Financial statement fraud is a white-collar crime usually perpetrated by management insiders to represent a company in a more favorable fiscal light. Fraudsters are motivated by personal gain, such as performance-based compensation; enhancing the company’s reputation by misleading potential investors; or simply buying time until financial mistakes and losses can be properly corrected.

Financial statement fraud is a crime of opportunity. Companies with lax internal controls, manual accounting systems, or dishonest and overly aggressive leaders are more likely to fall prey. The key to combating financial statement fraud is to prevent it from ever happening. If it can’t be prevented, then it’s important to find it as fast as possible.

What Is Financial Statement Fraud?

Financial statement fraud is the deliberate misrepresentation of a company’s financial statements, whether through omission or exaggeration, to create a more positive impression of the company’s financial position, performance, and cash flow.

Usually committed by senior management, this crime is typically a means to an end. The motives for perpetrating financial statement fraud include personal gain, keeping the business afloat, and retaining status as a leader in the organization. Fraudsters attempt to inflate the perceived worth of the company to make the stock appear more attractive to investors, to obtain bank approvals for loans, and/or to justify large salaries and bonuses when compensation is tied to company performance.

Regardless of the motive, financial statement fraud causes problems with current and potential investors and shareholders. It can result in large-scale reputational damage as well as serious sanctions from regulators—the US Securities and Exchange Commission (SEC), for example—and even arrests.

Key Takeaways

  • Financial statement fraud is committed when people with access to financial documents and information manipulate data to make the company appear more successful than it is.
  • Warning signs for financial statement fraud are numerous and fall into four categories: financial, behavioral, organizational, and business.
  • To detect fraud, have an auditor analyze the relationships among different financial numbers and compare the ratios to years past or industry norms.
  • The No. 1 way to prevent financial statement fraud is to implement strong internal controls that enforce the segregation of duties so that no single employee has authorization to manipulate financial data.
  • This can be accomplished by using an automated ERP system.

Financial Statement Fraud Explained

Financial statement fraud impacts organizations of all sizes across the public, private, nonprofit, and government sectors. The perpetrators can come from all areas of a company, including accounting, operations, sales, customer service, and even owners and executives. Some work alone, but when they act as a group, the scale of the deception can multiply. Likewise, the higher up and more tenured the perpetrator, the larger the size of the fraud tends to be. When it comes to financial statement fraud, the most common high-risk departments are accounting, finance, and executives. When caught, most offenders are fired and referred to law enforcement for prosecution.

Because it can take a while to detect financial statement fraud—often up to two years—effective internal antifraud protections are essential. When in place, they catch fraudulent activity quicker, so losses tend to be smaller. Further, it’s worth noting that financial statement fraud generally doesn’t happen in a vacuum—it’s frequently combined with misappropriation and/or corruption, compounding the potential for loss.

Financial statement fraud is slightly less frequent in larger organizations than in those with fewer than 100 employees. This is likely because larger companies have more resources for better segregation of duties and more formal internal control mechanisms, such as an internal audit team. That being said, when financial statement fraud does occur in large companies, the magnitude can be devastating for victims.

The Sarbanes-Oxley Act

The Sarbanes-Oxley Act (SOX) was enacted by Congress in 2002 in response to major financial and accounting scandals that caused significant losses for American investors. Its goal is to bolster investor confidence and protect against fraud, primarily through increased corporate accountability and strengthened internal control requirements. SOX applies to all public companies, their wholly owned subsidiaries, companies planning an initial public offering, foreign businesses that trade on US stock exchanges, and some private companies with publicly traded debt. It’s an extensive piece of regulation, but the key aspects related to financial statement fraud are:

  • Personal accountability: SOX requires a company’s CEO and CFO to personally attest to the material accuracy of financial reporting and the effectiveness of the internal control environment. Stiff penalties, including multimillion-dollar fines, repayment of incentive-based compensation, and criminal jail time, are levied for willful misrepresentation.
  • Public Company Accounting Oversight Board (PCAOB): SOX established the PCAOB to set new auditing standards and oversee the quality of external audits of publicly traded companies. The PCAOB is the enforcement arm of the SEC, limiting authority of the American Institute of Certified Public Accountants to setting auditing standards only for private companies and other non-public entities.
  • Auditor independence: SOX includes a framework of standards that aims to reduce potential conflicts of interest between external auditors and their clients. These include mandatory rotation of audit partners and restrictions on allowable non-audit services.

Types of Financial Statement Fraud

Business fraud comes in many forms, including bribery, kickbacks, and payroll fraud. When it comes to financial statement fraud, most cases involve intentionally misrepresenting accounting so that share prices, financial data, or other valuation methods make a company seem more profitable. Wrongdoers manipulate revenue, expenses, liabilities, and assets to portray the company in a more positive light. Here are some typical approaches:

  • Overstating revenue: A company can commit fraud by claiming money as received before the goods or services have been delivered. This can be done by prematurely recording future expected sales or uncertain sales. If the company overstates its revenue, it creates a false picture of fiscal health that may inflate its share price.
  • Fictitious revenue and sales: Fictitious revenue involves claiming the sale of goods or services that didn’t occur, such as double-counting sales, creating phantom customers, or overstating or otherwise altering the legitimate invoices of existing customers. Perpetrators of this kind of fraud may reverse the false sales at the end of the reporting period to help conceal the deceit. Famously, this is what Wells Fargo did in a fraud scheme that came to light in 2016. To meet impossible sales goals, employees created millions of checking and savings accounts on behalf of clients—but without their consent.
  • Timing differences: This involves understating revenue in one accounting period by creating a reserve that can be claimed in future, less robust periods. Other forms of this type of fraud are posting sales before they’re made or prior to payment, reinvoicing past due accounts, and prebilling for future sales.
  • Inflating an asset’s net worth: This form of financial statement fraud occurs when a company overstates assets by failing to apply an appropriate depreciation schedule or valuation reserve, such as inventory reserves. In addition to inflating the asset value, it will result in overstated net income and retained earnings, which inflate shareholders’ equity.
  • Concealment of liabilities or obligations: Concealment is a type of fraud where liabilities or obligations are kept off the financial statements to inflate equity, assets, and/or net earnings. Examples of concealed liabilities include loans, warranties attached to sales, and underreported health benefits, salaries, and vacation time. The easiest way to conceal liabilities is to simply fail to record them.
  • Improper or inadequate disclosures: The information disclosed in financial statements must be accurate and clear so as not to mislead the reader. Accounting changes must be disclosed if they have a material impact on financial statements. When this type of fraud is committed, significant events, related-party transactions, contingent liabilities, and accounting changes are obscured or omitted from financial statements.
  • Falsifying expenses: Another form of financial statement fraud occurs when a company doesn’t fully record its expenses. The company’s net income is exaggerated and costs are understated, creating a false impression of the amount of net income the company is earning.
  • Misappropriations: A serious form of financial statement fraud is altering the statement to mask theft or embezzlement hidden in the company’s double-entry bookkeeping or the inclusion of fake expenses. This form of fraud is usually perpetrated by an individual looking to enrich themselves, as opposed to forms of fraud that are intended to inflate the valuation of the company to investors and the business community.

Financial Statement Fraud Warning Signs

When a forensic accountant investigates financial statement fraud, they look for red flags that indicate suspicious business practices and raise concern. By becoming familiar with these common fraud indicators, management can minimize the potential for financial statement fraud and mitigate future risks. Warning signs can be grouped into the following categories: financial, behavioral, organizational, and business.

Financial warning signs: When someone has “cooked the books,” certain patterns jump out as suspicious and anomalous to investigators:

  • Rising revenue without corresponding growth in cash flow—this is the most common warning sign of financial statement fraud.
  • Consistent sales growth while competitors are struggling.
  • A spike in performance in the final reporting quarter of the year.
  • A significant, unexplained change in assets or liabilities.
  • Unusual increases in the book value of assets, such as inventory and receivables.
  • Frequent, complex third-party transactions that have no logical business purpose, don’t appear to add value, or make it hard to determine the actual nature of a particular transaction.
  • Missing or altered documents.
  • Discrepancies and unexplained items and/or transactions on accounting reconciliations, such as invoices that go unrecorded in the company’s financial books.
  • Aggressive revenue recognition practices, such as recognizing revenue in earlier periods than when the product was sold or the service was delivered.
  • Growth in sales without commensurate growth in inventory—or vice versa.
  • Improper capitalization of expenses in excess of industry norms.

Behavioral warning signs: According to a 2024 global fraud study by the Association of Certified Fraud Examiners (ACFE), 84% of fraudsters displayed at least one behavioral red flag while committing their crimes. These behavioral red flags will crop up at work, as well as in the fraudster’s personal life:

  • A manager or accountant living beyond their means and/or having financial difficulties.
  • Dishonest, hostile, aggressive, and unreasonable management attitudes.
  • Control issues, such as an unwillingness to share duties pertaining to company finances.
  • Management displaying inordinate concern with managing the reputation of the business.
  • Loans to executives or other related parties that are written off.
  • Inexperienced or lax management and/or accountants.
  • Sudden replacement of an auditor, resulting in missing paperwork.
  • Refusal to take time off for fear that their “pinch-hitter” will uncover the scam.

Organizational warning signs: The corporate structure and operational practices of a business can reveal circumstances that are more favorable to those who wish to commit financial statement fraud. An environment where accounting systems and controls are weak and fail to conform to governance best practices allows for false or misleading information to remain unchallenged. Examples include:

  • Frequent organizational changes, such as unusually high turnover in management or key accounting personnel.
  • Unexplained or disproportionate management bonuses based on short-term targets.
  • Operating and financial decisions that are dominated by a single person or a few people acting in concert.
  • A board of directors full of insiders.
  • Undue emphasis on meeting quantitative targets.
  • Sloppy or manual management/operational business processes, as opposed to automated processes embodied in business software.

Business warning signs: External factors, such as overall industry downturns and wild divergence from peer company norms, can be indicators of potential fraud. A keen auditor will notice business results and organizational behavior that seem out of alignment with the overall patterns in that particular industry, such as:

  • Profitability and/or operating margins that are out of line with peers.
  • Significant investments in volatile industries or during industry turndowns.
  • Unusually high revenue and low expenses at times that can’t be explained by seasonality.
  • Operating results that are highly sensitive to economic factors, such as inflation, interest rates, and unemployment.

Financial Statement Fraud Detection

The primary responsibility for the detection of financial statement fraud resides with company management. Prevention of fraud is most effective with a strong team consisting of an audit committee comprising internal and external auditors and a board of directors that sets a tone for ethics at the organization. Auditing standards establish that auditors have a responsibility to reach a reasonable assurance that financial statements are clear of misstatement due to either error or fraud. The auditors’ responsibilities are to appropriately identify, assess, and respond to fraud risks, using the many tools and techniques at their disposal.

Auditors look for troublesome relationships among financial data that indicate cause for deeper investigation. Investigating the relationships among numbers in financial statements offers comprehensive insight into a company’s financial health. The foundation of financial analysis is understanding what the relationships among certain financial statement balances should be so that auditors recognize when the numbers are off-base. For example, a healthy company tries to maintain a consistent balance between assets and liabilities. An unexpected shift from historical norms could indicate that management is trying to hide something. An increase in the ratio could mean liabilities are being hidden; a downward shift could mean the company is borrowing heavily to finance operations.

Another key ratio to note is sales versus cost of goods or services sold. Typically, these numbers rise and fall together; the more goods sold, the more materials and expenses are incurred to produce them. This directly proportional relationship holds true for sales versus accounts receivable as well. As sales increase, so should accounts receivable. When these numbers fall out of proportional relationship to each other, further investigation is warranted. Analyses such as these are called comparative ratio analysis, and they help auditors spot accounting irregularities by measuring the relationship between two different financial statement amounts. Ratios are calculated from current year numbers, then compared to previous years, other companies, the industry, or the economy. When there are significant changes from year to year or between entities, a more detailed examination is required to help uncover potential fraud.

Another tool fraud examiners use to interpret a company’s standing is percentage analysis—vertical and horizontal. Vertical analysis examines the relationships among items on any one of the financial statements during one reporting period. The relationships among the components are expressed as percentages that can be compared across periods. Horizontal analysis analyzes the percentage change in individual financial statement items year over year. The first year is considered the base, and subsequent changes are computed as percentages of the base period. Comparative analysis tools help investigators identify financial inconsistencies, increasing the odds of detecting fraud.

Consequences of Financial Statement Fraud

Financial statement fraud can cause multiple operational disruptions for a business. For starters, the investigation alone can be a significant distraction from core business activities, and it’s typically costly. Further, the remediation efforts—whether involving management changes, the loss of key personnel, or the costs and process changes to implement more stringent antifraud controls—can pose significant change management challenges. Beyond these issues, financial statement fraud has several immediate, medium-, and long-term consequences for a company and its management, including:

  • Legal consequences: Individuals involved in financial statement fraud can face criminal charges, potentially leading to imprisonment. Additionally, they may also lose professional licensing and be barred from serving as officers or directors of any public company. Both individuals and companies can be charged with substantial fines and penalties. Civil lawsuits from shareholders, creditors, and other affected parties are also common, and courts may mandate enhanced compliance programs, such as external monitoring, as part of their judgments.
  • Market consequences: Stock prices often plummet upon discovery of fraud, resulting in losses for current investors and scaring off future investors who lose confidence in the company. The company is also likely to have difficulty raising capital or qualifying for loans because of a lack of credibility. And when financing is available, it may be at a higher cost of capital because of increased perceived risk. In severe cases, the company can be delisted from stock exchanges.
  • Reputational consequences: Damage to a company’s brand and public image can have a lingering impact on its ability to do business. Customers may lose trust and boycott the products or services. Supplier and partner relationships become strained, leading to less favorable terms or termination. And it may be difficult to attract or retain high-performing employees. Media scrutiny compounds these reputational issues and makes future marketing less effective.

Financial Statement Fraud Examples

According to the ACFE’s 2024 global fraud study, financial statement fraud is the costliest type of occupational fraud, with a median loss of $766,000. However, in the best-known examples of this genre of white-collar crime, the losses can add up to hundreds of millions of dollars.

For example, in the Tyco International scandal of 2002, former company CEO and chairman Dennis Kozlowski and former corporate CFO Mark Swartz stole as much as $600 million from the company. They conspired to overstate reported financial results, smoothing those reported earnings, and hiding extraordinary amounts of senior executive compensation from investors. These top executives spent millions of dollars of company money on personal expenses, covering their tracks by limiting the scope of internal audits and bypassing the firm’s legal department when filing disclosure documents with the SEC. Both men served time in prison.

The Enron scandal, which surfaced in 2001, revealed that America’s seventh-largest company was involved in corporate corruption and fraudulent accounting practices, eventually leading to bankruptcy. Shareholders lost $74 billion and employees lost their jobs and billions in pension benefits. Executives of the firm committed many layers of financial fraud. One example was their misuse and manipulation of a cost accounting method called mark-to-market, which permitted the company to log estimated profits as actual profits. The company would build an asset—for example, a power plant—and immediately claim projected profits on its books, even though the asset had yet to earn a dime. If the revenue on the asset was less than the projected amount, the company would transfer it to an off-the-books corporation where the loss wouldn’t be noticed, allowing Enron to write off unprofitable activities without hurting its bottom line. By hiding its losses, Enron projected an image of solvency and success that was incompatible with its true fiscal situation.

Colonial Bank was the 27th-largest commercial bank in the United States when Catherine Kissick, head of the Mortgage Warehouse Lending Division, and her co-conspirators engaged in a scheme to defraud various entities and individuals. The guilty parties bought over $1 billion in mortgages from Taylor, Bean & Whitaker that the mortgage company didn’t actually own. Taylor, Bean & Whitaker began running overdrafts on its Colonial Bank master bank account, with Kissick and her co-conspirators covering up the overdrafts by sweeping overnight money from one account to another and through fictitious sales of mortgage loans to Colonial Bank. These maneuvers caused false information to be recorded on Colonial Bank’s records and false financial data to be filed with the SEC, including overstated assets for worthless mortgage loans. The bank failed in 2009, costing the FDIC’s Deposit Insurance Fund an estimated $2.8 billion. Kissick was sentenced to eight years in prison.

7 Tips to Prevent Financial Statement Fraud

While fraud detection and the ability to quickly perceive the warning signs of fraud are helpful during and after the malfeasance, companies should put systems in place to prevent financial statement fraud from happening at all. From accounting software that separates duties to corporate values of integrity and honesty role modeled by upper management, these seven prevention tips will help seal avenues for fraud and convey a message to employees that honesty is the best—and only—policy.

  1. Institute strong internal controls: The first and most important step to preventing financial statement fraud is to institute strong internal accounting controls. Key to this is segregation of duties, which involves dividing responsibility for bookkeeping, deposits, reporting, and auditing among different people to reduce the temptation and opportunities to commit fraud. Keep unauthorized personnel out of the accounting system by using passwords, lockouts, and electronic access logs. Perform accounting reconciliations on a regular basis to verify that accounting system balances match up with external sources, like banking statements and customer records. These practices will help thwart attempts to commit fraud. that accounting system balances match up with external sources, like banking statements and customer records. These practices will help thwart attempts to commit fraud.
  2. Perform periodic audits of financial statements: Companies should regularly assess their financial statements for accuracy to make sure their internal controls are effectively preventing fraud. A deep dive into the financial information can surface weaknesses in the internal controls that lead to corrective measures. When employees know an external auditor will be reviewing their work, they’re less likely to stray from the honest path.
  3. Set a tone of honesty at the top: Employees look to leadership to learn what is acceptable at an organization—morally and behaviorally. Management should lead by ethical example, demonstrating the values they want to see replicated in the company culture. Starting with onboarding, train employees to recognize fraud, meet ethical and legal standards, and be aware of consequences for breaches in conduct.
  4. Use ERP accounting software: An ERP system automates accounting operations, linking billing, accounts receivable, accounts payable, and cash management. The system enforces segregation of duties and strict approval mechanisms, which help prevent unauthorized transactions. Taking the human variable out of these processes reduces the points of vulnerability where would-be fraudsters could wreak havoc.
  5. Establish a tip hotline/reporting system: According to the ACFE, tips from employees, vendors, or customers are the No. 1 way fraud is detected. Instituting a formal fraud reporting system, either by phone, email, or web, empowers participation in fraud prevention. Making it anonymous eliminates the fear of reprisals that could hold a potential whistleblower back from reporting malfeasance.
  6. Don’t tie management bonuses and compensation to short-term goals: Performance-based pay can have dangerous outcomes, including incentivizing fraud. According to the Academy of Management, people with unmet goals were more likely to engage in unethical behavior than people attempting to do their best. When leaders care more about looking good on paper than creating value over the long term, illegal means to better performance, including falsified financial statements, can seem like an appealing pathway to “success.”
  7. Follow up on gut instincts: Notice if something feels off about the company’s financial statements and follow up with a deeper inquiry. If communications with key accounting personnel are vague or misleading, something may be amiss.

How Accounting Software Can Help

Implementing an ERP accounting system is one of the best solutions to detect, diagnose, and investigate financial statement fraud. An ERP system performs comprehensive audit-tracking so that documents can’t be manipulated or lost. It can also issue alerts when names, addresses, or banking details change on client accounts, or in instances of irregularities in file integrity. Most ERP software also enforces the segregation of duties, which prohibits fraudsters from performing unauthorized functions within the accounting system. NetSuite ERP is an all-in-one cloud business management solution that helps businesses operate more effectively by automating core processes and providing real-time visibility into operational and financial performance. It’s additive and complementary to the organizational structures, ethical enculturation, and procedural checks and balances that, together, lower the risk of financial statement fraud.

The victims of financial statement fraud are widespread, including investors whose intentions are stymied by false impressions of success, company employees whose jobs and pensions become compromised when organizational fraud is uncovered, and the general public whose trust is violated by leaders who fail to uphold standards. The best way forward is to eliminate temptation through strict controls, frustrating those who would commit financial statement fraud. If that isn’t possible, become familiar with the red flags of fraud so that criminals are apprehended as swiftly as possible.

Financial Statement Fraud FAQs

How are financial statement frauds committed?

Financial statement fraud—when a company changes the figures on its financial statements to make it appear more profitable—can take multiple forms. These include overstating revenue, inflating the net worth of assets, concealing liabilities and obligations, and issuing incorrect disclosures. Fraud is typically committed when individuals have access to accounting systems and financial documentation, as well as criminal motivation, such as animus against a corporate entity.

Is falsifying financial statements illegal?

Yes, individuals and companies that commit financial statement fraud can be prosecuted under the law. If convicted, they face fines and lengthy prison sentences.

What is the purpose of financial statement fraud?

Financial statement fraud is intended to mislead the users of financial information to create a better picture of a company's financial position, performance, and cash flows.

What are the five classifications of financial statement fraud?

The five classifications of financial statement fraud are fictitious revenues, timing differences, improper asset valuations, concealed liabilities and expenses, and improper disclosures.

How do accountants find fraud?

Accountants find fraud through a combination of analytical procedures, substantive testing, and employing professional skepticism. They look for red flags, such as unusual transactions, inconsistencies in financial data, or deviations from expected patterns. Accountants also use forensic techniques and leverage technology like AI to detect potential anomalies.

What is the most common behavioral red flag for fraud?

The two most common behavioral red flags for fraud are living beyond one’s means and pressure from financial difficulties. These behaviors can indicate that an individual has a motive to commit fraud.

Is financial statement fraud different from embezzlement?

Yes. Financial statement fraud involves intentionally misstating or omitting material information in financial reports to mislead users who rely on them. Embezzlement is a different type of fraud that involves the misappropriation of assets entrusted to someone, typically for personal gain.