Financial statement fraud includes intentional, material misrepresentations. Tracy Coenen explains the concept of financial statement fraud to a group.
Anyone who is being honest will tell you that financial statement audits don’t find fraud. On the rare occasion they do, but by and large audits are not designed to detect fraud and the auditors don’t have enough fraud detection training.
One solution to this problem is the engagement of forensic accountants to look for fraud. But companies don’t seem to interested in going the extra step.
Today Hewlett-Packard announced that an internal investigation revealed accounting fraud by Autonomy, a company that was acquired by HP last year for more than $10 billion. More specifically, the company said:
In the last week Big Four auditing firm PricewaterhouseCoopers has been sued over its performance of audits of companies with massive frauds. First, PwC was named as a defendant in a suit filed by the Federal Deposit Insurance Corporation as the receiver for Colonial Bank.
Colonial Bank went under thanks to a fraud by Taylor Bean & Whittaker Mortgage Corp., its largest mortgage banking customer. Executives at Taylor Bean & Whitaker cooked up a scheme whereby they sold $400 million in worthless mortgages to Colonial Bank. The mortgages were worthless because they either did not exist, or had already been sold to other investors.
In the current issue of Forbes magazine, accounting watchdog Francine McKenna has written an article about the SEC’s failure to take a hard line on accounting fraud in public companies. Despite all of the high profile accounting frauds uncovered in the past decade, the Securities & Exchange Commission appears to be focusing its efforts on going after Ponzi schemes rather than accounting fraud. Francine reports that of the 735 enforcement actions brought by the SEC in 2011, only 89 were related to fraudulent or misleading accounting and disclosures by public companies.
Some people say that Sarbanes Oxley has been doing its job relative to increasing prevention and detection of accounting fraud, but evidence of that is almost non-existent. Auditors would have the public believe that auditors are being more effective in finding and reporting fraud, but the evidence does not back this up.
What is a company to do when it wants to hide losses? Manipulation of the financial statements is the obvious first choice. It’s not hard. Sure companies have “internal controls,” which are supposed to include policies and procedures which ensure that financial information is properly recorded. But companies of all sizes have problems with their internal controls, such that it’s not terribly difficult to issue fraudulent financial statements.
Michael Woodford was dismissed in October as CEO of Olympus, and subsequently disclosed that he was fired because he raised questions about some acquisitions by the company. He alleges that Olympus paid incredibly high prices for companies it acquired, and also paid huge “advisory fees” to agents who supposedly represented Olympus in the transactions. The purpose behind these transactions? To cover up investment losses that were decades old without drawing any attention to the issue.
When a whistleblower goes to a government agency with allegations of fraud and corruption, no one knows whether the government will act. The more detailed and credible the allegations, the more likely the government will ask questions. The company may even have the great “fortune” of being subject to a full-blown government investigation.
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 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.
The story of the alleged $31 million fraud at Koss Corp by the company’s former VP of Finance, Sue Sachdeva, hasn’t gotten much air time over the last month or so. Aside from the usual class action lawsuits when there is a fraud discovered at a public company, the only bits of news that are remotely notable at Koss are the continued declaration of dividends and the filing of a 10-Q without any financial statements included.
Koss is a public company, but the stock is thinly traded. The Koss family apparently owns about 70% of outstanding shares of stock. The declaration of a dividend, therefore, is nothing more than the Koss family publicly announcing that they are going to pay themselves.
Francine McKenna at re: The Auditors has an interesting post and set of comments about internal audit functions at public companies and the importance of internal auditors.
External auditors look at a company’s financial statements and a small amount of underlying transactions in order to issue a report that the financial statements are properly presented. (It’s really a check of math and application of accounting rules.) The financial statement audits aren’t designed to detect fraud, and so they almost never do.
In contrast, the internal audit function is engaged in ongoing audits of the financial reporting process and other numbers-related projects. The scope of internal audit work varies greatly from company to company.