Corporate fraud often is concealed when a company intentionally misrepresents material information in its financial reports. Such misrepresentations can result from the misapplication of accounting principles, overly aggressive estimates of figures and material omissions. For example, financial statements might report revenues that are either pre-mature (not yet earned) or outright fictitious. They could also manipulate profitability by reporting operating expenses as capital assets, or perhaps by concealing liabilities—such as neglecting to record or disclose a million-dollar lawsuit that they just lost—again to make a company appear more profitable than it truly is for the purpose of calming current investors and for attracting unsuspecting new ones.
But as time goes on, ultimately the fraud will have to uncover itself—but for how long? As investors with Bernie Madoff found out—possibly decades! So corporate fraud, similar to a Ponzi scheme, is like a runaway train that will crash…however, some tracks run longer than others. So while it continues, in order to conceal and further their frauds, perpetrators must come up with more of the same—or perhaps new methods. They often conceal or omit information that could damage or improperly change the bottom-line results that appear in financial statements. Such omissions include:
- Events likely to affect future statements, such as impending product obsolescence, new competition and potential lawsuits,
- Potential liabilities, such as loan covenant violations or contingency liabilities,
- Accounting changes that materially affect financial statements—including methods of accounting for depreciation, revenue recognition or accruals—and that are subject to financial statement disclosure rules under generally accepted accounting principles (GAAP), and
- Related-party transactions or those with a party with whom an owner or member of management has a financial interest—and that may not be at arms-length terms (i.e., varying significantly from what the current market would bear or pay).
Perpetrators will also engage in fraudulent manipulation, particularly in the areas of revenue, expenses, reserves and one-time charges. Falsified financial statements can recognize sales prematurely, improperly value sales transactions (by, for example, inflating the per-unit price) or report phantom sales that never occurred. Conversely, expenses can be manipulated by delaying their recognition—whether to match the expenses with their corresponding revenue or to avoid reporting a loss. Another trick is to improperly capitalize expenses so they appear on the company’s balance sheet as an asset, rather than on its income statement as a reduction of profit.
Another easily falsified and manipulated area within fraudulent financial statements relates to reserves, or other estimated balances, that are more “subjective” (to a degree) and have been calculated using intentionally flawed concepts or estimates. For example, fraudsters could justify a smaller amount of reserves for bad debts on their accounts receivable by underestimating the percentage of uncollectible receivables—or a reserve for unsaleable inventory by neglecting to consider that a percentage of their product expires tomorrow.
Reading between the lines
When fraud is suspected, a Forensic CPA can dig into complex financial statements and uncover manipulation that might not be apparent to the untrained eye. A fraud expert begins by reviewing the suspicious statements for unusual trends and relationships. Any leads are followed by more intensive forensic accounting work, such as analysis of specific transactions, journal entries, work papers and supporting documentation. This type of examination goes far beyond a standard annual audit, which, by itself, may still not uncover that the fraud even exists.
The Forensic CPA may also employ several types of analyses:
- Vertical analysis compares the proportion of each financial statement item—or groups of items—to a total within a single year that can be measured against industry norms.
- Horizontal analysis compares current data with data from previous years to detect patterns and trends.
- Financial ratio analysis calculates ratios from the current year’s data and compares those with previous years’ ratios for the company, comparable companies and their relevant industry.
The effective and qualified expert must also have experience in the subject industry and be able to recognize noncompliance with GAAP.
In fact, noncompliance with GAAP is a significant red flag for financial statement fraud. The Association of Certified Fraud Examiners (ACFE) has identified several other behavioral red flags, including employees who live beyond their means, exhibit a cavalier attitude toward internal controls, or are overly defensive about their reporting and resistant to any changes concerning their numbers.
Keep a lid on fraud costs
Because of the complexity of corporate financial statement fraud, and the length of time that elapses before being exposed, these frauds result in significantly larger losses than your run-of-the-mill/straight-up embezzlement cases. The ACFE has estimated the median loss in financial statement fraud schemes to be $1 million—to say nothing of the public relations damage that the dishonest owners or management who manipulate the numbers can cause to an entity. With our vast experience in crawling over financial statements and knowing the key biases that drive someone’s “need” to perpetrate these frauds and victimize those who have entrusted them with hard-earned money, we can help limit your, or your clients’, losses—preferably before the investment is lost.
Richard Gordon, CPA/ABV/CFF, CFE, CGMA joined Lindquist LLP in 2014 as the Director of Forensic Services in the firm’s San Ramon office. In addition to being licensed as a CPA in California, Rich is a Certified Fraud Examiner (CFE) and is Accredited in Business Valuation (ABV) and Certified in Financial Forensics (CFF) through the American Institute of Certified Public Accountants (AICPA). He is a member of the AICPA’s Forensic & Valuation Services section, the Association of Certified Fraud Examiners, and the California Society of Certified Public Accountants’ (CalCPA) Forensic Services Section. Rich possesses vast forensic experience in the areas of family law, financial statement and tax fraud, contract disputes, economic damages, bankruptcy fraud, and embezzlement cases, in which he has successfully represented both prosecution and defense. Contact him at (925) 277-9100 with questions.