Depreciation isn't a real cash expense. It is a non-cash transaction that allows accountants to track the wear and tear of assets over time. As assets are written off, the amount is expensed on the income statement, and the asset value is written down on the balance sheet. The net effect is lower asset values and a lower net income. Since depreciation expense affects net income and the amount paid to the IRS for taxes on net income, depreciation fraud is not unusual to find, particular if the company is under financial distress.
Determine the historical depreciation methodology used. If depreciation stays the same each year, the business is probably using straight line depreciation, which is the most popular depreciation method. The method spreads depreciation out in equal parts over the life of the asset. If depreciation is going down, the business is probably using a declining balance methodology.
Identify how the depreciation expense has changed during the period of expected fraud. If depreciation expense is going up, it is a sign the company has purchased additional assets and is writing off more of assets over time. If depreciation expense decreased significantly, it is a sign that the company has fewer assets on the books.
Check to make sure assets reflect changes in depreciation expense. If the depreciation expense is going up, look for an increase in assets on the balance sheet. If depreciation expense is going down, look for a decrease in assets on the balance sheet. If the balance sheet does not follow suit, this may be a sign of fraud.
Check the income statement. If net income has increased along with the change in depreciation expense, this may be a sign of fraud.
Check the company's actual tax returns. If the company reported lower net income than it reported on the net income statement to shareholders, this may be a sign of depreciation fraud, especially if it occurs for two years in a row.
James Collins has worked as a freelance writer since 2005. His work appears online, focusing on business and financial topics. He holds a Bachelor of Science in horticulture science from Pennsylvania State University.