Of all the fraud schemes perpetrated in our world today, financial statement fraud seems to get the least air time. That makes no sense, as financial statement fraud happens to be one of the most costly types of fraud.
The problem is that involved parties, both inside and outside the company, rely on the information provided in the financial statements. They assess the financial results and make predictions and decisions about the future of the company based on those results.
Financial statements are the measuring stick that numerous parties use to assess the financial health of a company. Falsified financial statements can mean only one thing – those assessments are faulty.
Financial statement fraud causes a median loss of $2 million per fraud scheme, according to the most recent occupational fraud study done by the Association of Certified Fraud Examiners. That amount dwarfs asset misappropriation schemes, which only cause median losses of $150,000 per scheme.
Asset misappropriation schemes are easy to understand and recognize. They include the direct theft of money, inventory, equipment, or other company assets. Most everyone can relate to the theft of property and money, and the results of such theft are tangible.
But financial statement fraud is an ugly fraud. Its methods are complex and often not understood by the average consumer or investor. And its results often aren’t tangible to the average person, unless we’re talking about a famous fraud like Enron.
Financial statement fraud is almost always perpetrated by upper management or company owners. Executives are entrusted with entire companies. They have access to nearly all data and employees, and they can exploit this access to commit and fraud and cause the fraud to be concealed.
The power the executive has by virtue of her or his position in the company is closely linked with the high cost of financial statement fraud. Power and access within a company make it possible for larger frauds to be committed and covered up.
The breach of trust when an executive is involved in fraud is huge. How can lower-level employees be expected to act ethically when those in charge of the company lack ethics of their own?
One of the most innocent-sounding terms used to describe financial statement fraud is “earnings management.” Such a phrase minimizes the seriousness of the crime. “Management” almost makes it sound like something good!
But earnings management isn’t a noble effort. It is, in fact, financial statement fraud. The degree and seriousness can vary, but it is fraud nonetheless. It is the purposeful manipulation of account balances in order to make the financial statements conform to some predetermined template.
Especially with public companies, there are expectations related to the financial results, and executives may alter numbers to conform. Earnings management (financial statement fraud) means that management played games with the numbers, shifting revenue or expenses from one period to the next, or inflating assets or underreporting liabilities.
In addition to the opportunity to manipulate revenue, expenses, assets and liabilities, there are other forms of financial statement fraud that are gaining in popularity. Schemes include the misuse of reserves, often referred to as using reserves as “cookie jars” to shift income and expenses between periods depending upon the company’s “need” for the financial statements to fall within certain parameters.
The misapplication of accounting rules is another opportunity for financial statement manipulation. Executives may deliberately incorrectly apply accounting rules in a way that enhances the company’s financial results.
One of the simplest ways to manipulate financial statements is through the omission of information. There are rules regarding explanations and disclosures that must accompany financial statements. Without that additional information, the financial statements themselves might easily be misinterpreted. Deliberately omitting necessary information from the notes to the financial statements is a simple, but effective, way to tender misleading financials.
Financial statement fraud can have an impact on any person or organization that has a financial interest in the success or failure of a company. A manipulation of the company’s reported earnings or assets can affect a bank that extends credit to the company, a shareholder who invests money in the company, and those organizations that enter into contracts or agreements with the company.
The manipulation of financial statements also affects employees. It has the power to put employees out of work once the fraud is exposed or collapses. It also has the power to enrich employees – mostly those involved in the fraud, but potentially those who are not. Good financial results (actual or fabricated) can be linked to promotions, raises, enhanced benefit packages, bonuses, and the value of stock option awards.
Financial statement fraud will cause shareholders to overpay for their investment in the company and they will get less value for their money than they are aware. They may lose part or all of their investment if the company ultimately fails or has to go through some sort of reorganization in order to remain viable. Shareholders also lose the opportunity to invest their money in other companies which may have better actual financial results or which may be more honest in their operations.
Banks lose money, which affects other bank customers who ultimately make up for those losses and affects the bank’s investors. Creditors can lose large sums of money, which may not have been risked if the creditors knew the true financial condition of the company.
If enough financial statement frauds occur, or if the frauds are large enough, there are wide-reaching effects for other companies. Consider the case of the Sarbanes-Oxley Act of 2002. The legislation followed the collapse of some large public companies with executives who engaged in significant financial statement fraud.
This legislation attempted to address financial statement fraud and bring more reliability and transparency to the financial reporting process. Sarbanes-Oxley required companies to make changes, and it also changed how independent auditors do their work.
The legislation has caused companies to collectively spend billions of dollars on assessing their processes, engaging consultants to help with the assessments, and enhanced independent audits. This is an indirect cost of financial statement fraud, but its impact on companies is direct. It has been very expensive.
Financial statement fraud often doesn’t have a readily apparent or direct financial impact on interested parties. But because it is rampant and its indirect costs are so high, it is important that the users of financial statements be aware of the risk and the impact.
Regulations may be effective in curbing some of this fraud, but a skeptical eye on the part of interested parties might be more effective in protecting investors, creditors, and other business partners from the negative effects of financial statement fraud.