and overall will have less of an impact on the financial statements.
Longer-term leases will likely result in more favourable rental rates, but will increase exposure
on the balance sheet. Impact to corporate agreements. Companies need to review the
ramifications that the change in lease rules will have on corporate agreements such as
compliance with debt covenants and bonus and commission agreements tied to EBITDA.
Consultation with lenders, legal counsel and accounting advisors is advised to determine if
agreements should be amended for changes caused solely by the lease accounting rule change.
Understatement of e-Commerce state tax payments
Fraud activities that are carried out within a company are understating the income and not paying
taxes on the right amount of earned income. Fraud can occur in any company or corporation,
several aspects of e-business present unique risks. The distinctiveness of the Internet-driven
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economy creates pressures and opportunities specific to e-commerce fraud. Many of these fraud
risks are found within organizations. Once theses fraudulent activities are found within the
firewalls and securities checks, it can be much easier to infiltrate the systems, steal money, and
information, and cause damage to the system itself.
There are elements that motivate fraud and they are pressure, opportunity, and rationalization.
Once we reduce these elements then we can reduce or eliminate these opportunities. The lack of
contact can be a factor, because we do not know what they are thinking if they have no contact
with the other people within the organization. We ask ourselves what pressures exist or what
rationalizations crooks are using. There are five different elements traditional business use: (1)
the control environment, (2) risk assessment, (3) control activities or procedures, (4) information
and communication, and (5) monitoring. The attitude of management lies in the essence of
effectively controlled organizations. As long as top management believes that direct control is
important, then others within the organization will respond carefully observing established
controls.
Fraud can be prohibited through direct controlled activities such as adequate disconnection of
duties, proper authorization of activities and business, adequate records and documents, physical
control over records and assets, and self-sufficient checks on performances, but often in e-
commerce business it is not effective enough.
Leases on technology assets seem inflated:
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Under both US GAAP, revenue is not recognized until it is both realized (and realizable) and
earned. FASB requires lessees and lessors to disclosure certain information about leases in their
financial statements or in the notes. These requirements vary based upon the type of lease and
whether the issuer is the lessor or lessee (Kieso, Weygandt, & Warfield, 2007). These disclosure
requirements provide investors with the following information: General description of the nature
of leasing arrangement, the nature, timing, and amount of cash inflows and outflows associated
with leases, including payments to be paid or received for each of the five succeeding years. The
amount of lease revenue and expenses reported in the income statement each period. Description
and amounts of leased assets by major balance sheet classifications and related liabilities.
Amounts receivable and unearned revenues under lease agreements (Kieso, Weygandt, &
Warfield, 2007). The portion of the monthly payments related to future maintenance, service
and supplies should be recognized as revenue later, when the services are actually provided.
Revenue from the lease should be recognized immediately upon delivery of the equipment and
interest cost should be recognized over the lease period. The consequences to the fraudulent
activities include that the revenue will be overstated on the financial statement and the company
could face charges from the Securities and Exchange Commission (SEC) for inappropriately
allocating lease receipts, which affects the timing of income that it reports. If it was to be done
according to SEC guidelines, it would report income in different time periods (Kieso, Weygandt,
& Warfield, 2007). The people that are involved consist of management, board of directors, the
banks, shareholders as well as the lessees. Recommended internal controls would include
frequently conducting internal audits as well as ensuring there is a separation of duties.
Understatement of e-Commerce state tax payments:
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E-Commerce fraud is currently a significant problem, and it’s growing every day. In recent
years, the technology revolution has provided perpetrators with new ways to commit and conceal
fraud and to convert their ill-gotten gains (Strayer University, 2011). US GAAP require entities
to account for both current tax effects and expected future tax consequences of events that have
been recognized (that is, deferred taxes) using an asset and liability approach (Ernest &Young,
2010). Fraudulent activities within the organization would mean that the company is
understating the income; therefore, not paying taxes on the true amount of earned income.
Although fraud can occur in any environment, several aspects of e-business environments
present unique risks. These characteristics of the Internet-driven economy create pressures and
opportunities specific to e-commerce fraud. Just like other frauds, these new frauds are
perpetrated when pressures, opportunities, and rationalizations come together. Many of the most
serious e-commerce fraud risks are found within organizations. Once perpetrators are within
firewalls and security checks, it can be much easier to infiltrate systems, steal money and
information, and cause damage (Strayer University, 2011). Preventing fraud in every business
setting involves reducing or eliminating the elements that motivate fraud: pressure, opportunity,
and rationalization. The lack of personal contact makes it hard to know what pressures exist or
what rationalizations perpetrators are using. True security is found when algorithms and
processes are made public and stand the test of time. One of the best ways to prevent fraud in e-
business settings is to focus on reducing opportunities, usually through the implementation of
appropriate internal controls. In traditional businesses, internal controls involve five different
elements: (1) the control environment, (2) risk assessment, (3) control activities or procedures,
(4) information and communication, and (5) monitoring. The essence of effectively controlled
organizations lies in the attitude of their management. If top management believes that control is
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important, others in an organization will respond conscientiously observing established controls
(Strayer University, 2011). Fraud can also be prevented through control activities such as
adequate separation of duties, proper authorization of transactions and activities, adequate
documents and records, physical control over assets and records, and independent checks on
performance, but often in e- businesses they are not effective (Strayer University, 2011).
Fictitious employees receiving post-employment benefits
Under GAAP, the periodic post-retirement benefit cost under defined contribution plans is based
on the contribution due from the employer in each period. The defined benefit obligation is the
present value of benefits that have accrued to employees through services rendered to that date,
based on actuarial methods of calculation. The rule was not sufficient because they were able
create fictitious employees to pay post-employment benefits. The consequences for this
fraudulent activity lead the company to lose a lot of money. Payment records should be
compared to human resources files periodically to verify that a person is still employed within
the company. Red Flags for fictitious employees would focus on these items: high withholding
exemptions or no withholding for income taxes, no voluntary deductions for health insurance,
retirement, or other normal deductions for the employee population. No vacation, sick, or
personal time charges, no salary adjustments, merit adjustments, or promotions, duplicate bank
account numbers matching to other logical databases, e.g., security access, computer security
access file or company telephone records. Fictitious employees tend to occur in departments
where they would not be evident, and the local manager has a high degree of control over the
hiring process. Audit Strategies for fictitious employees could include the following for each
person, meet the individual and inspect a government-issued identification and search for
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evidence of work performance. This may be as simple as inspecting employee’s work area
(Audit Strategy for Payroll Fraud, 2010). Persons involved in this situation can include payroll
manager, human resources department as well as the employee that is receiving the payments.
Because these payments are tax-deductible, these payments affect the company as a whole, the
contributions that have been made to these fictitious employees, were part of payments that
received tax benefits. Taxes will have to be paid on these payments.
Hiding cash in order to help in future quarters where earnings do not meet analyst’s
expectations:
Over the last three years, SEC investigations have uncovered earnings management practices that
have pushed the boundaries of GAAP, even to the point of out-right fraud. In some instances,
independent auditors were blamed for not catching or correcting accounting irregularities. In
others, it is clear that management intended to deceive outside auditors and audit committees.
Regardless of fault, when earnings management and fraudulent accounting schemes are
uncovered, the monetary losses can be staggering.
Enron’s stock fell from its high of $90.75 to $0.68 after the SEC began investigating Enron’s
accounting practices (www.nysscpa.org). After the collapse in the market value of its stock,
Enron was forced to seek bankruptcy protection, resulting in the largest bankruptcy in U.S.
history. A recent Financial Executives International (FEI) report indicates that the stock market
lost more than $34 billion during the three-day period during which the three most egregious
cases of abusive earnings management in 2000 (Lucent Technologies, Cendant, and Micro
Strategy) surfaced (www.nysscpa.org). While SEC documents indicate that the accounting
irregularities at Lucent, Cendant, and Micro Strategy were primarily “abusive” earnings
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management schemes or outright fraud, all three companies began their abusive and fraudulent
practices by engaging in earnings management schemes designed primarily to “smooth” earnings
to meet internally or externally imposed earnings forecasts and analysts’ expectations
(www.nysscpa.org). Earnings management practices can be designed either to assist managers in
fulfilling their obligations to stakeholders or to deceive investors. The SEC’s concept of
“abusive” earnings management suggests analytical approaches to uncovering such practices. In
addition, the accounting profession has taken steps to educate accountants about earnings
management practices and their effects and consequences. In general, analysts expectations and
company predictions tend to address two high-profile components of financial performance:
revenue and earnings from operations (www.nysscpa.org). The pressure to meet revenue
expectations is particularly intense and may be the primary catalyst in leading managers to
engage in earnings management practices that result in questionable or fraudulent revenue
recognition practices. One FEI study indicates that improper revenue recognition practices were
the cause of one-third of all voluntary or forced restatements of income filed with the SEC from
1977 to 2000 (www.nysscpa.org). Other top managers engaging in improper revenue
recognition practices may do so with the full cooperation of employees that may not understand
the impropriety of their actions. For example, an SEC investigation revealed that premature
revenue recognition practices were such an integral part of operations at one manufacturing
company that MIS personnel wrote a program to automatically freeze the computer date while
the quarter was held open (www.nysscpa.org). In another case, one manufacturer obtained audit
evidence for sales recognized prematurely by shipping legitimate orders to its own warehouses
and holding the products until customer-requested shipping dates in later periods
(www.nysscpa.org). In many cases, managers attempt to meet quarterly expectations by
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prematurely or improperly recognizing revenue for sales that do not meet criteria for recognition
under GAAP but would be legitimately recognized in future periods. Such premature revenue
recognition can go unnoticed if company managers do not consistently engage in such practices
or if the company continues to grow. Nonetheless, because revenue expectations for future
quarters are based primarily on revenues recognized in current quarters, analysts’ expectations
for the quarters following those in which revenue was prematurely or improperly recognized are
typically inflated (www.nysscpa.org). The magnitude of the inflated expectations is usually
compounded by the addition of “growth” factors, rendering the new quarterly expectations
difficult or impossible to achieve without further manipulations or fraudulent accounting
activities (www.nysscpa.org). The seemingly common consequence of improper revenue
recognition practices is that, once started, companies must continue earnings management
activities in order to meet ever-increasing internal sales targets and analysts’ expectations.
Frequently, the earnings manipulations or fraudulent activities involving revenue generate the
need for more complex and sophisticated accounting techniques to ensure analysts’ earnings
expectations are met (www.nysscpa.org). Eventually, companies must engage in more blatant
fraudulent activities by creating artificial reserves, understating reserve liabilities, using creative
acquisition accounting practices, or otherwise manipulating GAAP to perpetuate myths
involving company “growth” (www.nysscpa.org).
Concealing inventory shrinkage because it seems low for the country:
Concealing inventory shrinkage because it seems low for the industry implies that a company is
not reporting the correct numbers. Because most companies in their industry have higher
shrinkage numbers, they wanted to stay within the norm to avoid sending up red flags. But what
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they have done was subjected themselves to inventory fraud rather than reporting the truth.
Reporting the actual shrinkage would have proven that they had good inventory control methods
in place which could have been an example for the other companies in their industry. According
to experts, inventory is the most common area for financial statement fraud. It is the easiest type
of fraud to perpetuate and the hardest for even outside auditors to detect (Wiersema,
2001).Overstating inventory increases the company’s bottom line dollar for dollar. The reason is
that whatever winds up in ending inventory is not a cost against income this period. The cost is
deferred until the indefinite future, which causes a corresponding loss the next year, unless the
overstatement continues. Most managers who have engaged in inventory fraud experience it as
an addiction. The amount of fraud continues to increase for the additional benefits it gives
(Wiersema, 2001). Cost of Goods Sold (COGS) would be overstated as well, resulting in your
net income being overstated, which could possible increase your tax liability. Inventory Control
is the procurement, care and disposition of materials. There are three kinds of inventory that are
of concern to managers: raw materials, in-process or semi-finished goods, and finished goods. If
a manager effectively controls these three types of inventory, capital can be released that may be
tied up in unnecessary inventory, production control can be improved and can protect against
obsolescence, deterioration and or theft (Inventory Control, 2002). Trying to protect your
company from the inside is different. Ultimately, protecting your company depends on having
adequate accounting controls that go beyond physical safeguards. It is important to ensure you
have an adequate internal control system in place according to your needs. For quantities, there is
no substitute for accurate perpetual records that account for every transaction. It essential that the
records leave a permanent audit trail, so they cannot be altered after the fact, this leaves out
many of the cheaper software packages (Wiersema, 2001).Company executives realize that
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effective inventory management may be the difference between operating success and failure. To
enhance inventory management, Wal-Mart has implemented radio frequency identification
(RFID ), a scanning technology similar to bar codes that allows inventory to be tracked from the
supplier to the final consumer, and promises dramatic reductions in inventory costs (Strayer
University, 2011). If there is any incentive pay that is tied to production levels, this could lead to
inventory fraud. Workers are eager for the extra money and collude to over-report production,
which can only be detected by taking an independent physical count (Wiersema, 2001). This
process can be very costly and time consuming for a small business. Similarly, an inflated
inventory value can lead to higher earnings, which, in turn, generate higher staff bonuses or, the
overstated value can hide substantial shortages arising from theft against the company. These are
going to be areas of concerns that will need to be monitored closely (Wiersema, 2001).
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References:
Nikolai/Bazley, ET AL; Mason, OH: Strayer University; (1st custom edition 2011) ACC499
Accounting Undergraduate Capstone; (Cengage Learning).
Strayer University. (2011). ACC 499: Accounting undergraduate capstone. Mason, OH
Cengage Learning.Wiersema, W. H . (2001, April).
Kieso, D. E., Weygandt, J.J., & Warfield, T. D. (2007). Intermediate Accounting, 12th Ed.Wiley.
Alvin A. Arens, Randal J. Elder, Mark S. Beasley; 2010 Auditing and Assurance Services.
AICPA, AU Section 316; Consideration of Fraud in a Financial Statement Audit; revision 2007.
S. Waters; About.com; Retailing; “Top 4 Sources of Shrinkage”; retrieved December 16, 2012 at
http://retail.about.com/od/lossprevention/tp/shrink_sources.htm
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