09 May

Why is Financial Statement Fraud Such a Big Deal?

The manipulation of a company’s financial statements does not occur as often as asset misappropriation schemes like payroll fraud, check kiting, or inventory theft. And the losses from financial statement fraud aren’t readily apparent to most people. When money is stolen directly (asset misappropriation), it’s easy to see what the harm is to the company.  Financial statement fraud schemes are much more costly than other types of fraud. Some may wonder what the losses in a financial statement fraud could be. After all, the employees involved are just manipulating numbers on paper, but there is really no harm to anyone, right? Wrong.

Financial statement fraud is so expensive because its effects are far-reaching. Just a few of the many effects of financial statement fraud include:

  • Bank offers a loan that is riskier than it believed.
  • Stock price becomes inflated.
  • Company pays higher bonuses than it should.
  • Executives issued more stock options than they deserve.

Banks can be stuck with bad loans they never would have made if they knew the true financial situation of the company. Investors buy stock they might not otherwise have bought. Employees get bonuses and perks that are higher than they should be, and the company has a lower ability to pay those bonuses based on the true numbers.

When a financial statement fraud is finally uncovered, millions or billions of dollars stand to be lost by interested parties. Investors want their money back. Banks call loans. Customers stop doing business with the company. Employees lose jobs because of reduced revenue. The outlook of the company looks worse, and all of these negative effects snowball until many times, the company is put out of business.

Companies that are often likely candidates for financial statement fraud, sometimes referred to as earnings management, are ones that appear to be doing significantly better than other companies in their industry. There is always an industry leader, and there is always a possibility that a particular company has a much more efficient operation than competitors. But more often, industry conditions affect all the players in a similar fashion. A company that has jumped ahead of all others in the industry with a much higher level of profits can be engaged in financial statement fraud. The better the financial results are compared to the bulk of the companies in the industry, the more skeptically the financial statements should be viewed.

Financial statement fraud should not be taken lightly, even if the causes and effects seem a bit abstract.

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