Column: Financial statement fraud

Columnist says it’s not just Wall Street’s problem

I recently had lunch with a banker whose job it is to review financial statements to determine whether a client is creditworthy. I talked to him about the increase in financial statement fraud cases, as evidenced by the 2010 Association of Certified Fraud Examiners (ACFE) Report to the Nations. The 2010 report indicated that the median loss created by financial statement fraud exceeded $4,000,000 (double the reported losses in 2008). My banker friend indicated that he appreciated the information, but that I had certainly made him nervous about his job.

Now more than ever is the time for him to be nervous. Why? Because the high stake business environment we operate in generates even more pressure for management (or an individual) to create fraudulent financial statements.

Remember, three items are usually working in tandem for any fraud to occur. The first is pressure, an internal stress on an individual or company. The second is rationalization; an internal thought process to make a bad decision seem reasonable. Third is the opportunity for the fraud to occur.

Take a company who has been hit by a difficult economic climate. Perhaps it’s time for their line of credit to be renewed at the bank. Come the end of the fiscal year, they realize the financial data they need to send to the bank will not comply with agreed covenants – an internal pressure indeed. Perhaps management sees an opportunity to accrue additional revenue, money that’s not expected until the year following, to ensure compliance with agreed covenants. They rationalize this decision by saying to themselves, “we’ll renew the line of credit, we’ll be able to buy materials to sell our product, and those sales will generate more than enough revenue to cover the loan payments. We’ll just do this one time, and no one will know.” 

No harm, no foul, right? Would a banker say the same thing?

Financial statement fraud can take many forms, including recording fictitious revenues, concealing liabilities or expense, improperly valuing assets or omitting key financial disclosures. In addition, this type of fraud can be difficult to uncover.

Compounding this problem is a common misconception that a financial statement audit performed by a CPA firm is an insurance policy against fraud. Unfortunately, audits are not designed to detect fraud. In fact, less than five percent of fraud cases are discovered by external audits (as per the 2010 ACFE Report). Simply put, audits ensure that financial statements are “reasonably stated.” Auditors are limited to testing amounts “material” to the financial statements and random sampling of transactions; their job is not to detect fraud.

There are steps that investors, bankers, owners and their CPA firms can take to ensure that financial statements have not been manipulated. Aside from the typical analytical analysis of the financial statements, reviewing transactions recorded at the end of a period, verifying that assets and inventory actually exist (i.e. a physical review) and determining whether accounts receivable reflect current amounts due (or whether “old” accounts have been re-aged to look “current”) are excellent testing methods.

Further, understanding the hallmarks of financial statement fraud can also provide insight. Is management dominated by a single person or small group? Is the company experiencing rapid growth or unusual profitability as compared to companies in the same industry? Are restrictions placed on bankers or CPA’s during their information gathering process? Are there significant or unusual transactions with related parties or are there significant or unusual transactions recorded at the end of an accounting period?

We may not hear about financial statement fraud on Main Street, but the impact on angel investors, financial institutions – and sometimes – the company itself, can be devastating. 

Tiffany Couch, CPA/CFF CFE, is owner of Acuity Group PLLC, a forensic accounting firm in Vancouver. She is also a faculty member of the ACFE. She can be reached at 360.573.5158.