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© November/December 2003
Association of Certified Fraud Examiners
FRAUDBASICS
Financial Statement Fraud, Part One
Financial statement fraud usually involves overstating assets, revenues and profits and understating liabilities, expenses
and losses. However, the overall objective of the manipulation may sometimes require the opposite action.
Financial statement fraud is the deliberate misrepresentation of the financial condition of an enterprise accomplished
through the intentional misstatement or omission of amounts or disclosures in the financial statements to deceive
financial statement users.
Financial statement fraud is usually a means to an end rather than an end in itself. When people "cook the books" they
may doing it to "buy more time" to quietly fix business problems that prevent their entities from achieving its expected
earnings or complying with loan covenants. It may also be done to obtain or renew financing that would not be granted
or would be smaller if honest financial statements were provided. People intent on profiting from crime may commit
financial statement fraud to obtain loans they can then siphon off for personal gain or to inflate the price of the
company's shares, allowing them to sell their holdings or exercise stock options at a profit. However, in many past cases
of financial statement fraud, the perpetrators have gained little or nothing personally in financial terms. Instead the focus
appears to have been preserving their status as leaders of the entity - a status that might have been lost had the real
financial results been published promptly.
Financial statement fraud usually involves overstating assets, revenues, and profits and understating liabilities, expenses,
and losses. However, the overall objective of the manipulation may sometimes require the opposite action, e.g.,
concealing higher-than-expected revenues or profits in a good year to help the subsequent year that is expected to be
tougher.
Cost of Financial Statement Fraud
inancial statement fraud typically has a devastating impact on the reputation and the financial position of organizations
and people involved. The stock market capitalization of entities affected by financial statement fraud may fall
substantially almost overnight, losing billions of dollars for investors. A 2002 report by the U.S. General Accounting Office
(GAO-03-138) found that in the three trading days surrounding the initial announcement of a restatement, the companies
studied lost $100 billion in market capitalization.
According to a 1999 study by the Committee of Sponsoring Organizations of the Treadway Commission (COSO),
"Fraudulent Financial Reporting: 1987-1997, An Analysis of U.S. Public Companies," 51 percent of the companies studied
ended up in bankruptcy or experienced an ownership change.
Many jobs may be lost as companies restructure to try to restore profitability. As media interviews of former Enron
employees showed, financial statement fraud can exert a high toll on the well-being of employees who may lose their
jobs, their pensions, their savings invested in their employer's stock, and health care and other benefits. The entity's
auditors are likely to be sued for the amount of investors' losses, which these days may mean tens of billions of dollars
for large public companies. For large and small companies alike, financial statement fraud can be hugely costly and
potentially a corporate deathblow.
Why Financial Statement Fraud is Committed
Most commonly, financial fraud is used to make a company's earnings look better on paper. It sometimes covers up the
embezzlement of company funds. Financial fraud occurs through a variety of methods, such as valuation judgments and
fine points of timing the recording of transactions. These more subtle types of fraud often are dismissed as either
mistakes or errors in judgment and estimation. Some of the more common reasons why people commit financial
statement fraud include to:
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encourage investment through the sale of stock;
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cover inability to generate cash flow;
demonstrate increased earnings per share or partnership profits interest thus allowing increased
dividend/distribution payouts;
dispel negative market perceptions;
obtain financing or to obtain more favorable terms on existing financing;
receive higher purchase prices for acquisitions;
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demonstrate compliance with financing covenants;
meet company goals and objectives; and
receive performance-related bonuses.
However, in government contracts, just the opposite may be true: assets and revenues are understated, and liabilities
and expenses are overstated. Why? As explained by government auditors, entities may rely on understated revenues or
overstated expenses to get more money for a project or contract.
This limited list of reasons shows that the motivation for financial fraud does not always involve personal gain. Sometimes, the cause of fraudulent financial reporting is the combination of situational pressures on either the company or the
manager and the opportunity to commit the fraud without the perception of being detected. That is to say, if red flags
(situational pressures and opportunity) are present, then the risk of financial reporting fraud increases significantly.
Examples of situational pressures include:
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sudden decreases in revenue or market share experienced by a company or an industry;
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financial pressures resulting from bonus plans that depend on short-term economic performance (these
pressures are particularly acute if the bonus is a significant component of the individual's total compensation).
unrealistic budget pressures, particularly for short-term results (the pressures become even greater with
arbitrarily established budgets that are without reference to current conditions); and
Opportunities to commit fraud most often arise gradually. Generally, these opportunities can stem from lack of adequate
oversight functions within the entity. The existence of an oversight function does not guarantee the detection of
fraudulent acts; the oversight functions also must respond effectively. The perception of detection, not internal control
per se, is arguably the strongest deterrent to fraud.
Some of the more obvious opportunities for the existence of fraud are:
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the absence of, or improper oversights by, the board of directors or audit committee or the neglectful behavior
of the board or committee;
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weak or nonexistent internal controls, including an ineffective internal audit staff and a lack of external audits;
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financial estimates that require significant subjective judgment by management.
unusual or complex transactions (an understanding of the transactions, their component parts, and their impact
on financial statements paramount to fraud deterrence); and
Effect of Fraud on Financial Statements
Fraud in financial statements takes the form of:
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overstated assets or revenue; or
understated liabilities and expenses.
Overstating assets and revenues falsely reflects a financially stronger company by inclusion of fictitious asset costs or
artificial revenues. Understated liabilities and expenses are shown through exclusion of costs or financial obligations. Both
methods result in increased equity and net worth for the company. This overstatement and/or understatement results in
increased earnings per share or partnership profit interests or a more stable picture of the company's true situation.
To demonstrate these over/understatements, the schemes typically used have been divided into eight classes. Because
the maintenance of financial records involves a double-entry system, fraudulent accounting entries always affect at least
two accounts and, therefore, at least two categories on the financial statements. While the areas described below reflect
their financial statement classifications, keep in mind that the other side of the fraudulent transaction exists elsewhere. It
is common for schemes to involve a combination of several methods. The five classifications of financial statement
schemes are:
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fictititous revenues;
timing differences;
improper asset valuations;
concealed liabilities and expenses; and
improper expenses.
In the Jan./Feb 2003 issue: descriptions of the five classifications of financial statement schemes
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