Financial statement fraud is generally defined as the falsification, alteration, or manipulation of material financial records, supporting documents, or business transactions.  It is often perpetrated by the intentional omissions or misrepresentations of events, transactions, accounts, or other significant information from which financial statements are prepared.

According to the Association of Certified Fraud Examiners 2020 Report to the Nations study, financial statement fraud represents 10% of the reported cases, with a median loss of $800,000.  On average, financial statement frauds go undetected for two years.

5 ways Financial Statement Fraud occur?

Financial statement frauds typically occur around “gray areas” of professional judgement. They tend to push the boundaries of management and professional judgement.

1. Fictitious Revenues – Example: Recording a sale that did not occur, recognizing a sale with conditions, creating fake customers and fictitious sales.
2. Timing Differences – Example: Shifting revenues or expenses between one period and the next, increasing or decreasing earnings as desired. Often done through manipulating when revenue is recognized, abusing long-term contracts, and channel stuffing.
3. Improper Asset Valuation – Example: Under or overstating accounts receivable, inventory, fixed assets, or business combinations.
4. Concealed Liabilities and Expenses – Example: Omitting liabilities/expenses, capitalizing expenses, failure to disclose warranty costs.
5. Improper Disclosures – Example: Not disclosing subsequent events, relate party transactions, management fraud, or accounting changes.

Red Flags for Financial Statement Fraud

Some red flags include:

• Rapid growth or unusual profitability, especially compared to that of other companies in the same industry.
• Recurring negative cash flows from operations or an inability to generate cash flows from operations while reporting earnings and earnings growth.
• Unusual growth in the number of days’ sales in receivables.
• Unusual increase in gross margin or margin in excess of industry peers.
• Unusual decline in the number of days’ purchases in accounts payable.
• Assets, liabilities, revenues, or expenses based on significant estimates that involve subjective judgments or uncertainties that are difficult to corroborate.
• Nonfinancial management’s excessive participation in or preoccupation with the selection of accounting principles or the determination of significant estimates.
• Domination of management by a single person or small group without compensating controls.
• Ineffective board of directors or audit committee oversight over the financial reporting process and internal control.
• Significant, unusual, or highly complex transactions, especially those close to period end that pose difficult “substance over form” questions.
• Recurring attempts by management to justify marginal or inappropriate accounting on the basis of materiality.
• Nonfinancial management’s excessive participation in or preoccupation with the selection of accounting principles or the determination of significant estimates.

See posted article Are the Financial Statements Wrong for additional considerations.

Overstatement or Understatement?

It is important to note that most auditors and CPAs are taught and focus on conservativism.  With financial statement fraud, conservativism (in the accounting sense) means that the risk to the financial statements relate to the overstatement of assets and income, and the understatement of liabilities and expenses.  As fraud examiners and forensic accountants, we try to assess what is motivating the owner(s) and management.  We recognize that the notion of conservativism may be wrong. For instance, the owner of a business may be more motivated by tax concerns or perhaps a divorce.  Accordingly, he/she may want to understate assets and income and overstate liabilities and expenses.

Culture of Management and Ethics

Another thing to consider is management’s culture. What is the tone at the top? Does the leadership act and behave in an ethical manner? Do they encourage an environment for staff to question and challenge leadership? As an ancient proverb states, “A fish rots from the head down.”

Questions?

When investors, creditors, and others rely on falsified financial information,  bad decisions can be made resulting in damages or improper valuations.  If you have concerns about financial statement fraud or any other areas of forensic accounting, please contact us.