In a recent case investigated by the Royal Canadian Mounted Police (RCMP), the senior executives of a publicly traded company were charged with fraud related to the financial statements of the company. The RCMP stated that the accused created an elaborate scheme of paper trails that exaggerated the financial position and the performance of the company in order to mislead investors, creditors and auditors. Revenues were overstated in successive quarters, false sales were recorded in the accounting records and high interest loans were not recorded. The company eventually went into bankruptcy, at which point the deception was uncovered. Creditors and investors lost millions and employees suffered through unpaid wages.
Financial statement fraud is the deliberate misrepresentation of the financial condition of an enterprise. Its intent is to deceive financial statements users (e.g., shareholders, creditors, regulators). It has many forms and guises, but is perpetrated through intentional misstatements or omissions of amounts in financial statements. It occurs in large publicly traded companies. It occurs in small family-owned firms. CGAs should be aware of the red flags that may indicate the presence of financial statement fraud and then make the appropriate examination to determine if their concerns are warranted. It is often the small extra inquiry by an accounting professional that exposes the presence of financial statement fraud.
The extent of financial statement fraud varies but the techniques used to perpetrate it generally fall into the following categories:
- fictitious revenues
- fraudulent asset valuations
- fraudulent timing differences
- concealed liabilities and expenses
- improper or fraudulent disclosures or omissions
Fictitious revenues are probably the most common form of financial statement fraud. In this scenario, false sales are recorded in the books and records of the company. Often, the offsetting entry will be to accounts receivable. However, there are also other methods of manipulating the revenue side of financial statements. Other techniques include the recording of consignment sales and sales with conditions, failing to record the return of goods sold, improper write-off of receivables, and non-recognition of sales discounts. All these techniques can have the effect of making revenues appear greater than they actually are.
Fraudulent Asset Valuations
Improper asset valuations can be used to manipulate financial statements to the point that they are misleading and fraudulent. This can be done in several ways. Often, an intentional violation in the application of the “Lower of Market or Cost Rule” has been done in order to manipulate the financial statements of an enterprise. Estimates of an asset’s residual value or useful life can also be manipulated. Other schemes to inflate current assets at the expense of long term assets can be undertaken in order to manipulate financial ratios.
Fraudulent Timing Differences
The misapplication of timing difference protocols in accounting can result in financial statements being manipulated. Essentially, timing differences can shift revenues from one reporting cycle to another. The same technique can be used to shift expenses. The result can be that expenses are either overstated or understated in a particular period. In the context of fraud, this technique allows the management of a company to manipulate earnings in order to hit predefined targets.
Concealed Liabilities and Expenses
Concealed liabilities and expenses can have significant impact on financial statements, because concealed amounts have a direct impact on the bottom line of a corporation. The pre-tax income is increased to the full amount by the expense that is not recorded. Concealing liabilities is often easier to do than inventing fictitious revenues, as the latter often requires the creation of false documentation such as false invoices or sales receipts. Concealing liabilities can be as simple as capitalizing an expenditure, rather than correctly placing the cost in the appropriate expense account. Another method is the understating of warranty costs for an enterprise. Failing to adequately disclose the true warranty expense for a business can be of benefit to corporate criminals who wish to manipulate financial statements.
Improper or Fraudulent Disclosures or Omissions
As a general rule, financial statements must contain all information to prevent a user of those financial statements from being misled. Notes to financial statements should contain narrative disclosures, supporting schedules, and any other information required to avoid misleading financial statement users. Improper or inadequate disclosure in financial statements can be any of the following:
- accounting changes
- liability omissions
- management fraud
- related party transaction
- subsequent events
The degree of the lack of disclosure in any of these examples can amount to the fraudulent omission of a material fact that, in turn, makes the issuance of financial statements fraudulent.
The Defence Against Financial Statement Fraud
Financial statement fraud can be insidious and shrouded. It may have perpetrated for years in any particular business or organization without exposure. Often, when it is finally detected, it is too late; creditors, investors and shareholders have been victimized with no hope of recovery. How then, can we immunize ourselves from financial statement fraud?
The answer lies in a close examination of financial statements for any red flags that may emerge. Each of the types of financial statement fraud outlined in this article has its own red flag, but there are many common warning signs of financial statement fraud. (I recommend the Canadian edition of the Fraud Examiners’ Manual, published by the Association of Certified Fraud Examiners, for extensive reference.)
While I’ve grouped the examples into categories for the sake of simplicity, any one of these warning signs—sometimes alone, sometimes in combination with other signs—can be the key to the discovery of fraud.
Accounting and Statement Warning Signs
- Negative cash flows while reporting positive earnings.
- Rapid growth or unusual profitability.
- Unusual and highly complex transactions, often close to year end.
- Unusual changes in key financial ratios.
- Unusual increases in gross margin.
Economic and Sector Warning Signs
- Assets, liabilities and expenses based on significant estimates.
- Declines in customer demand.
- Increasing business failures in the sector.
- Significant bank accounts or operations in tax haven jurisdictions.
- Significant related-party transactions.
- Rapid growth or unusual profitability.
- Repeated use of materiality to justify inappropriate accounting entries.
Corporate Culture and Structural Warning Signs
- Domination of management by a single person or small group.
- Excessive participation by non-financial managers in accounting issues.
- Formal or informal restrictions on the auditor that limit access to key persons.
- Ineffective communication and implementation of company’s values and ethical standards.
- Ineffective or weak board of directors and audit committee.
- Known history of violations of securities laws by the company, related entities and its executives or board members.
- Overly complex organizational structure involving unusual entities.
CGAs should be aware of the basic types of financial statement fraud and the red flags that mandate closer examination. This basic knowledge will help CGAs and their clients from falling victim to fraudsters who seek to deceive investors, creditors and others with materially false financial statements.