Could your company stand a fraud loss of $150,000 or even $1,000,000? According to the Association of Certified Fraud Examiners (ACFE) these are the median losses suffered by small and large businesses from financial statement fraud. The ACFE classifies fraud into three major types: Asset Misappropriation, Corruption and Financial Statement Fraud. In their 2016 Report to the Nations ACFE identifies financial statement fraud as the least frequent, occurring in less than 10% of reported fraud cases. Even though financial statement fraud is relatively rare it results in the greatest losses of around $1,000,000 each. Even in small businesses the median loss from financial statement fraud is $150,000.
No fraud scheme is easy to uncover but financial statement fraud is unusually difficult because it relies on the detailed analysis of financial statements. While CPA audited statements are the most reliable documents even those cannot prove that fraud is not occurring. In many companies financial statements may not be audited and may only be prepared by the company itself. In the following sections I will discuss some of the difficulties in looking for financial statement fraud and identify general tips to keep in mind while searching for this elusive activity.
To begin the search for fraud several years of financial statements should be obtained. At a minimum the balance sheet, income statement and statement of cash flows are necessary. The statement of cash flows ties the balance sheet and income statement together as shown in the diagram below. Without it the job of finding fraudulent activity becomes much more difficult.
The person behind a financial statement fraud is usually someone with access to the company’s accounting system allowing that person to create or approve transactions. In companies with poor internal controls one person may be able to both create and approve entries. The fraud requires a combination of creating fraudulent transactions in the accounting system and altering or creating fake business documents to back up the transactions.
It is rare for one person in a company to know how to manipulate the accounting system, create fraudulent documents and have access without oversight so frequently these frauds are carried out by several persons working in collusion. On occasion a “trusted” senior executive may be behind the fraud.
Discovery of financial statement fraud by external auditors is uncommon according to ACFE’s Report to the Nations. Most often these fraud schemes are discovered when a tip is received from an employee. This emphasizes the need for a whistleblower and hotline program within a company to complement the internal or external audit functions.
Before beginning an analysis of financial statements some common sense tests can be performed. First, a company with significantly higher sales and/or profitability than other companies in the same type of business might point to possible fraud. This is especially so when the outsized growth has occurred over several years. It is even more likely when the fast growing company has no unique product or service that is being offered.
A company that exhibits both high sales growth with high profitability over time is very rare. Remember, high sales growth is often caused by lower pricing which typically results in lower profitability. A good example is Amazon.com which is using a low pricing strategy to take market share from other companies at the cost of its profitability. Conversely, higher profitability is frequently the result of higher pricing but high prices tend to decrease sales.
The second common sense test is whether the company with strong growing profitability is exhibiting positive cash flow from operations. Highly profitable companies will normally have strong operating cash flow. If the “Cash Provided by Operating Activities” section of the Statement of Cash Flows does not exhibit positive cash flow then another caution signal may be flashing.
There are few free sources of industry sales and profitability information but yahoo.finance.com and google.com/finance have some data. Others to look at are bizstats.com and valuationresources.com. Your commercial and wholesale contacts at local banks and local CPAs may be able to help as well.
Common methods of executing financial statement fraud are creating fictitious revenues, concealing expenses and liabilities, improper asset valuation and timing differences. Some involve recording sales that did not occur. To conceal the fact that cash for these sales has not been received the fictitious payment is often recorded as an Account Receivable (A/R). Over time, as fictitious revenues are created the size of the A/R category grows. In the exhibit below note how the Days of sales tied up in A/R shows steady growth. The fraudster is using uncollected A/R to hide the fact that some of the sales growth the company is experiencing is fictitious.
The complete analysis of financial statements and supporting documents is beyond the scope of this article and an actual analysis of suspected fraud will require the support of trained and experienced forensic accountants. However, the use of the common sense tests can help identify company financial statements that may be suspicious and warrant additional scrutiny.”
The ACFE uses the three factor model of fraud: Pressure, Opportunity and Rationalization. Of these three most companies can only prevent the opportunity for someone to commit fraud. Strong internal controls are the best preventative measure against financial statement fraud.