Such practices are called income smoothing and

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Such practices are called income smoothing and earnings management. Earnings manage- ment involves deliberate actions taken by management to meet earnings objectives. Income smoothing is a form of earnings management in which revenues and expenses are shifted between periods to reduce fluctuations in earnings. One technique to smooth income is to reduce the value of inventory and other assets of an acquired company at the time of acquisition, resulting in higher earnings when the assets are later sold. Companies may also deliberately overstate inventory obsolescence reserYes and allowances for doubtful accounts to counter higher earnings. Although less frequent, several notable cases of fraudulent financial reporting involve inadequate disclosure. For example, a central issue in the Enron case was whether the company adequately disclosed obligations to affiliates known as special-purpose entities. E. F. Hutton, a now defunct brokerage firm, was charged with intentionally overdrawing accounts at various banks to increase interest earnings. These overdrafts were included as liabilities on the balance sheet, but the balance sheet description of the obligations did not clearly state the nature of the liabilities. Misappropriation of assets is fraud that involves theft of an entity's assets. In many cases, but not all, the amounts involved are not material to the financial statements. However, the theft of company assets is often a management concern, regardless of the materiality of the amounts involved, because small thefts can easily increase in size over time. The term misappropriation of assets is normally used to refer to theft involving employees and others internal to the organization. According to estimates of the Association of Certified Fraud Examiners, the average company loses five percent of 554 Part2 /THE PROCESS OF AUDITING
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FRAUDUTENT FINANCIAL REPORTING STATISTICS A recent study commissioned by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) analyzes fraudulent financial reporting by U.S. public companies over the period 1998-2007. The study updates an earlier study that analyzed fraudulent financial reporting for the period I987-1997. There were 347 alleged cases of fraudulent financial reporting from 1998-2007. compared to 294 cases from 1987-'I997. The size of the companies and magnitude of the frauds were much larger in the later period. The companies alleged to have engaged in fraud had median assets and revenues of almost $'I00 million in the period t99A-2007. ln contrast, the companies in the I987-1997 period had median assets and revenues of under $ l6 million. The median fraud increased from $4.1 million in the earlier period to $12.1 million in the 1998-2007 period. The average fraud soared from $25 million in the earlier period to almost $400 million in the later period, influenced by the major frauds at companies such as Enron and WorldCom.
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