"As originally published in Expert Perspective, a Crowe Chizek and Company LLC publication, Summer 2006. All rights reserved."

Financial statement fraud can have severe consequences. In examining financial statements, professional investigators often focus their attention on certain red flags. By familiarizing themselves with these common fraud techniques and indicators, management can minimize the impact of financial statement fraud and mitigate future risks.

Allegations of financial statement fraud continue to make headline news. If the allegations prove to be true, the results can be devastating to lenders, shareholders, boards of directors, employees, and others who rely on those statements.

For example, credit may be extended to undeserving entities, companies may be sold for unwarranted prices and shareholders may invest in overvalued securities.

While the "devil is in the details" seems apropos in confronting financial statement fraud, there are red flags that may, if heeded, minimize the impact of this fraud and mitigate future fraud risks.

Certified Public Accountants (CPAs) and Certified Fraud Examiners (CFEs) often assist management and boards of directors in investigating allegations of financial statement fraud, evaluating existing fraud detection and prevention controls, and suggesting other fraud prevention measures. CPAs and CFEs define financial statement fraud as the deliberate misrepresentation of an enterprise's financial results accomplished through intentionally misstating or omitting amounts or disclosures to deceive financial statement users.

Fraudulent financial reporting is accomplished in the following ways:

  • Manipulation, falsification, or alteration of accounting records or supporting documents from which the financial statements are prepared;
  • Misrepresentation in, or intentional omission from, the financial statements of events, transactions, or other significant information; and
  • Intentional misapplication of accounting principles relating to amounts, classification, manner of presentation, or disclosure.

Common Fraud Techniques

The financial statement fraud work performed by CPAs today has been influenced by a 1999 study on financial statement fraud sponsored by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The COSO Report1, released in March 1999, identified common techniques (or schemes) used within U.S. public companies to fraudulently misstate financial information submitted to the Securities and Exchange Commission (SEC).

Among the areas that continue to be a focal point for CPAs and CFEs as they perform financial statement fraud-related services are:

  • Improper revenue recognition
    • Recording of fictitious revenues
    • Recording revenues prematurely
  • Overstatement of assets
    • Overstating existing assets
    • Recording fictitious assets
    • Improper recording of expense items as assets
  • Understatement of expenses and liabilities

Improper Revenue Recognition

The COSO Report found that in over half the companies examined, the financial statement fraud involved overstating revenues2. Sales-based performance incentives, management pressure to meet revenue growth goals, and aggressive analyst projections are circumstances which increase the risk of fraudulent revenue recognition within companies.

Several schemes have been used to fraudulently misstate revenues. These schemes give the appearance that the revenue recognition criteria, as described within accounting principles generally accepted in the United States, have been met and without further examination may not be detected. The COSO Report3 cites these methods used to misstate revenue:

  1. Sham sales — To cover the fraud, company representatives may falsify inventory records, shipping records, and invoices and record the fictitious transactions as sales. In certain instances, the company may ship the goods to another location. In others, the company may pretend to ship the inventory and hide it from company auditors.
  2. Premature revenues before all the terms of the sale are completed — Generally, this scheme involves recording sales after the goods are ordered but prior to shipping them to the customer.
  3. Conditional sales — The transactions are recorded as revenues even though the sales involve unresolved contingencies or terms that are amended with side agreements which often eliminate the customer's obligation to keep the merchandise.
  4. Improper cutoff of sales — To increase revenues, the accounting records are held open beyond the balance sheet date so that sales actually occurring in the subsequent accounting period are recorded in the current period.
  5. Improper use of the percentage-of-completion method — Revenues are overstated by accelerating the estimated percentages of completion for jobs in progress.
  6. Unauthorized shipments — Revenues are overstated by shipping goods the customer never ordered or by shipping defective products and recording revenues at full, rather than discounted, prices.
  7. Consignment sales — Revenues are recorded for consignment shipments or shipments of goods for customers to consider on a trial basis.

Overstating Assets

The COSO Report noted that in about half of the companies examined, the instances of fraud involved an overstatement of assets by understating allowances for receivables, overstating the value of inventory, property, plant, equipment, and other tangible assets, and recording assets that did not exist.4

The COSO Report identified these asset accounts as ones that were frequently fraudulently misstated:

  • Inventory,
  • Accounts receivable,
  • Property, plant, and equipment,
  • Loans/notes receivable,
  • Cash,
  • Investments,
  • Patents, and
  • Oil, gas and mineral reserves5

Understating Expenses and Liabilities

The COSO report indicated that in approximately 18 percent of the companies examined, the financial statement fraud involved understatement of expenses or liabilities.6

Among the mechanisms used in fraudulent financial reporting, particularly as it relates to overstatement of assets and understatement of expenses and liabilities, are:

  1. Management override of controls — The COSO Report stated that in over 72 percent of the cases, the CEO appeared to be associated with the fraud.7 Management is often in the best position to perpetrate fraud because of its position of authority and access to all areas of the organization. CPAs are obligated to specifically consider this risk in performing an audit.
  2. Use of journal entries — CPAs recognize that "material misstatements...due to fraud often involve the manipulation of the financial reporting process by (a) recording inappropriate or unauthorized journal entries throughout the year or at period end, or (b) making adjustments to amounts reported in the financial statements that are not reflected in formal journal entries..."8 Accordingly, CPAs design specific tests of journal entries and other adjustments affecting the financial statements to detect fraudulent activities.
  3. Biased accounting estimates — In preparing financial statements, management is responsible for making a number of judgments or assumptions that affect significant accounting estimates. For example, management may estimate the net realizable value of company inventory, the estimated liability related to an announced facility closure, or the estimated fair market value of an investment in a privately held company for which no ready market exists.

  4. Fraudulent financial reporting is often accomplished through intentional misstatement of accounting estimates. CPAs assess whether differences between estimates that are best supported with audit evidence and estimates included within the financial statements indicate a possible bias on the part of management.

  5. Unusual transactions — Fraudulent financial reporting may also involve unusual, significant transactions which were carried out to engage in fraudulent financial reporting or conceal the misappropriation of assets. CPAs consider such factors as the business rationale for conducting the transaction, the review and approvals obtained, and the relationship of the other party to the business in assessing the appropriateness of the transaction.

Evaluating the Risk

CPAs are obligated to consider the risk of fraud in performing financial statement audits. In addition, CPAs should conduct the engagement with a mindset that recognizes the possibility that a material misstatement resulting from fraud could be present, regardless of any past experience with the entity and regardless of the auditor's belief about management's honesty and integrity.

CPAs are required to exercise professional skepticism, which requires an ongoing questioning of whether the information and evidence obtained suggests that a material misstatement resulting from fraud has occurred.

Financial statement fraud is known to have severe consequences which can include bankruptcy, significant changes in ownership, the delisting by national stock exchanges, and financial penalties. In addition, senior management may be subject to class action legal suits, SEC fines, and potential jail time if convicted of fraud.

By familiarizing themselves with common financial statement fraud techniques and indicators, management will be able to identify the circumstances involving fraudulent financial reporting and avoid potentially devastating outcomes.

SIDEBAR (Chart)

Indicators of Potential Fraud

CPAs consider these indicators of potential fraud in evaluating audit evidence:

  • Responses to inquiries about analytical relationships are vague, implausible, or conflict with other evidential matter obtained. (For example, these inquiries might involve unusual changes in monthly revenue or unusually high profit margins when compared to competitors).
  • Journal entries and other adjustments which have the following identifying characteristics of fraud:
    • Entries are made to unrelated, unusual, or seldom used accounts;
    • Entries are made by individuals who typically do not make journal entries;
    • Entries are recorded at the end of the period or as "post closing" entries which have little to no explanation; and
    • Entries containing round numbers or journal entries recorded in the preparation of the financial statements.
  • Accounting records contain discrepancies including:
    • Transactions are not recorded in a complete or timely manner or are improperly recorded as to amount, accounting period, classification, or entity policy; and
    • Unsupported or unauthorized balances or transactions.
  • Conflicting or missing evidential matter including:
    • Missing documents;
    • Altered documents;
    • Unavailability of original documentation;
    • Significant unexplained items on accounting reconciliations;
    • Missing inventory or other physical assets of significant size;
    • Inability to produce evidence of key systems development, program changes, and implementation activities; and
    • Unusual discrepancies between recorded transactions and evidence obtained from third parties.
  • Problematic or unusual relationships between the auditor and management including
    • Denial of access to records, facilities, employees, vendors, customers, and others from whom audit evidence might be sought;
    • Undue time pressures imposed by management to resolve complex or contentious issues;
    • Management intimidation of auditors' assessments and work performed;
    • Unusual delays for requested information; and
    • Unwillingness to add or revise disclosures to make them more complete and transparent.

Footnotes:

1. The Committee of Sponsoring Organizations (COSO) of the Treadway Commission, Fraudulent Financial Reporting: 1987-1997, An Analysis of U.S. Public Companies, March 1999.

2. The Committee of Sponsoring Organizations (COSO) of the Treadway Commission, Fraudulent Financial Reporting: 1987-1997, An Analysis of U.S. Public Companies, March 1999, page 6

3. Ibid, page 32

4. Ibid, page 31

5. Ibid, page 34

6. Ibid, page 31

7. Ibid, page 1

8. Statement 99 on Auditing Standards, Consideration of Fraud in a Financial Statement Audit, Auditing Standards Board, October 2002.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.