Financial Statement Fraud – Watch Out for These Red Flags

Financial statement fraud is defined as the deliberate alteration of the company’s financial statements in order to mislead the users of financial information and create a better picture of the company’s financial position, performance and cash flows. It is generally considered to be the misrepresentation of financial information that is communicated to investors in publicly traded companies. This information is communicated through company press releases, SEC filings such as Forms 10-K and 10-Qs, and analyst conference calls. Notable examples of past financial statement fraud in publicly traded companies include Enron, WorldCom, and Tyco. Other more recent financial statement frauds include Logitech International and Weatherford International.

However, financial statement fraud doesn’t occur solely in large publicly traded companies. It occurs in all types of entities and doesn’t necessarily include the investing public as its victims. Financial statement frauds are also committed to misrepresent financial information to financial institutions, regulators, suppliers, donors, and business partners.

In all types of financial statement frauds, the fraud is usually perpetrated by someone in management at the company in order to achieve some desired objective. According to the Association of Certified Fraud Examiners’ (“ACFE”) 2018 Report to the Nations¹, financial statement fraud schemes are the least common but one of the most costly types of fraud. The ACFE 2018 Report showed that financial statement fraud represented only 10% of the cases reported, but experienced the highest median loss, at $800,000 per incident. The report indicated that 27% of owner/executive frauds involved financial statement fraud. The report also identified the fields of Construction, Technology, Professional Services, Retail, and Food Services as the most prevalent for financial statement fraud occurrences. The ACFE data is not limited to public companies; for example, a closely held corporation with limited capital may overstate its inventory or accounts receivable to secure financing.

In order for financial statement fraud to occur, the following needs to be present:

• An executive or executives, who will benefit from the fraud;
• Subordinates, accountants and others who are willing to assist in carrying out the fraud; and
• Unsavvy or unalert gatekeepers such as auditors or the board of directors.

Common financial statement fraud schemes include or involve the following:

• Improper revenue recognition/fictitious revenues;
• Underreporting expenses;
• Improper asset valuation;
• Improper recording of liabilities; and
• Improper or inadequate disclosures.

Of the above schemes, revenue recognition is the most common, has the largest dollar losses, and can vary greatly in execution. Inventory and related party transactions are also highly susceptible to fraud.

There are red flags and warning signs that are often missed in detecting financial statement fraud. These include, but are not limited to:

• Increasing revenue while cash flow remains the same;
• Unexplained, significant changes in assets and liabilities;
• A spike in earnings before the end of the fiscal year;
• Unexplained bonuses or loans;
• Missing documents;
• Discrepancies and unexplained transactions; and
• Too little cash collected from the revenues being reported.

A business that is found to have engaged in financial statement fraud can ruin its reputation, be at risk for lawsuits, incur regulatory involvement, and face possible criminal prosecution. When fraud is suspected, consultation with an attorney and a CPA who specializes in forensic accounting is strongly recommended. (This should be done sooner rather than later).

For more information about how to recognize financial statement fraud, contact your Marcum forensic specialist.

SOURCE

1. Association of Certified Fraud Examiners (“ACFE”) Report to the Nations 2018 Global Study on Occupational Fraud and Abuse.