ETHICAL ISSUES RELATED TO PAYROLL AND FIXED ASSETS PROCESSES (STUDY OBJECTIVE 8)
Chapter 9 presented ethics issues related to expenditure processes, such as those involving the traditional systems of purchasing and cash disbursements. This chapter examines additional issues specific to the payroll and fixed assets processes.
The payroll system is the target of several types of fraud schemes. The most common means of defrauding a company involves dishonest employees' falsification of time sheets in an effort to receive excess compensation. There are many different ways that these frauds may be carried out. The following list presents some of the typical sources of time sheet falsifications:
- Exaggeration of hours worked
- Falsification of overtime or holiday time worked, payable at higher rates
- Falsification of sales in order to increase commission payouts
- Overstatement of job-related expenses, which may be reported with the time sheets and reimbursed via the paycheck.
Other types of time sheet falsification may be carried out in the employee's effort to unfairly take time off work. Many companies have certain conditions under which they pay their employees for absences due to illness, disability, personal hardships, or vacations. Dishonest employees may take advantage of these policies in order to receive excess paid leave. For example, an employee may falsely call in sick or lie about a family emergency in order to receive pay for the time off. Or someone may fake an injury in order to collect disability payments. Another scheme involves the employee abusing the company's vacation policy by failing to record vacation hours taken. As a result, these employees might take more time off work than they have earned. These types of frauds are actually a form of theft from the company; since the employees receive unearned compensation, they are actually stealing the company's cash and receiving it in their paychecks.
The fraud schemes described involve falsified time sheets. Supervisory review of time sheets is very important in preventing these types of fraud and the significant costs that companies may bear in paying for excess compensation. In some extreme cases, employees may collude with their supervisors in order to perpetrate these kinds of fraud. For example, a supervisor may be willing to approve an employee's falsified time sheet in exchange for a share of the extra money. Therefore, it is important that the company's management be aware of the possibility of such misconduct and carry out a review of time sheets that is thorough enough to detect these kinds of schemes. Supporting documentation should be required for certain absences from work and for commission and expense payments.
Another type of payroll-related fraud is the creation of a ghost employee. A ghost employee is an entity who receives a paycheck, but who does not actually work for the company. It may be a previous employee who has been terminated or is deceased, a friend or relative of a fraudster within the company, or simply an imaginary employee created by a fraudster. Regardless of the manner in which the ghost has been contrived, this unethical conduct is often initiated by someone within the company's payroll function. Bogus documentation is typically created in order to circumvent the company's internal controls and carry out the fraud. However, a ghost employee usually cannot survive unless a deficiency in segregation of duties exists. In order to pull off this plot, fraudsters need access to both the payroll preparation function and the paycheck disbursement activities. Following are some clues that a ghost employee may be lurking in the company's midst:
- The payroll register identifies paychecks without adequate tax withholdings.
- The personnel files contain duplicate addresses, Social Security numbers, or bank account numbers.
- Payroll expenses are over budget.
- Paychecks were not claimed when the paymaster distributed them.
- Paychecks returned with the bank statement contain dual endorsements, meaning that the ghost employee's paycheck was signed (forged) over to another person.
Notice that the last two items pertain to manual payroll processes. For companies with automated systems of paycheck deposits, these methods of detecting a ghost employee would not be available. Payroll frauds, such as ghost employees, can still occur in direct deposit payroll systems. A fraudster could set up a bank account and have fraudulent checks directly deposited.
The payroll-related frauds described earlier are generally employee frauds resulting in the embezzlement of company funds. Fixed assets–related fraud, described next, tends to be very different in that it involves management's misstatement of financial information.
Since fixed asset accounting involves the estimation of key information, including useful lives and salvage values, it relies on the conscientious efforts of employees to determine the inputs to the accounting reports. Unfortunately, with the many pressures on managers to present favorable financial results, managers may resort to unethical conduct in order to massage accounting numbers. This unethical practice is commonly referred to as earnings management. Fixed assets are one area where earnings management may be prevalent, due to the judgmental nature of the underlying data. For example, one way of reducing expenses (and thus, increasing net income) reported on the income statement is to extend the lives of fixed assets beyond their reasonable usefulness so that the cost of the assets is spread over a greater length of time. Similarly, the amount of the estimated salvage value could be increased above the expected amount in order to reduce the depreciable cost of the asset. Both of these schemes would reduce the amount of depreciation expense reported on the income statement in any given period. If these schemes are undertaken solely to distort earnings, they are unethical.
Another earnings management tactic is to misclassify repair and maintenance expenses as capitalized costs. This allows the costs to be spread over the life of the asset rather than reported as an expense in the year incurred.
A misclassification practice was performed at WorldCom, Inc., as the company transferred billions of dollars worth of facility-related expenses into asset accounts in 2001 and 2002. These misclassifications led to the restatement of WorldCom's financial statements and the ultimate downfall of the corporation.
Another misclassification case involves Krispy Kreme Doughnuts, Inc. This company has been criticized for its aggressive practices related to fixed assets reporting. When Krispy Kreme buys back its doughnut franchises, it records the amounts paid as intangible assets, even though much of the outlay is for fixed assets. It does not depreciate or amortize fixed assets, so the related costs are not reported as expenses on the income statement. Krispy Kreme defended its practices, claiming that the assets were not impaired and should not be expensed until used. This is an earnings management tactic that allowed the company to show favorable financial results, despite its dwindling profits. Following an SEC investigation, Krispy Kreme's top executives agreed to settle the matter and pay monetary fines, but they admitted no wrongdoing.
Sunbeam is another company that inflated earnings through fixed asset manipulation. During a year in which it reported dramatically increased profits, it treated certain period costs (for product development, packaging, and marketing) as fixed assets. Capitalizing these expenditures allowed for only a small part to be expensed each year via depreciation, rather than their entire amount being expensed in the year incurred.
Although there is no direct benefit (in terms of immediate cash received) to a fraudster who engages in earnings management, it is nonetheless unethical because it results in the falsification of the company's financial statements. Many investment and credit decisions are made on the basis of assumptions that the financial statements are a fair representation of the company's financial situation, so many parties stand to benefit or lose from the information contained therein. Fraudsters would realize indirect benefits if the company were able to continue to operate with favorable financial results reported. For instance, they may have increased job security, or they may receive a year-end bonus. However, the people who make business decisions on the basis of misstated information may suffer financial losses if they rely on the accuracy of falsified information when making their decisions.