Financial Statement Fraud: Detection & Prevention

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; to enhance the company’s reputation by misleading potential investors; or to simply buy 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 cannot 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 — e.g., the U.S. Securities and Exchange Commission (SEC) — 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.
• 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 between different financial numbers and compare the ratios to years past or industry norms.
• The No. 1 way to prevent financial statement fraud is to have in place a system of strong internal controls that enforce the segregation of duties so that no single employee has authorization to view and alter all financial data. This can be automated through an enterprise resource planning (ERP) system.

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 did not 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 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 one 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 are made or prior to payment, reinvoicing past due accounts and prebilling for future sales.
• Inflating an asset’s net worth. This form of fraud occurs when a company overstates assets by failing to apply an appropriate depreciation schedule or valuation reserve, like inventory reserves. It will result in overstated net income and retained earnings, which inflates 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 can 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 the financial statements. When this type of fraud is committed, items such as significant events, related-party transactions, contingent liabilities and accounting changes are obscured or omitted from the financial statements.
• Falsifying expenses. Another form of financial statement fraud occurs when a company does not 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 through 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 and 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 the Association of Certified Fraud Examiners (ACFE), 85% of fraudsters displayed at least one behavioral red flag while committing their crimes. These behavioral red flags will crop up at work and 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 displays 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 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, like inflation, interest rates and unemployment.

Financial Statement Fraud Detection

The primary responsibility for 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 who set 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 between numbers in financial statements offers comprehensive insight into a company’s financial health. The foundation of financial analysis is understanding what the relationships between 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 (COGS). Typically, these numbers rise and fall together; the more goods sold, the more materials and expenses that 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 either of 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 between items on any one of the financial statements during one reporting period. The relationships between 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.

Financial Statement Fraud Examples

According to the 2020 global fraud study conducted by the ACFE, the median loss for financial statement fraud is $954,000. However, in the best-known examples of this genre of white-collar crime, the losses can add up to hundreds of million dollars.

For example, in the Tyco International scandal of 2002, former company CEO and chairman Dennis Kozlowski and former corporate chief financial officer 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 would not 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 did not 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 is to institute strong internal accounting controls. Key to this is segregation of duties, which involves dividing responsibility for bookkeeping, deposits, reporting and auditing between 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 ensure 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 test 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 are 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 enterprise resource planning (ERP) accounting software. An ERP system automates accounting operations, streamlining 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 an internal hotline/reporting system. According to the ACFE, in 2020 companies with hotlines detected fraud at a much higher rate than those without (49% compared to 31%). Instituting a formal fraud reporting system empowers all employees to participate 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

Engaging an ERP accounting system is one of the best solutions to detect, diagnose and investigate financial statement fraud and simple human error, like non-compliance due to lack of regulatory know-how. Unlike manual accounting systems, an ERP performs comprehensive audit-tracking so that documents can’t be manipulated or lost. ERPs can set up alerts that issue notifications when names, addresses or banking details change on client accounts, or in instances of irregularities in file integrity.

Another function in most ERPs is the enforcement of segregation of duties, which prohibits fraudsters from performing unauthorized functions within the accounting system. The ERP can be set up to require CFO approval on high-stakes transactions or information transfers. Additionally, an ERP system makes it easy to comply with regulations, laws and industry-specific practices so that both less experienced employees and those who would defraud the organization are kept in check.

NetSuite ERP is an all-in-one cloud business management solution that helps organizations operate more effectively by automating core processes and providing real-time visibility into operational and financial performance. It is additive and complementary to the organizational structures, ethical enculturation and procedural checks and balances that, together, lower the risk of financial statement fraud.

Conclusion

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 incorrect disclosures. Fraud is committed when individual(s) have access to accounting systems and financial documentation, and criminal motivation, such as striving for larger compensation or 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 the 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.