Financial Statement Fraud: Strategies for Detection and Investigation

CHAPTER SIX

Improper Capitalization of Costs

ONE OF THE MOST common methods of fraudulently making a company appear financially stronger is through the capitalization or deferral of expenses. This method instantly takes expenses, which reduce net income, and converts them into assets.

There are several categories of expenses that are the most likely candidates for improper capitalization, including the following:

1. Start-up costs

2. Research and development costs

3. Repairs and maintenance (capitalized as property and equipment)

4. Software development and acquisition

5. Websites

6. Development of intangible assets

7. Advertising

8. Other deferrals and prepaid expenses

While WorldCom may be the most well-publicized and most material case of improper capitalization of expenses (to the tune of more than $3 billion), the American Italian Pasta Company (AIPC) case may be even more useful for illustrating the many methods with which this category of fraud can be perpetrated.

AIPC engaged in no fewer than four different methods of expense capitalization, resulting in overstatement of earnings from 2002 through 2004. Three of the methods involved improper capitalization of costs associated with the installation of new pasta production lines in the company's manufacturing plants. Normally, the costs capitalized in adding new production lines included internal plant labor and other internal costs, in addition to amounts paid to third parties. Capitalizing internal labor costs is consistent ...