Beware: Natural Disasters Create an Opportunity for Fraud

A major natural disaster such as the California wildfires does more damage than just what you see. When the cleanup and restoration begin, there can be more trouble in the form of fraud.

Isn’t fraud the last thing you should be thinking about? Isn’t the most important thing to just recover from the disaster and move forward? Yes, that’s important. But unfortunately, unscrupulous people and businesses make the issue of fraud something that cannot be ignored.

The most obvious opportunity for fraud starts with contractors who clean, restore, and replace destroyed property. Dishonest contractors may use the widespread need for services as an opportunity to overcharge insurance companies and property owners. They may bill for work not performed, unfairly inflate prices, or not complete projects.

Property owners may use the wildfires as an opportunity to bilk insurance companies by inflating the value of lost items, submitting claims for items never owned, or otherwise dishonestly reporting lost items to the insurance company.

But the fraud that is often overlooked by the average consumer is when a business that has caught fire later manipulates financial statements. A natural disaster can be the perfect opportunity to bury costs or be the scapegoat for a bad quarter or year.

It is understood that it may be difficult to look at financial statements critically after a natural disaster. After all, the victims have already been through a lot with the cleanup and the attempt to restore operations. Those looking at the financial statements might be inclined to be less skeptical than usual.

My article Financial Statement Fraud Under Fire, written for the Oklahoma Society of CPAs, addresses this issue as it relates to last year’s wildfires in Texas and Oklahoma. These issues and concerns are similar to the issues that will be faced in California in the coming months.

The financial statement issues that could arise include the following:

  • Revenue overstatement: Financial pressures may cause companies to deliberately fabricate revenue. Companies affected by wildfires probably should show decreased revenue in the months following the disaster. If revenue shows no noticeable change, further examination is warranted.
  • Accounts receivable reserve understatement: Reserves are at risk for misstatement following natural disasters. Companies with significant fire damage are likely to pay their suppliers more slowly, and the risk of nonpayment is high. Generally accepted accounting principles require the establishment of a reserve for uncollectible accounts receivable that aren’t likely to be collected, and this is an area that can be manipulated by management.
  • Obsolete inventory: Wildfires may offer companies an opportunity to reduce inventory write-offs this year. To the extent that obsolete inventory is damaged by fire, insurance coverage may apply. However, the valuation of the inventory may be called into question, and companies may attempt to overvalue the inventory for insurance purposes.
  • Capitalization of expenses: It is often tempting for companies to capitalize expenses and deduct them over several accounting periods rather than expense the entire cost immediately. Costs related to fire cleanup 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 cleanup costs won’t benefit future accounting periods and therefore shouldn’t be capitalized.
  • Insurance reimbursement: 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.

Business owners and executives need to resist the temptation to manipulate financial statements following a natural disaster such as a wildfire. Users of the financial statements must be aware of the risk of misstatements and earnings management, and should exercise professional skepticism in the weeks and months following the wildfires.

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