Exposing Financial Statement Fraud by Richard Pollack, CPA
It has been almost 20 years to the day that one of the country’s largest publicly traded companies filed for bankruptcy protection amid what continues to be cited as one of the largest accounting frauds in history. However, since the collapse of Enron and subsequent enactment of legislation to prevent similar scandals, corporate fraud and similarly deceptive accounting practices continue to occur at businesses throughout the world.
While fraud can take many forms, the most costly and damaging category is financial statement fraud, which can bring a business down and cause irreparable, long-term harm to employees, clients, investors and other third parties. Whether these deceptions are committed due to economic pressure, an opportunity to get around the system or a rationalization that it is in the best interest of the company and its stakeholders, they always involve a deliberate and intentional manipulation of facts, including material misstatements and omissions of financial detail, to exaggerate a company’s earnings and its true financial picture. Too often, they involve collusion among various parties within an organization, making them difficult – but not impossible – to detect. Conducting a forensic examination of a company’s financial records with a keen understanding of some of the most common schemes are critical to exposing these frauds.
Exposing Financial Statement Fraud
Overstatement or falsification of revenue is the most common form of financial statement fraud. It can occur when a fraudster creates fictitious revenue or customers, records future sales in the current period, reports increased revenue without equally rising cash flow or records sales that never occurred.
Understatement of expenses and liabilities reduces a company’s debt on paper, thereby making the company look financially stronger. It can occur when a fraudster records expenses as assets or fails to record them at all. Additional ways to manipulate financial statements include leaving special purpose entities or subsidiaries off a parent company’s books or failing to report certain obligations as liabilities.
Improper asset valuation exaggerates a company’s assets and portrays the assets in a more positive financial light. It can involve improperly valuing inventory, investments (such as securities or other investments without a ready market for sale, for example thinly traded stock), fixed assets or accounts receivable. It may also involve creating fictitious receivables, not writing down obsolete inventory on a company’s balance sheet, manipulating the estimates of an asset’s useful life and overstating the residual value.
Related party transactions may create conflicts of interests. Therefore, it is critical to carefully analyze these transactions and identify them when investigating financial statement fraud.
Exposing financial statement fraud can be challenging whether it is committed on behalf of a large, multi-national company or a small business. Perpetrators typically take special care to conceal their actions in an elaborate paper trail with falsified records that can go undetected for years. Sometimes the fraud is buried in a series of complex transactions; other times it can be found in a single transaction fraudulently recorded in the accounting records. Detection can be accomplished with appropriate forensic procedures that include analysis of multiple years of financial records, analysis of public documents, background investigations, interviews of knowledgeable persons, and laboratory analysis of physical and electronic evidence. The forensic specialist can play an important role in assisting attorneys, regulators and others in detecting financial statement fraud.
About the Author: Richard A. Pollack, CPA/ABV/CFF, ASA, CBA, CFE, CAMS, CIRA, CVA, CGMA is director-in-charge of the Forensic and Advisory Services practice with Berkowitz Pollack Brant, where he has served as a litigation consultant, expert witness, court-appointed expert, forensic accountant and forensic investigator on a number of high-profile cases. He can be reached at the CPA firm’s Miami office at (305) 379-7000 or via email at info@bpbcpa.com.
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