Financial Statement Fraud: Detection & Prevention (2024)

Financial statement fraud is a white-collar crime usually perpetrated by management insidersto represent a company in a more favorable fiscal light. Fraudsters are motivated bypersonal gain, such as performance-based compensation; to enhance the company’sreputation by misleading potential investors; or to simply buy time until financial mistakesand 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 fallprey. 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 financialstatements, whether through omission or exaggeration, to create a more positiveimpression of the company’s financial position, performance and cash flow.

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

Regardless of the motive, financial statement fraud causes problems with current andpotential investors and shareholders. It can result in large-scale reputational damage aswell as serious sanctions from regulators — e.g., the U.S. Securities and ExchangeCommission (SEC) — and even arrests.

Key Takeaways

• Financial statement fraud is committed when people with access to financial documentsand 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 financialnumbers 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 ofstrong internal controls that enforce the segregation of duties so that no singleemployee has authorization to view and alter all financial data. This can be automatedthrough an enterprise resource planning (ERP)system.

Types of Financial Statement Fraud

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

• Overstating revenue. A company can commit fraud by claiming money asreceived before the goods or services have been delivered. This can be done byprematurely recording future expected sales or uncertain sales. If the companyoverstates its revenue, it creates a false picture of fiscal health that may inflate itsshare price.
• Fictitious revenue and sales. Fictitious revenue involves claiming thesale of goods or services that did not occur, such as double-counting sales, creatingphantom customers or overstating or otherwise altering the legitimate invoices ofexisting customers. Perpetrators of this kind of fraud may reverse the false sales atthe end of the reporting period to help conceal the deceit. Famously, this is what Wells Fargo did in a fraud that came tolight in 2016: To meet impossible sales goals, employees created millions ofchecking and savings accounts on behalf of clients — but without their consent.
• Timing differences. This one involves understating revenue in oneaccounting period by creating a reserve that can be claimed in future, less robustperiods. Other forms of this type of fraud are posting sales before they are made orprior to payment, reinvoicing past due accounts and prebilling for future sales.
• Inflating an asset’s net worth. This form of fraud occurs when acompany overstates assets by failing to apply an appropriate depreciation schedule orvaluation reserve, like inventory reserves. It will result in overstated net income andretained earnings, which inflates shareholders’ equity.
• Concealment of liabilities or obligations. Concealment is a type offraud where liabilities or obligations are kept off the financial statements to inflateequity, assets and/or net earnings. Examples of concealed liabilities can include loans,warranties attached to sales and underreported health benefits, salaries and vacationtime. The easiest way to conceal liabilities is to simply fail to record them.
• Improper or inadequate disclosures. The information disclosed infinancial 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 financialstatements. When this type of fraud is committed, items such as significant events,related-party transactions, contingent liabilities and accounting changes are obscuredor omitted from the financial statements.
• Falsifying expenses. Another form of financial statement fraud occurswhen a company does not fully record its expenses. The company’s net income isexaggerated and costs are understated, creating a false impression of the amount of netincome the company is earning.
• Misappropriations. A serious form of financial statement fraud isaltering the statement to mask theft or embezzlement through double-entrybookkeeping or the inclusion of fake expenses. This form of fraud is usuallyperpetrated by an individual looking to enrich themselves, as opposed to forms of fraudthat are intended to inflate the valuation of the company to investors and the businesscommunity.

Financial Statement Fraud Warning Signs

When a forensic accountant investigates financial statement fraud, they look for red flagsthat indicate suspicious business practices and raise concern. By becoming familiar withthese common fraud indicators, management can minimize the potential for financial statementfraud 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”,certainpatterns jump out as suspicious and anomalous to investigators:

• Rising revenue without corresponding growth in cash flow — this is the most commonwarning 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 aparticular 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 periodsthan 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 FraudExaminers (ACFE), 85% of fraudsters displayed at least one behavioral red flag whilecommitting their crimes. These behavioral red flags will crop up at work and in thefraudster’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 thescam.

Organizational warning signs. The corporate structure and operationalpractices of a business can reveal circ*mstances that are more favorable to those who wishto commit financial statement fraud. An environment where accounting systems and controlsare weak and fail to conform to governance best practices allows for false or misleadinginformation to remain unchallenged. Examples include:

• Frequent organizational changes, such as unusually high turnover in management or keyaccounting 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 inconcert.
• A board of directors full of insiders.
• Undue emphasis on meeting quantitative targets.
• Sloppy or manual management/operational business processes, as opposed to automatedprocesses embodied in business software.

Business warning signs. External factors such as overall industry downturnsand wild divergence from peer company norms can be indicators of potential fraud. A keenauditor will notice business results and organizational behavior that seem out of alignmentwith 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 byseasonality.
• 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 companymanagement. Prevention of fraud is most effective with a strong team consisting of an auditcommittee comprising internal and external auditors and a board of directors who set a tonefor ethics at the organization. Auditing standards establish that auditors have aresponsibility to reach a reasonable assurance that financial statements are clear ofmisstatement due to either error or fraud. The auditors’ responsibilities are toappropriately identify, assess and respond to fraud risks, using the many tools andtechniques at their disposal.

Auditors look for troublesome relationships among financial data that indicate cause fordeeper investigation. Investigating the relationships between numbers in financialstatements offers comprehensive insight into a company’s financial health. Thefoundation of financial analysis is understanding what the relationships between certainfinancial statement balances should be so that auditors recognize when the numbers areoff-base. For example, a healthy company tries to maintain a consistent balance betweenassets and liabilities. An unexpected shift from historical norms could indicate thatmanagement is trying to hide something. An increase in the ratio could mean liabilities arebeing hidden; a downward shift could mean the company is borrowing heavily to financeoperations.

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, themore materials and expenses that are incurred to produce them. This directly proportionalrelationship holds true for sales versus accounts receivable aswell. As sales increase, so should accounts receivable. When either of these numbers fallout of proportional relationship to each other, further investigation is warranted.

Analyses such as these are called comparative ratio analysis, and they help auditors spotaccounting irregularities by measuring the relationship between two different financialstatement amounts. Ratios are calculated from current year numbers, then compared toprevious years, other companies, the industry or the economy. When there are significantchanges from year to year or between entities, a more detailed examination is required tohelp uncover potential fraud.

Another tool fraud examiners use to interpret a company’s standing is percentageanalysis — vertical and horizontal. Vertical analysis examines the relationshipsbetweenitems on any one of the financial statements during one reporting period. The relationshipsbetween the components are expressed as percentages that can be compared across periods.Horizontal analysis analyzes the percentage change in individual financial statement itemsyear over year. The first year is considered the base, and subsequent changes are computedas percentages of the base period.

Comparative analysis tools help investigators identify financial inconsistencies, increasingthe odds of detecting fraud.

Financial Statement Fraud Examples

According to the 2020 global fraud study conducted by the ACFE, the median loss for financialstatement fraud is $954,000. However, in the best-known examples of this genre ofwhite-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 chairmanDennis 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 executivecompensation from investors. These top executives spent millions of dollars of company moneyon personal expenses, covering their tracks by limiting the scope of internal audits andbypassing 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-largestcompany was involved in corporate corruption and fraudulent accounting practices, eventuallyleading to bankruptcy. Shareholders lost $74 billion and employees lost their jobs andbillions in pension benefits. Executives of the firm committed many layers of financialfraud. One example was their misuse and manipulation of a cost accounting method calledmark-to-market, which permitted the company to log estimated profits as actual profits. Thecompany would build an asset — for example, a power plant — and immediatelyclaim projectedprofits on its books even though the asset had yet to earn a dime. If the revenue on theasset was less than the projected amount, the company would transfer it to an off-the-bookscorporation where the loss would not be noticed, allowing Enron to write off unprofitableactivities without hurting its bottom line. By hiding its losses, Enron projected an imageof solvency and success that was incompatible with its true fiscal situation.

Colonial Bank was the 27th-largest commercial bank in the United States when CatherineKissick, head of the Mortgage Warehouse Lending Division, and her co-conspirators engaged ina scheme to defraud various entities and individuals. The guilty parties bought over $1billion in mortgages from Taylor, Bean & Whitaker that the mortgage company did notactuallyown. Taylor, Bean & Whitaker began running overdrafts on its Colonial Bank master bankaccount, with Kissick and her co-conspirators covering up the overdrafts by sweepingovernight money from one account to another and through fictitious sales of mortgage loansto Colonial Bank. These maneuvers caused false information to be recorded on ColonialBank’s records and false financial data to be filed with the SEC, including overstatedassets for worthless mortgage loans. The bank failed in 2009, costing the FDIC’sDeposit Insurance Fund an estimated $2.8 billion. Kissick was sentenced to eight years inprison.

7 Tips to Prevent Financial Statement Fraud

While fraud detection and the ability to quickly perceive the warning signs of fraud arehelpful during and after the malfeasance, companies should put systems in place to preventfinancial statement fraud from happening at all. From accounting software that separatesduties to corporate values ofintegrity and honesty role modeled by upper management, these seven prevention tipswill help seal avenues for fraud and convey a message to employees that honesty is the bestand only policy.

1. Institute strong internal controls. The first and most importantstep is to institute strong internal accounting controls. Key to this is segregationof duties, which involves dividing responsibility for bookkeeping, deposits,reporting and auditing between different people to reduce the temptation andopportunities to commit fraud. Keep unauthorized personnel out of the accountingsystem by using passwords, lockouts and electronic access logs. Perform accountingreconciliations on a regular basis to ensure that accounting system balances matchup with external sources, like banking statements and customer records. Thesepractices will help thwart attempts to commit fraud.

2. Perform periodic audits of financial statements. Companies shouldregularly test their financial statements for accuracy to make sure their internalcontrols are effectively preventing fraud. A deep dive into the financialinformation can surface weaknesses in the internal controls that lead to correctivemeasures. When employees know an external auditor will be reviewing their work, theyare less likely to stray from the honest path.

3. Set a tone of honesty at the top. Employees look to leadership tolearn what is acceptable at an organization, morally and behaviorally. Managementshould lead by ethical example, demonstrating the values they want to see replicatedin the company culture. Starting with onboarding, train employees to recognizefraud, meet ethical and legal standards and be aware of consequences for breaches inconduct.

4. Use enterprise resource planning (ERP) accounting software. An ERPsystem automates accounting operations, streamlining accounts receivable, accountspayable and cash management. The system enforces segregation of duties and strictapproval mechanisms, which help prevent unauthorized transactions. Taking the humanvariable out of these processes reduces the points of vulnerability where would-befraudsters could wreak havoc.

5. Establish an internal hotline/reporting system. According to theACFE, in 2020 companies with hotlines detected fraud at a much higher rate thanthose without (49% compared to 31%). Instituting a formal fraud reporting systemempowers all employees to participate in fraud prevention. Making it anonymouseliminates the fear of reprisals that could hold a potential whistleblower back fromreporting malfeasance.

6. Don’t tie management bonuses and compensation to short termgoals. Performance-based pay can have dangerous outcomes, includingincentivizing fraud. According to the Academy of Management, people with unmet goalswere more likely to engage in unethical behavior than people attempting to do theirbest. When leaders care more about looking good on paper than creating value overthe long term, illegal means to better performance, including falsified financialstatements, can seem like an appealing pathway to “success.”

7. Follow up on gut instincts. Notice if something feels off about thecompany’s financial statements and follow up with a deeper inquiry. Ifcommunications with key accounting personnel are vague or misleading, something maybe amiss.

How Accounting Software Can Help

Engaging an ERP accounting system is one of the best solutions to detect, diagnose andinvestigate financial statement fraud and simple human error, like non-compliance due tolack of regulatory know-how. Unlike manual accounting systems, an ERP performs comprehensiveaudit-tracking so that documents can’t be manipulated or lost. ERPs can set up alertsthat 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 prohibitsfraudsters from performing unauthorized functions within the accounting system. The ERP canbe 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 andindustry-specific practices so that both less experienced employees and those who woulddefraud the organization are kept in check.

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

Conclusion

The victims of financial statement fraud are widespread, including investors whose intentionsare stymied by false impressions of success, company employees whose jobs and pensionsbecome compromised when organizational fraud is uncovered, and the general public, whosetrust is violated by leaders who fail to uphold standards. The best way forward is toeliminate temptation through strict controls, frustrating those who would commit financialstatement fraud. If that isn’t possible, become familiar with the red flags of fraudso 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 tomake it appear more profitable, can take multiple forms. These include overstating revenue,inflating the net worth of assets, concealing liabilities and obligations, and incorrectdisclosures. Fraud is committed when individual(s) have access to accounting systems andfinancial documentation, and criminal motivation, such as striving for larger compensationor animus against a corporate entity.

Is falsifying financial statements illegal?

Yes, individuals and companies that commit financial statement fraud can be prosecuted underthe 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 createa 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, timingdifferences, improper asset valuations, concealed liabilities and expenses and improperdisclosures.