3 Common Types of Financial Statement Fraud

There are different forms of financial statement fraud that companies might commit. Here are three of the most common types of financial statement fraud to be on the alert for.

The 3 most common types of financial statement fraud

1. Overstating revenue

Probably the most common financial statement fraud is the manipulation of sales (revenue) figures. It's in the company’s best interest to report higher sales, as opposed to lower sales, so virtually every company runs the risk of overstating sales.

In some industries, it’s very clear when a sale has occurred. If a customer enters a retail store and purchases an item from a cashier, there is little doubt that a sale has occurred. In many businesses and industries, however, it's not so straightforward, and there is some "gray area" when it comes to deciding when a sale has occurred.

Consider the insurance industry: You pay your insurance premium in advance of receiving your policy. Money has changed hands, but the insurance company can't record revenue yet because the company hasn't yet done anything to earn that money. Calculations must be done to determine what revenue has actually been earned during the accounting period.

The more complex the sales agreements, the more difficult it can be to determine when a sale occurs. Consider a long-term sales contract in which a customer agrees to buy a certain amount of a product or service over several years. Varying contract terms can affect when revenue may be recognized from this type of transaction.

The waters become even more muddied when management is expected to make estimates about certain items on the financial statements. The accounting rules say they should be "conservative," but that rule is often not followed. As business has become more complex, it is clear that the risk of misstating revenue is high. And the risk doesn't really lie in understating a company's revenue. There's usually not much motivation to do that. The motivation is, instead, to inflate sales figures.

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Revenue overstatement can also occur in a very straightforward fashion through booking revenue for sales that have not occurred. In this case, there is no gray area. This situation might include booking a completely fictitious sale. It could also include booking a sale of an item for which title has not passed.

It can be confusing in industries in which physical goods are being sold, and there is a question as to when the sale is complete. Is it complete when the manufacturer finishes making the product? Is the sale complete when the item leaves the plant? Or does the sale not become official until the customer receives the product? The answer to these questions can vary depending on the industry and the agreements between the manufacturer and the customer.

2. Overstating assets

Asset accounts are manipulated to enhance a company's balance sheet, especially to positively impact important ratios involving assets. At higher risk of overstatement are current assets such as accounts receivable. Companies don't always like to write down or reserve for outstanding balances that customers aren't going to pay. Yet the accounting rules require these write-downs to be done when management is aware that an account is uncollectible.

Failing to make these write-offs in a timely fashion is financial statement fraud, plain and simple. But it's often done because it's easy to get away with. There can be a high level of activity in the area of accounts receivable, so auditors aren't very likely to detect manipulations in these accounts. And if the manipulations are discovered, it's easy for management to claim that they weren't aware that an account should be written off or they weren't aware that it was so long overdue.

Other ways to commit financial statement fraud related to assets include: failing to write down assets with impaired values (such as goodwill or other intangible assets), filing to write down obsolete inventory, or failing to record expenses for accounts with collection problems.

3. Understating expenses

One surefire way to increase a company's profits and enhance the financial statements is by not booking expenses as the company incurs them. The manipulation of expenses can be very simple. Management can hold expenses and wait to book them until future periods.

Another option is improperly capitalizing the expenses instead of immediately booking them to the profit and loss statement. For example, one automobile dealership had high advertising expenses. During a period of depressed sales, the owner of the dealership was worried about presenting the real financial results to the automaker. Therefore, several months’ worth of advertising expenses was capitalized instead of expensed. Not only did the income statement improve immediately, the balance sheet looked better too because current assets were increased by this manipulation.

A company with a large construction project may also use this financial statement fraud method rather easily. As buildings and equipment are quickly being added to the balance sheet, it might not be noticed if management moves some expenses into fixed assets. Again, this creates an instant improvement in the company’s financial picture because the balance sheet looks stronger and profits are inflated. The risk of detection of the inflated fixed assets is low.

Companies can also manipulate expenses by not writing down assets such as accounts receivable, inventory, or buildings and equipment to their correct values under the accounting rules. There are many instances when companies should book an expense and create a reserve for an asset with an impaired (decreased) value. It is tempting to ignore this rule, especially because by ignoring it, expenses are kept artificially low.

Finally, companies can reduce their expenses by failing to report sales discounts, returns, and allowances. Failing to account for such items again reduces the company’s expenses. The additional profits created by such a scheme fall right to the bottom line. This is also an area of the financial statements that's often not heavily scrutinized, minimizing the chance of detection.

FAQs about financial statement fraud

Below we have summarized the most important questions and answers on the subject.

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