Financial statement fraud impacts 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.