Financial Statement Fraud: How It Is Done

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Financial statement fraud happens is one of the most costly types of fraud. It is a significant problem because people 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.

Upper management or company owners are the ones who are usually responsible for financial statement fraud. Executives are entrusted with entire companies. They have access to nearly all data and employees, and they can exploit this access to commit and conceal fraud.

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.

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 is difficult to detect. A tip from an employee about the manipulation of accounting records is the primary way that financial statement fraud is detected. It can also be discovered through an intense analysis of the company’s financial statements over time. There are telltale signs in the financial ratios, which tend to move in strange ways when the numbers are being manipulated.

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