Financial Statement Fraud and How to Spot It
Fraud is something that happens all too often in the business world, especially fraudulent financial statements. In fact, fraudulent financial statements account for approximately 10% of white-collar crime incidents. While there are other white-collar crimes that happen more frequently, the financial impact they make is usually less severe than financial statement fraud.
Enron is one of the most well-known examples of a company that committed accounting fraud, which included financial statement fraud among many other transgressions. It used various methods to improve the appearance of its financial statements, including off-the-books accounting practices and special purpose vehicles (SPVs) to hide its debt and liabilities.
Surprisingly, the company was able to hide its losses for about a year, but in 2001 the jig was up. Wall Street journalists uncovered Enron’s shady accounting practices and the company declared bankruptcy by the end of the year. Enron was a scandal that rocked the world, and even non-Wall Street types felt the crash.
Types of Financial Statement Fraud
Enron was a huge company that committed fraud, but unfortunately, fraud happens at all levels. SMBs and large corporations alike can turn to fraudulent financial statements to help get them out of an uncomfortable bind.
There are five main types of financial statement fraud:
- Including fake sales or recording future expected sales as having happened
- Not recognizing, or understating, expenses
- Incorrect valuation of assets, which includes inflating the net worth of assets
- Hiding liabilities in the balance sheet
- Including unsuitable disclosures like related-party transactions and structured finance deals
Detecting Signs of Fraud
If you’re concerned that fraud may be taking place in your company, here are 5 signs to look out for:
- Year-end surge. When a company shows a significant surge in the last quarter of the fiscal year, take a closer look. Sometimes companies feel pressured to meet expectations and resort to fudging the numbers.
- Auditor replacement. Sometimes auditors need to be replaced, which is normal and doesn’t signify anything underhanded. However, if an accounting period is missed because of auditor replacement, it can provide a window for those who want to play with the company’s reports to do so. Keep an eye out.
- Accounting anomalies. If revenue grows without corresponding cash flow growth, something may be fishy. Usually, sales and cash flow operate as a unit.
- Growth while competitors struggle. If competitors in the industry are all struggling and your company is reporting consistent growth, this could be a sign that something is off. Unless your company is unquestionably superior to all its competitors, there needs to be a reason why it’s succeeding when others are not.
- Third-party transactions. Companies that sometimes seek to commit fraud often add many related-party and third-party transactions to their reporting in order to conceal debt from the balance sheet. If you spot a rise in these types of transactions, it may be cause to dig deeper.
The Next Steps
If the worst-case scenario plays out and you discover fraud within your company, there are a few basic things you can do.
- Gather evidence. Whether you take screenshots or photocopy documents, make sure that you save the evidence. If the people committing fraud discover that someone is on their trail, they will try to cover their footprints.
- Keep it confidential. Don’t start telling colleagues and friends what you suspect. While you may have discovered fraud, you may not know whether one person is behind it or more. You also may not know the extent of it or how serious it is. Instead of sounding a loud alarm, quietly seek out the person responsible for handling fraud in your company. In many cases, there is a designated fraud incident manager. Tell them, but no one else, since evidence may start disappearing if word gets out.
- Handle the situation. If you are the designated fraud manager, it’s up to you to delicately dig and see what exactly is going on. You’ll need to consider a civil and criminal response. In some cases, the guilty party can be fired, and you can clean up the mess relatively easily; in other cases, the perpetrator may need to be reported to the appropriate authorities and your company may end up paying a hefty price.
There is never a pleasant way to handle fraud, but there is an efficient way and an inefficient way. If you suspect fraud in your company, it’s important to know how to spot it and then deal with it. The future of your company is at stake.