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Financial Statement Frauds

What is financial statement fraud?

Financial statement fraud is the manipulation of information used by companies to prepare their financial statements. Manipulating these statements allows the company to portray a false financial picture.

Financial statements are released by a company to the public and financial institutions and are usually the only window into a company's financial affairs available to the average investor, and sometimes the only information available to banks and other institutional investors.

Who are the victims?

The victims are the investors, shareholders, bankers and other financiers. The also include the people that have superannuation investments with financial institutions that invest in these companies.

Who are the offenders?

The offender is not the company as an entity, but a group of people within the company. There may be (and usually is) a number of offenders acting together and they can be high ranked officers, but that is not always the case.

Why commit financial statement fraud?

The aim is to create a false impression of the financial position of the company. There are usually two objectives:

1. to make the company's performance and stability look better to increase investor's confidence and thereby increase the share price or remuneration paid to officers of the company; or
2. to lower the company's profit in order to lower the company's tax liability or share price.

With better financial results, financiers will be more willing to invest monies and at better rates. Better financial results should also inflate the share price of the company. This will benefit people that are paid performance bonuses or receive options as part of their remuneration package. It will also make it easier to use the company's shares for acquisitions.

How is financial statement fraud done?

The two basic ways are manipulating:

1. the actual amounts that are used the statements; and / or
2. the timing of the recognition of the amounts and when they will appear in the statements.

METHODS OF FINANCIAL STATEMENT MANIPULATION

1. THE USE OF TIME IN FINANCIAL STATEMENT FRAUD

The accounting matching principle states that revenues and expenses should be recorded in the period in which they relate. People can use timing to:

(a) bring sales from a later period into an earlier period to increase this period's revenues; and
(b) delay expenses from the current period to the next period to decrease this period's expenses.

Both actions will cause problems in the next period. They make the current period look better, but make the next period look bad. This is a short term fix to get an immediate result.

The opposite approach (delaying the recognition of sales and bring forward expenses) may be taken if the aim is to reduce profits, and thereby taxation expenses and share prices.

1.1 The early recognition of revenues

The early recognition of revenues is generally the early recognition of sales by recording future sales into the current period. The more legitimate method of doing this is to ask the customer to bring his order forward into the current period and complete the sale. The fraudulent method is to manipulate when the sale is recorded.

When is a sale recorded?

Businesses have different ways of determining when a sale has been made and should be recorded.

Sometimes a sale is recorded when the stock is shipped - so a sale for the next period can be recorded in this period if the stock is shipped to the customer in this period, even if they do not want it now. If the stock cannot ship directly to the customer, it can be shipped to a third party warehouse and held until required by the customer. The stock has been shipped and the sale is booked in this period.

Sometimes a sale is recorded when the invoice is issued - so issuing the invoice early, before shipping the stock or even receiving a firm order, creates a recordable sale. Sending the invoice to the wrong address, so that it will be returned to you some days later (after the end of the period), will save sending the invoice to the customer early and risking upsetting them.

Sometimes a sale is recorded when the order is received - so orders for stock, even if they are for delivery over a extended time period or non-binding, can be requested from customers. You then allow customers to withdraw orders at some time in the future.

For every method of determining when sales should be recorded, there will be a way of booking the sale early. This has been a common method for companies to show good quarterly earnings from period to period to keep investors and analysts interested in the stock.

Example

ABC Company is short of the sales numbers that are expected by its investors for the period. Its policy is to book sales as invoices are prepared. To make these figures, the sales manager invoices a delivery that will not occur until the middle of the next period and holds the invoice. As the invoice has been prepared, the sale is recorded and the period's figures are made.

1.2 The late recognition of expenses

The matching principle states that expenses should be recognized in the period in which the related benefit is received. But expenses may be recorded when the service is requested, the invoice is received or when the payment is made. Requesting services early or making prepayments of expenses can bring the expense into an earlier period, delaying the processing of invoices or making late payments can delay recording expenses until the next period.

Manipulating the timing of expenses is the same as manipulating the timing of revenues. The trigger for the recording of expenses is used to bring forward or hold off expenses from period to period.

1.3 Using time to reduce taxes

Manipulating the transactions in the reverse way, holding off the booking of sales to the next period and bringing forward expenses to this period, can be used to lower the profits and reduce any tax liability.

2. FICTITIOUS REVENUES

Improving revenue figures can be as simple as recording sales that did not occur. A entry into the journals debiting debtors and crediting sales will work if your books will not be audited. That will create the illusion of increased sales and matching debtors, keeping the books balanced.

More sophisticated methods will depend on what trigger is used to book sales. If that trigger is the shipment of stock, the company can ship unordered stock to someone and book a sale of the stock. Delaying recording the return of the stock will extend the life of the transaction. The transaction is undone in the next period, but that may be after the results have had their use.

If you book sales when orders are placed, you can create a lot of orders that never get filled and book these as sales. The orders are canceled in a later period. You can send stock to customers on consignment, but book it as a sale of the stock through an order.

More sophisticated frauds can involve entering into convoluted transactions with a willing third party that result in a 'paper' sale or extraordinary (by that I mean false) revenues under a transaction, but no real revenue that results is real profits.

Example

ABC enters into transactions with companies in the same industries selling rights to use each others excess capacity. They sell rights to their excess capacity and buy rights to the other party's excess capacity. The two payments are offset, so no money changed hands.

The transaction is for $10 million and the rights lasted for 10 years. They booked the $10 million revenue in the current year even though the rights were for 10 years, and capitalize the payment of $10 million for the purchase, expensing it over the 10 year life of the rights at $1 million each year. They created a $9 million profit in the current year. But you also created a $1 million expense in each of the next 9 years.

3. IMPROPER DISCLOSURES OF LIABILITIES

There are a couple of ways that liabilities can be used to manipulate financial statements.

3.1 Omission of liabilities

Companies can hide liabilities by crediting a trading account with the balance of a liability account or a subsidiary company that holds the liability and effectively remove it from the balance sheet. The liability will not show up but the balance sheet will still balance.

The alternatives are:

(a) creating a fictitious long term loan to eliminate the short term liability (improving working capital);
(b) transferring the credit amount into a revenue account to create an increased profit figure;
(c) moving the liability to an equity account on the balance sheet; or
(d) move the liability to another entity so that it is off-balance sheet.

These basic schemes work easily when the financial statements are not audited.

3.2 Overstating and understating provisions

Businesses must make allowances for provisions for bad debts, sales returns, employee entitlements, tax etc in their financial statements. They must also allow for known financial matters that will cover more than one accounting period (e.g. large rectification work on a capital project).

The company can:

1. overstate or create provisions to get larger tax deductions or, if they are trying to buy shares in the company, make the accounts look worse and decrease the share price; or
2. understate provisions for expenses or future liabilities to make the accounts appear healthier.

As provisions are, to a great extent, estimations, they can usually be easily manipulated beyond what should be reasonable.

4. VALUATION OF ASSETS

There are many ways of inflating the values of or creating assets, including:

4.1 Inflation of inventory levels

Inventory on hand may be the largest asset of the company. There are two methods of manipulating the value of inventory.

The first is to value the inventory at a higher than appropriate level (an inflated selling or cost price) and count the correct amount of stock. Any count of the stock will show the right numbers of stock, but at an increased value. The value of stock may be less certain to verify in an audit.

The second is to value the stock at the correct dollar amount, but count an increased amount. This can be as simple as removing the stock from its boxes and counting the empty boxes as well as the real stock.

The 'Crazy Eddie' fraud included:

(a) Taking stock out of the boxes and counting the empty boxes;
(b) Allowing the CFO participating in the audit of inventories, helping the auditors count the stock;
(c) Listing cheaper inventory at the price of more expensive products;
(d) Disguising empty shelving by placing a wall of stock boxes at the front of the shelf so it looked like that there was shelf was full of stock;
(e) Getting suppliers to deliver stock a few days before the stock count and returning it shortly after the stock count;
(f) moving stock between locations so that it could be counted more than once.

4.2 Manipulating accounts receivable

The trade debtor's ledger can be given a range of values by adjusting what debts are written off the ledger. Not writing off debtors improves the financial position, as collectable debtors appear larger than they should, and there is a smaller expense for bad debts. Alternatively, writing off collectable debtors at the end of a period creates an expense and lowers taxable profits. You simply write them back on next period or when collected.

The creation of fictitious trade debtors, using a credit sales / debit debtors entry in the journals, can be used if the books are not audited. This adjustment is more common when smaller nonpublic companies seek finance. The entry can be as easily reversed after the end of the period.

DETERRENCE AND DETECTION

Internal and external audits

External auditing was created so that an independent person could look behind the financial statements and discover whether they were accurate. The opinion on the accuracy or truth of the financial statements is used by investors and financiers in making investment decisions. Internal auditing is meant to ensure that the company is recording transactions correctly on an ongoing basis.

Auditing is the way that most financial statement frauds are uncovered. Unless the auditors and the fraudster are colluding, there is a good probability that the audit function will uncover frauds.

Moral leadership

Financial statement frauds are committed internally within the company. Someone inside the company, usually high up in the company structure, commits or allows these frauds to occur for various reasons. The best way of preventing these frauds is a strong and moral leadership. Employees take their lead from the heads of the company. They must set the example.

Pressure to perform

Too much pressure to get short term results is one of the main underlying causes of these frauds. If the pressure for results is too great, or the consequences of not getting the numbers are too great, the chances of improper or illegal behavior occurring will increase. The need for results has to be dealt with realistically.

Disclaimer
The enclosed information is of necessity a brief overview and it is not intended that readers should rely wholly on the information contained herein. No warranty express or implied is given in respect of the information provided and accordingly no responsibility is taken by Worrells or any member of the firm for any loss resulting from any error or omission contained within this fact sheet.

Acknowledgment
The material in this Fact Sheet was sourced from various publications including those listed in the Reading List on the Fraud Awareness page on this website.

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Last Updated: 11.4.2008