Accounting Fraud: Or How To Cook The Books And Avoid Investigation

The Historical Cost Concept Accounting Principle

Imagine, for a moment, trying to read a financial statement that had listed assets such as: cash $5,000; 14 boxes of oranges; 25 boxes of apples; 1000 board feet of lumber; 3 acres of land; and, 8 machines. A first question that might pop into your mind is: “How in the world do I add these assets to one another?”

It is immediately clear that for financial statements to be meaningful, amounts of dissimilar items must be stated in similar units. Money becomes the obvious choice of “similar units”. By converting different kinds of objects into monetary amounts, they can be dealt with arithmetically. This is called the “money-measurement concept” and is a fundamental principle of accounting.

This is great, but the problem is not yet solved. An asset may be recorded in dollars and cents (or whatever currency is appropriate for the country in which you live), but at what value? If I were allowed to choose the value I thought was appropriate for my assets, my tendency would be to state their value at the highest amount possible. That way, my financial statement would indicate that my business was strong, healthy, and worth a lot of money. Remember the “accounting equation”:

ASSETS – LIABILITIES = EQUITY

Higher assets mean higher equity. Wonderful, but what if I’m wrong? My banker and my investors are trusting that my financial statements are stated accurately. Furthermore, it is not reasonable to expect that every reader of my financial statements can or should have to appraise my assets.

In order to avoid the subjectivity of market value, an objective way of valuing assets had to be established. This was solved by using the “historical cost” concept. This concept states that the numbers reported on accounting financial statements shall be recorded at the amount that was actually paid for an asset, i.e., historical cost. Therefore, accounting does not record what an asset is actually worth, that is, its market value. This works out okay because most businesses are using their assets to conduct operations and are not trying to sell them. When a business offers an asset for sale, or perhaps the entire business, an appraisal to determine fair-market-value of the assets must be performed.

So we (preparers of financial statements) are going to use money as a measurement system and we will record our assets at the amount actually paid for them. This will keep us out of trouble and make it easier to understand what others are doing.

How to record ‘contributed labor’ on the company books.

Clients ask me this question from time to time and usually don’t like or understand the answer. The question is, “If I donate or contribute my labor to a charitable institution, can I record the cost, at my normal charge rate, as an expense on my financial statement?” The obvious result is that the client’s Net Profit will be lower leading to lower taxes.

It seems reasonable doesn’t it? After all, your time is worth money and you are giving it to a worthy cause. What’s the matter with that? First, read my October article titled, “The Historical Cost Concept Accounting Principle”. It explains that money must exchange hands, or a promise to pay money, before an amount can be recorded on the books because there needs to be an objective way to determine the value of a transaction. Was there any money or promise of money exchanged in the example? No, there was only a contribution of labor.

Second, from a debits and credits perspective, how would you record a contribution of labor? If you recorded a debit to an expense account called Contributions, what would be the credit entry? Not Cash. Not Payables. Maybe Equity? Let’s look at that. If you write a credit entry to increase Equity, then the expense entry lowers Net Profit as washes out the increase in Equity. Sound pretty good? Not really, because you just violated the accounting principle of Historical Cost. No money was actually paid, so there was no objective way to value the transaction.

What if you decided that your time was worth $1000 an hour? You worked eight hours so you recorded an expense of $8,000. That might be a big hit on the old Net Profit. Plus, it looks like you contributed a substantial amount to the business. More likely, someone who charged $75 an hour might be inclined to up it to $125 an hour if they felt they could. You can see why the Internal Revenue Service (IRS) would take a dim view of this. If left up to the discretion of millions of taxpayers the potential for abuse would be staggering.

Therefore, this practice is not allowed. The integrity of financial statement reporting must be protected, and the IRS doesn’t want to be cheated.

After explaining all this to clients, often they still don’t get it. Or, they don’t want to get it. They feel they gave up something so they should get something back, i.e., the write off. The IRS says that if you performed a service for someone then record that service as income on your books, then you can deduct it as a legitimate Contribution expense. I say, why bother, since they both wash each other out. It’s just extra accounting work.

I welcome your comments or questions on this sometimes confusing concept.

 

Recording Goodwill on the books

Have you ever seen “Goodwill” as an asset category on a set of financial statements? Do you wonder how the dollar amount was arrived at? Did you know that the only way Goodwill can be entered on the balance sheet is through a purchase?

For a definition and general understanding of Goodwill, be sure to read my blog article titled, “Valuing Goodwill: Avoid buying a Pig-in-a-Poke”. Let’s assume you’ve done that and you now know that Goodwill is the difference between the value of a business enterprise as a whole and the sum of the current fair values of its identifiable tangible and intangible net assets.

Let’s also assume that you have just purchased a sole proprietorship small business for $150,000. You paid for it by making a down payment of $50,000 from personal funds and acquired a bank loan for the remaining $100,000. The purchase consists of $70,000 in Fixed Assets, and $80,000 in Goodwill. The journal entry would be:

Account Debit Credit

Fixed Assets $70,000

Goodwill $80,000

Notes Payable $100,000

Capital Contributions $ 50,000

You know you can depreciate the Fixed Assets, but can you write off Goodwill? According to the Internal Revenue Service, under the MACRS system, Goodwill can be amortized over a fifteen year period.

If you bought the business on July 1, the first year’s amortization would be $2,666.67. Each full year would be $5,333.33. Simply divide $80,000 by 15 to get $5,333.33. Divide that amount by 2 to arrive at $2,666.67. Depending on what month of the year you purchased the business determines the amount amortization expense. The journal entry to record amortization for Goodwill would look like this:

Account Debit Credit

Amortization Expense $2,666.67

Accumulated Amortization $2,666.67

Pretty straightforward, wouldn’t you say?