Financial statement fraud is the most expensive type of fraud perpetrated by an employee, with a median cost of $2 million per scheme. It occurs the least often however, with financial statement manipulation present in only 10% of all fraud schemes.
This type of fraud is generally perpetrated by upper management, as they are typically the employees with the access and the influence to manipulate financial statements. Upper management usually has the most to gain from financial statement fraud, from increased performance bonuses, to more valuable stock options, to lucrative job promotions.
Financial statement fraud includes the deliberate misstatement of numbers by either booking false accounting entries or deliberately misapplying accounting rules. Either way, the financial statements are purposely inaccurate.
There are eight common ways to carry out a financial statement fraud:
- Overstatement of Revenue – Many financial statement manipulations are achieved by inflating sales. This can happen by booking completely fictitious sales, or by booking a sale before the revenue is actually earned.
- Understatement of Expenses – This usually occurs by holding expenses over to a later period, even when they were incurred in the current period. A company may also wrongly capitalize an item and expense it over several periods, rather than properly expensing it immediately.
- Overstatement of Assets – This could include not writing down or reserving for accounts receivable. Assets with impaired values or items like obsolete inventory may also not be written down or written off.
- Understatement of Liabilities – Management may move liabilities between current and long-term to meet lending requirements. They may also fail to record certain liabilities, or they may improperly record them to equity.
- Improper Use of Reserves – Commonly abused reserve accounts include reserves for accounts receivable, sales returns, warranties, and inventory obsolescence. These accounts are inherently risky because they require a great deal of judgment to determine their balances as the end of the accounting period.
- Mischaracterization as One-Time Expenses – Management may attempt to characterize a normal, recurring expense as one-time or nonrecurring. Removing the item from the heart of the financial statements gives the users of the financial statements a false impression of the company’s operating results.
- Misapplication of Accounting Rules – Accounting rules have some gray areas, and those committing fraud exploit those gray areas. The perpetrators force an accounting treatment that is beneficial to the fraud scheme, rather than determine the fair and correct way to treat a transaction.
- Misrepresentation or Omission of Information – Management may fail to provide certain information to the users of financial statements, deliberately misleading them about the company’s operations. Without all the information, it is impossible to fully understand a company’s financial position.
It’s critical to understand these financial statement manipulations, so that owners, executives, and the users of financial statements information can avoid falling victim to these schemes.