Financial Statement Fraud Under Fire

Written by Tracy L. Coenen, CPA, CFF

OSCPA Wire – Oklahoma Society of CPAs Newsletter

Any natural disaster creates opportunities for fraud and that’s exactly what recent wildfires have done. Dishonest executives have a chance to manipulate their financial statements following fire losses and no one may detect it.

When we think of fraud surrounding natural disasters, we commonly think of false or inflated insurance claims, abuse of Federal funds, or fake charities. One of the least-discussed opportunities for fraud is crating fraudulent financial statements. Companies that have suffered financial hardship because of wildfires or other natural disasters may be tempted to “enhance” or “manage” earnings.

Opportunities abound for financial statement fraud related to natural disasters, however, no obvious fraud cases of this type have been publicized. Is this because it hasn’t happened? Or could it be that auditors are more sympathetic to their clients as victims of natural disasters? Has the hardship of it all caused the financial watchdogs to take a softer approach to the business of auditing?

Accounting Standards
Accounting Principles Board (APB) Opinion No. 30 directs reporting of expenses related to “Extraordinary, Unusual and Infrequently Occurring Events and Transactions.” If a wildfire is considered unusual in nature and nonrecurring, then losses related to it would be shown as a line-item separate from continuing operations.

However, most would agree that wildfires in areas such as Texas and Oklahoma are not nonrecurring. That is, it’s more likely than not that a wildfire will occur again. Even though extensive fire damage might be considered unusual, the losses related to the fires must be included in income or loss from continuing operations because a similar event will likely occur again.

Financial Statement Fraud Risks
There are five areas of the financial statement that are most at-risk for manipulation by companies affected by wildfires:

1. Revenue overstatement could occur in companies directly affected by fire, as well as companies that do business with those damaged by fire. Financial pressures may encourage both to deliberately recognize fictitious revenues.

Auditors should pay special attention to revenues recorded after the disaster and ask themselves whether those financial results are reasonable. Companies affected by wildfires probably should show decreased revenues in the months following the disaster. If revenues show no noticeable change, further examination is warranted.

2. Accounts receivable reserves are also at risk for misstatement following natural disasters. Companies with significant fire damage are likely to pay their suppliers more slowly. The risk of non-payment of suppliers is also high. GAAP requires the establishment of a reserve for uncollectible accounts receivables aren’t likely to be collected. The entry records a corresponding expense, which is unattractive to companies.

Overstatement of accounts receivable is not always easy to spot, but auditors can examine significant customers and determine whether their operations are located in the path of wildfires. If so, further investigation of the collectibility of accounts receivable is warranted. Additional procedures might include confirmations and review of cash receipts subsequent to the close of the accounting period.

3. An annual concern shared by many companies is the problem of obsolete inventory. Companies identify old inventory that has little value and then decide whether they will recognize an expense in the current year as required by the accounting rules.

Wildfires may offer companies an opportunity to reduce inventory write-offs this year. To the extent that obsolete inventory was damaged by fire, insurance coverage may apply. However, the valuation of the inventory may be called into question and companies may attempt to over-value the inventory for insurance purposes.

Companies may also be tempted to write off obsolete inventory as damaged by fire even if that isn’t the case. Investors and users of financial statements may judge that type of write-off less harshly than a straight obsolete inventory write-off.

Auditors should critically examine write-offs due to wildfires and compare details to the prior year’s obsolete inventory reserves. If auditors observe the company’s annual physical inventory, they should look for damaged inventory and perform additional procedures to verify the correct accounting treatment.

4. It is often tempting for companies to capitalize expenses and deduct them over several accounting periods rather than expensing the entire cost immediately. Costs related to fire clean-up and rebuilding are no different. These costs may be substantial and executives may be inclined to spread the costs out over a few years, rather than expensing them when they are incurred.

Many fire-related clean-up costs won’t benefit future accounting periods and therefore shouldn’t be capitalized. Capitalization may be appropriate for some repair and replacement of significant equipment and buildings, but these situations should be easy to spot.

5. In addition to the rules on technical treatment of losses under today’s accounting rules, management must also consider the proper treatment of insurance reimbursements. Properly insured companies will be reimbursed for the majority of property losses and loss of business. However, insurance settlements and payments may not be made for some time.

Recoveries from insurance policies shouldn’t be recorded by companies until contingencies are resolved and the amount of insurance payment can be reasonably estimated. If a company includes an insurance receivable in the current year’s` financial statements, auditors should critically examine the source documentation and inquire with management.

Be Sympathetic But Skeptical

Will wildfire-related frauds be any different from other financial statement fraud? Probably not. Instead, natural disasters create a new avenue for fraud.

Most of the general population has sympathy for individuals and businesses affected by wildfire and this may cause them to be less skeptical about financial results, but auditors should make sure facts are not lost in management’s spin on the disaster’s affect on the financials.

Tracy L. Coenen, CFE, CPA, is president of Sequence Inc., a forensic accounting firm with offices in Milwaukee and Chicago. She can be reached via email at: [email protected].

Leave a Reply