ACC 691 Module 5 Asset Overstatement Assignment Example

Analysis of Capitalized Engineering Costs and Inventory Overstatement, 2024-2025

[Student Name]

Southern New Hampshire University

ACC 691: Detection and Prevention of Fraudulent Financial Statements

Module Five Assignment

[Instructor Name]

[Date]

The organization, setting and figures below are a composite written as a model document. No real employer, client, colleague or patient is described.

Analysis of Capitalized Engineering Costs and Inventory Overstatement, 2024-2025

Introduction

After the revenue schemes of late 2024, the company's managers needed additional profit that would not show up as unusual sales. They found it on the balance sheet. This paper analyzes two asset schemes uncovered by the 2026 investigation: the capitalization of engineering costs that did not qualify, and the double counting of finished goods moving between the main plant and a second assembly plant forty miles away. For each, it explains the scheme, identifies the requirement it violated, measures the effect on assets and pretax income for 2024 and 2025, describes concealment and recommends controls.

Scheme One: Engineering Costs Recorded as Software

In 2023 the company began developing controller software that would let restaurant chains monitor ovens remotely, a product it planned to sell. Under the software guidance for products to be sold, costs incurred after technological feasibility is established may be capitalized, while earlier costs, and all other engineering work, fall under ASC 730 and are expensed as incurred (Kieso et al., 2019). The project reached feasibility in March 2024, so a limited amount of coding and testing after that date could be capitalized.

From the third quarter of 2024, the vice president of engineering, at the CFO's request, told staff to charge their hours to the software project code regardless of the work. Time records later showed that about 70 percent of hours charged to that code went to redesigning fryer baskets, heating elements and door seals for existing equipment. Those activities are research and development or ordinary product maintenance; neither qualifies for capitalization.

The distinction is not a technicality. Capitalization is allowed for software after feasibility because, at that point, the company has shown that a saleable product exists and that the remaining costs build an asset with future revenue behind it. A redesigned fryer basket has no such separate future benefit; it keeps existing products competitive, which is what ordinary engineering is for. By moving those hours onto the software code, managers created an asset that represented nothing the company could sell, license or use apart from its existing product line.

Engineering costs capitalized versus qualifying, in millions

Amortization began in 2025 when the first module was released, so the 2025 income effect is the improperly capitalized amount less the amortization already recorded on it.

Scheme Two: Inventory Counted at Both Plants

Finished ovens moved daily between the second assembly plant and the main plant's warehouse. At the 2024 and 2025 year ends, the plant controller recorded truckloads sent in the last three days as goods in transit, keeping them on the shipping plant's books. The receiving warehouse, however, had already unloaded and counted many of the same units in its physical count. The result was that $7.6 million of finished goods at the end of 2025, and $3.6 million at the end of 2024, appeared twice. Inventory must be measured once, at cost, by whichever location has it, and goods in transit are recorded only until they arrive (Kieso et al., 2019).

Since a larger closing stock figure shrinks the cost charged against sales, each dollar of overstated ending inventory raises gross profit by a dollar in that year, and lowers it by the same amount the following year when the overstated balance becomes opening inventory. To keep 2025 profit up, the scheme had to grow, which is why the overstatement rose from $3.6 million to $7.6 million.

Quantifying the Effects

Overstatement of pretax income by year, in millions

The 2025 engineering figure is the $8.7 million of improper capitalization less $1.3 million of amortization on the excess. Combined with the revenue schemes analyzed in Module Two, the asset schemes made the difference between missing and meeting guidance in both years.

Concealment

The engineering scheme was concealed in plain sight. The project code was legitimate, so charges to it raised no automatic alert, and the capitalization memo prepared each quarter by the controller simply multiplied hours on the code by a standard rate. No one compared the code with project descriptions or engineers' weekly reports. The inventory scheme relied on timing. The in-transit list was prepared by the shipping plant's controller after the count, and the warehouse count sheets were not reconciled with shipping records until mid-January, after the auditors had completed their inventory procedures. Count sheets at the second plant were later found to include handwritten additions in a different ink.

Red Flags

Several signs appeared in the records. Other noncurrent assets rose by more than a third in 2024, which the company attributed to software investment, although its research spending reported in the notes fell by a similar amount. Days inventory rose from 64 to 72 in 2025, without a production slowdown, and the in-transit balance at year end was about four times its average at quarter ends. The COSO study of fraud cases by Beasley et al. (2010) found that overstated assets, including capitalized expenses and inventory, were among the most common methods after improper revenue recognition. Dechow et al. (2011) similarly found that growth in soft assets helped predict misstatements.

Recommended Controls

For capitalization, the company should adopt a written policy listing the criteria and require the controller and an engineering manager outside the project to approve each quarter's capitalized amount with a sample of time entries traced to work descriptions. Internal audit should test the policy annually. For inventory, every interplant shipment should carry a transfer document matched at receipt, the in-transit list should be prepared before the count by someone independent of both plants, and the count should be reconciled with transfers within two days. External auditors should observe counts at both locations at the same time, since staggered counts allow goods to be counted twice.

Conclusion

The engineering scheme violated the requirement to expense research and development, and the inventory scheme violated the rule that inventory is counted once, by the location that has it. Together they overstated assets by $24.4 million at the end of 2025 and pretax income by $13.0 million and $11.4 million in the two years. Both were hidden in records that no one reconciled, which makes reconciliation the central control.

References

Beasley, M. S., Carcello, J. V., Hermanson, D. R., & Neal, T. L. (2010). Fraudulent financial reporting: 1998-2007: An analysis of U.S. public companies. Committee of Sponsoring Organizations of the Treadway Commission.

Dechow, P. M., Ge, W., Larson, C. R., & Sloan, R. G. (2011). Predicting material accounting misstatements. Contemporary Accounting Research, 28(1), 17-82. https://doi.org/10.1111/j.1911-3846.2010.01041.x

Kieso, D. E., Weygandt, J. J., & Warfield, T. D. (2019). Intermediate accounting (17th ed.). Wiley.