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Financial reporting fraud can have serious legal consequences for your business. This involves deliberately misrepresenting your company’s financial statements to create a more favorable impression of your company’s cash flow and performance, often misleading investors.
By educating yourself and your employees on the various types of financial reporting fraud, you can ensure that your business practices proper and legal financial statement reporting practices.
Types of Financial Reporting Fraud
Understanding the different types of financial reporting fraud will help you identify instances of this type of fraud in your organization. Let’s explore what financial statement fraud looks like.
1. Overstating Revenue
When reporting revenue for your business, you must ensure that you do not report expected sales or revenue for an upcoming financial period. Revenue should only be reported after the official revenue audit has been completed for your organization.
Prematurely projecting what you expect your business to make is overstating revenue reporting. Doing so creates a false appearance to investors of how much your organization really makes, which can lead to an inflated stock price.
2. Reporting Fictitious Revenue and Sales
Like overstating revenue, you should not fictitiously report the sales of goods or services that did not occur. There are a few methods fraudsters will use to report fictitious income or sales. The most common way is by double counting sales.
Fraudsters may also alter legitimate customer invoices or create fictitious customer accounts or order statements. At the end of the financial reporting period, many fraudsters who commit these practices will try to reverse the false sales to cover up their deceit.
3. Underreporting Expenses
Not fully reporting the expenses for your company is also an example of corporate fraud. By underreporting the expenses incurred by your business, you are inflating the business's total net income. Be honest about your company’s expenses to record expenses and net income accurately.
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4. Differences in Accounting Periods
This type of corporate fraud is committed with the intention of understating revenue in one financial reporting period so that a reserve is created. This reserve is then claimed in a less robust period in the future. Some ways in which this type of fraud is committed is by prebilling for future sales, re-invoicing past due accounts, and posting sales before they are paid for or made.
5. Inflating the Worth of Assets
Inflating the worth of assets will also overstate a company’s net income and retained earnings. As a result, this will increase the shareholder's equity. The overinflation of assets most often occurs by not having a proper depreciation schedule or valuation reserve. Record this depreciation appropriately if your company has assets that will depreciate over time.
6. Concealment of Liabilities
Perpetrators of corporate fraud may try to conceal part of the company’s liabilities, such as loans and sales warranties, and also underreport salaries, vacation time, and employee benefits. Concealing liabilities is done to inflate assets, equity, and net earnings. This is one of the more problematic types of financial statement fraud to detect, as these assets are not added to the financial reporting statements. Be careful when auditing your organization’s financial statements for any missing liabilities.
7. Misappropriations
While most forms of fraud are usually done to inflate the company’s valuation, misappropriations are committed to enrich the perpetrator's life. This type of corporate fraud involves altering a financial statement to mask embezzlement or financial theft by including fake expenses or double-entry bookkeeping.
8. Inadequate or Improper Disclosures
Shareholders have a legal right to important company disclosures that would impact their decision to invest in the company. Companies must disclose significant company changes, contingent liabilities, accounting changes, and other transactions from financial statements to shareholders. Failure to do so is considered frauding investors through inadequate or improper disclosure.
Warning Signs of Financial Fraud
Now that you understand the different types of financial reporting fraud, how can you identify the warning signs in your organization? These warning signs can either be spotted through changed employee behavior or by discovering numerical discrepancies. Numerical changes are generally easier to spot, but behavioral changes can provide greater insight into concerted efforts to "cook the books."
Pay attention to excessive write-offs, unexplained changes in financial statements, and improper asset valuation. Behavioral warning signs may include sudden lifestyle changes, a reluctance to answer questions about financial matters, a company history of financial problems, and a management team that becomes increasingly evasive or overconfident when disclosing financial issues.
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5 Infamous Real-Life Examples of Financial Statement Fraud
These accounting fraud scandals have become increasingly common in recent years. You've probably heard of some of the most notorious cases involving Enron, Bernie Madoff, and Lehman Brothers. Let’s explore five infamous real-life examples of fraud scandals:
1. Enron
Enron was an energy company in Houston, Texas, founded by Kenneth Lay. In 2001, after Sherron Watkins, Enron's Vice President of Corporate Development, blew the whistle, it was concluded that the company deceived shareholders by hiding large debts from its balance sheet.
As a result, the company went bankrupt, shareholders lost $74 billion, and employees lost their jobs and retirement accounts. Several major players, such as CEO Kenneth Lay, CEO Jeffrey Skilling, and CFO Andrew Fastow, were sentenced to prison. However, Kenneth Lay died before he was scheduled to serve time.
2. Bernie Madoff
One of the famous real-life examples of financial statement fraud you've likely heard of is the American financier Bernie Madoff case. Madoff founded the Wall Street investment firm Bernard L. Madoff Investment Securities LLC. Madoff and his accountants, David Friehling and Frank DiPascalli, engaged in one of the largest Ponzi schemes in US history. They paid investors either with their own money or the money from other investors. The crimes were discovered during the 2008 financial crisis, and victims included high-profile individuals and charitable organizations.
Madoff and his associates faced severe legal consequences for their involvement in the Ponzi scheme. Madoff, Friehling, and DiPascalli were sentenced to prison. DiPascalli died before he entered prison. Madoff died in jail. He received the most severe punishment - a 150-year sentence and $170 billion in restitution.
3. Lehman Brothers
Lehman Brothers, founded in 1850 by Henry, Emanuel, and Mayer Lehman, was one of the largest investment banks in the world before it collapsed and went bankrupt in 2008 during the financial crisis. Lehman Brothers' collapse significantly contributed to the crisis, triggering a chain reaction of financial disasters that eventually became the Global Financial Crisis.
The financial scandal was caused by a combination of factors, with the subprime mortgage crisis being one of the primary causes. In addition to hiding over $50 billion described as sales that were actually loans, Lehman Brothers had heavily invested in mortgage-backed securities.
Subprime mortgages mostly backed these securities. This left the firm vulnerable to the subprime mortgage market's collapse, which eventually led to the firm's downfall. Lehman Brothers did not receive a bailout from the US government.
4. WorldCom
In 2002, WorldCom was one of the largest telecommunications companies in American history. However, the company's reputation was ruined beyond repair when its internal audit department found that the firm committed approximately $3.8 billion in fraudulent accounting practices.
The scandal led to the imprisonment of CEO and co-founder Bernie Ebbers, who received a 25-year sentence, as well as several top executives. Over 30,000 people who worked for WorldCom lost their jobs, and investors lost over $180 billion. WorldCom filed for bankruptcy in 2002.
5. Tyco International
Tyco International was one of the largest American security firms. It employed over 270,000 people. However, in 2002, it faced a major accounting scandal. Its CEO, Dennis Kozlowski, as well as the company's other top executives, were accused of stealing over $600 million from the company through fraudulent accounting practices, including tax evasion.
Its accounting firm, PricewaterhouseCoopers (PWC), failed to find and report the fraudulent transactions. Indeed, "banking sources," as reported by CNN, discovered unethical activities. Kozlowski and the CFO Mark Swartz were charged with stealing $170 million in Tyco's funds and receiving $430 million in fake stock sales.
The scandal resulted in the conviction of the CEO and CFO for up to 25 years. In addition, they were charged with millions in restitution and fines. Tyco received significant corporate restructuring and was merged into Johnson Controls.
These five scandals serve as a reminder of the importance of ethical accounting practices and the need for strong regulatory oversight to protect investors and maintain financial stability.
The failure of Lehman Brothers, for example, was a wake-up call for the financial industry, highlighting the importance of risk management and the need for more stringent regulations.
How to Prevent Financial Statement Fraud
Thankfully financial crimes like these can be avoided in your organization through education, periodic audits, enterprise resource planning software, and internal reporting methods. Let’s explore these procedures in more detail.
1. Establish Strong Internal Accounting Controls
A lack of proper internal controls happens when there are no procedures in place to prevent fraud or when existing processes are not being followed. Fraud is a lot like the perfect storm; there is a strong chance that one event will trigger others. If you want to detect financial statement fraud, keep an eye out for poor documentation and obvious accounting errors.
Some mistakes are obvious enough for auditors to catch them immediately, but others are not as easily apparent; for example, an incorrect balance sheet is casually filed even if it contradicts other sections of the statement.
2. Employee Training on Corporate Financial Crimes
Regular employee training sessions should include internal control procedures and how the company's books are prepared for submission to an external auditor. When employees understand the importance of their job, they're more likely to prevent fraud or corruption from happening in the first place; this can be accomplished by including positive team-building activities during training sessions. Needless to say, accountants should get fraud awareness training on a technical level, while the rest of the staff should be trained on general topics of financial crimes.
3. Utilize Enterprise Resource Planning Accounting Software
ERP accounting software can help to prevent financial fraud by automating many of the tasks involved in financial reporting. This always helps reduce the risk of human error and fraud because internal controls are activated by default and can be configured for a more granular evaluation of financial statements. ERP solutions can also help improve the transparency of all financial reporting, making it more difficult for fraudsters to conceal their activities; for example, activity logging and tracking of changes can help auditors find employees who are misreporting.
4. Perform Regular Financial Statement Audits
Here's another advantage of the accounting modules within ERP software suites: their automated auditing processes can spot real-time irregularities and be adjusted to look for specific actions. In the private sector of companies that aren't publicly traded, most incidents involving financial statement fraud are spotted by auditors; however, this is not the case with companies listed on Wall Street because financial journalists and investors are usually the first to notice something is not correct.
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5. Have an Anonymous Internal Reporting System
Having a system to report suspected fraud perpetrators internally is a crucial step in the fight against corporate financial fraud. Employees who suspect fraudulent activities within their organization may hesitate to come forward due to fear of retaliation or lack of trust in the reporting process. By implementing an anonymous reporting system, employees can confidentially report their concerns without the risk of exposure. This encourages a culture of transparency and accountability, allowing potential fraud to be detected and addressed promptly.
An effective reporting system should provide multiple channels for reporting; examples may include a dedicated hotline or an online platform, but you can also code it into the corporate ERP solution. Be sure to check with your legal department when setting up these systems.
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Conclusion
In the end, combating financial statement fraud requires a multi-faceted approach that combines vigilant detection methods and robust internal controls. By understanding the different ways people commit fraud, recognizing the warning signs, establishing strong internal accounting controls, providing comprehensive employee training, leveraging ERP accounting software, conducting regular financial statement audits, and implementing an anonymous reporting system, organizations can significantly enhance their ability to detect and prevent fraudulent activities.
