Introduction
Before we dive into the details of fraudulent financial reporting let’s talk about some basics. Financial statements are important documents for any business entity as they provide a comprehensive overview of a company’s financial activities and performance. They summarize financial position, profitability, and cash flows, and are used by investors, creditors, regulators and other stakeholders (which are termed as users of financial statements) to evaluate the company’s financial health. Financial statements typically include an income statement, balance sheet and cash flow statement, which provide a detailed breakdown of a company’s revenue, expenses, assets, liabilities, equity and cash flows over a specific period of time. These statements are essential for making informed decisions about investing in or lending to a company, as well as for evaluating a company’s overall financial stability and potential for growth. Sometimes, the amounts disclosed in the financial statements may not be true and this may mislead the investing decisions of the investors. This is what is called financial statements fraud or fraudulent financial reporting.
To understand fraudulent financial reporting, first we should know what is fraud and material misstatement.
Meaning of fraud
Fraud is an intentional act done by one or more individuals among management, those charged with governance, employees, or third parties, involving the use of deception to obtain an unjust or illegal advantage.
Meaning of material misstatement
Information is material if its misstatement (i.e., omission or erroneous statement) could influence the economic decisions of users taken on the basis of the financial information. That means any information is a material misstatement if it influences the decisions of users of the financial statement.
Meaning of fraudulent financial reporting
Fraudulent financial reporting is a branch of fraud which involves intentional misstatements including omissions of amounts or disclosures in financial statements to deceive financial statement users.
Fraudulent financial reporting may be accomplished by the following:
1. Manipulation, falsification (including forgery) or alteration of accounts
2. Misrepresentation or intentional omission
3. Intentional misapplication of accounting principles
There are numerous ways of committing this type of fraud. Some of the methods are given below:
1. Inflating or suppressing purchases and expenses.
2. Inflating or suppressing sales and other items of income
3. Inflating or deflating the value of closing inventory
4. Failing to adjust outstanding liabilities or prepaid expenses
5. Charging items of capital expenditure to revenue or by capitalising revenue expenses.
Why do management or employees commit fraud?
Following are certain instances:
1. Financial obligations or pressure.
2. Management’s unrealistic goals.
3. Dissatisfied employees or lack of motivation among employees.
4. Name game (e.g. management using power of authority by asking employees to do something illegal).
5. Opportunity to commit fraud.
How do you identify financial fraud?
Identifying financial fraud can be a complex process, as fraudsters can use a variety of techniques to conceal their activities. However, when someone has “cooked the books”, certain patterns can be identified, and it pays to be aware of the following red flags:
1. Unusual or inconsistent financial transactions: Transactions that are unusual in size, frequency, or nature, or that do not match the company’s usual patterns of behaviour.
2. Accounting irregularities: Changes in accounting methods or practices that do not comply with generally accepted accounting principles.
3. Suspicious documentation: Incomplete, altered, or forged documents, or documents that are not backed up by appropriate supporting evidence.
4. Internal control weaknesses: Weaknesses in the company’s internal controls, such as poor segregation of duties or lack of oversight, that could make it easier for fraud to occur.
5. Behavioural red flags: Look for changes in employee behaviour, such as an employee who is suddenly living beyond their means, exhibiting erratic behaviour or refusing to take time off.
Prevent financial statement fraud
While fraud detection and the ability to quickly perceive the warning signs of fraud are helpful during and after the malfeasance, companies should put systems in place to prevent financial statement fraud from happening at all. From accounting software that separates duties to corporate values of integrity and honesty modelled by upper management, these prevention points will help seal route to fraud and convey a message to employees that honesty is the best policy.
1. Institute strong internal controls. The first and most important step is to institute strong internal accounting controls. Key to this is segregation of duties, which involves dividing responsibility for book keeping, deposits, reporting and auditing between different people to reduce the temptation and opportunities to commit fraud. Keep unauthorized personnel out of the accounting system by using passwords, lockouts and electronic access logs.
2. Perform periodic audits of financial statements. Companies should regularly test their financial statements for accuracy to make sure their internal controls are effectively preventing fraud. A deep dive into the financial information can surface weaknesses in the internal controls that lead to corrective measures. When employees know an external auditor will be reviewing their work, they are less likely to stray from the honest path.
3. Set a tone of honesty at the top. Employees look to leadership to learn what is acceptable at an organization, morally and behaviourally. Management should lead by ethical example, demonstrating the values they want to see replicated in the company culture. Starting with onboarding, train employees to recognize fraud, meet ethical and legal standards and be aware of consequences for breaches in conduct.
4. Use enterprise resource planning (ERP) accounting software. An ERP system automates accounting operations, streamlining accounts receivable, accounts payable and cash management. The system enforces segregation of duties and strict approval mechanisms, which help prevent unauthorized transactions.
Conclusion
The victims of financial statement fraud are widespread, including investors, company employees whose jobs and pensions become compromised when organizational fraud is uncovered and the general public, whose trust is violated. The best way to eliminate fraud is to implement robust controls and timely audits which will not only reduce the risk of fraud reporting but also maintain the trust of the users of financial statements.
Authors: Dhruv Mehta | Associate Consultant |Email: blogs@bilimoriamehta.com | Contact: +91 98709 25375
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