Financial Statement Red Flags to Detect Internal Theft
Businesses worldwide lose five percent of revenue each year due to occupational fraud committed by their very own employees, according to the Association of Certified Fraud Examiners’ Global Fraud Study for 2016.
In 94.5 percent of fraud cases, perpetrators took some effort to hide the fraud by creating or altering physical documents. Intentional misstatements or omission of material information in an organization’s financial reports are typically perpetrated to conceal poor financial performance or to create an inflated picture of a business’s true financial health. While these instances of financial statement fraud represent the least common form of occupational fraud, they typically are the most costly, resulting in median losses of $975,000 per organization. Moreover, the longer the fraud goes undetected, the greater the financial damage to the company.
Preventing and mitigating the damaging effects of financial statement fraud requires businesses to accept the possibility that it can happen to them and to put into place a series of internal anti-fraud controls. Because perpetrators will go to extremes to evade these controls, businesses must also be able to recognize the red flags that point to the most common schemes.
To portray a business in the most positive financial light, fraudsters may exaggerate assets by improperly presenting accounts receivables, inventory, fixed assets and investments. They may create fictitious clients, sales transactions, assets and accounts receivable, or they may understate an asset’s basis, manipulate the estimation of an asset’s useful life and residual value or fail to account for obsolete inventory.
Red flags include the following.
- a large and inexplicable accumulation of fixed assets or depreciation schedules and estimates of assets’ useful lives that are inconsistent with the business’ industry;
- missing documents and discrepancies between recorded transactions and evidence obtained from third parties; and
- reports of a growth in inventory without corresponding growth in sales.
CONCEALED EXPENSES AND LIABILITIES
A business may understate or hide expenses and debt in an effort to bump up its recognition of revenue. Examples of expense manipulation include:
- misclassifying expenses as assets;
- failing to record certain obligations as liabilities; or
- leaving special purpose entities or subsidiaries off a parent company’s books.
In some instances a business may avoid recording any expenses at all, including notes and loans to executives, or it may overstate liabilities in order to establish “cookie jar reserves” to pay for future expenses and appear that it is boosting profits.
Red flags can include a high number of complex third-party transactions, unauthorized journal entries or discrepancies between journal entries and that which is reported in financial statements, as well as transactional entries made to unrelated or rarely used accounts. Additionally, a business may manipulate its expenses by improperly capitalizing expenses in excess of industry norms.
IMPROPER REVENUE RECOGNITION
The most common form of financial statement fraud occurs when a business falsifies revenue. This is often accomplished by overstating revenue through premature revenue recognition or the recording of fictitious sales that never actually occurred. Alternatively, a business may understate its revenue by shifting revenue to a later period or improperly recording its percentage-of-completion contracts.
Red flags include:
- the reporting of increasing revenue without corresponding growth in cash flow;
- a significant increase in revenue at the end of a reporting period; and
- the recording of revenue for consignment sales, or any sale, before a product or service is delivered to a customer.
Similarly, a business engaged in improper revenue recognition may report growth in revenue or margins that far exceeds those of other companies in the same industry, or it may report positive earnings while cash flow declines.
Businesses may include footnotes in their financial statements to provide readers with material information and additional explanations about their operations that are not easily understood by reviewing the numbers in the financial statement by themselves. However, there are times when a business will purposely omit from these statements information—such as related-party transactions, liabilities arising from legal actions or accounting method changes—to conceal its true financial condition and outlook.
Financial statement fraud is a real threat to businesses large and small across all industries. The first line of defense against these criminal activities is the implementation of systems, policies and controls intended to safeguard an organization and deter fraud or stop it in its tracks at the first sign of detection.
Investigations conducted by qualified forensic accountants can also aid in exposing fraud before businesses suffer significant losses. These professionals have the knowledge and experience required to interview relevant parties and analyze multiple years of financial records, public documents and other forms of physical and electronic evidence to identify the source of a fraud. Moreover, their understanding of the law and their ability to provide expert testimony in legal proceedings further provide businesses with valuable support in prosecuting fraudsters.