Financial statement fraud is among the most common types of fraud. It involves intentionally reporting false information in a company’s financial statements. Also called “cooking the books”, financial statement fraud is also one of the most costly types of fraud. According to a study done by the Association of Certified Fraud Examiners, financial statement fraud causes a median loss of $2 million per fraud scheme.
A commonly used term for financial statement fraud is “earnings management”. This term almost sounds like a legitimate practice, but it is anything but that. The U.S. Securities and Exchange Commission (SEC) has defined earnings management as “the use of various forms of gimmickry to distort a company’s true financial performance in order to achieve a desired result.” Not all earnings management practices are in violation of generally accepted accounting principles (GAAP). Some practices considered as earnings management bend the rules of GAAP in order to achieve certain financial goals, but are not in violation of them.
Financial statement fraud is almost always perpetrated by the upper management of a company. They have access to nearly all information in a company and they have tremendous influence over the employees under them, which can make it possible for them to conceal the fraud. Financial statement fraud is different from most other types of occupational fraud in a major way: the goal is not usually to directly enrich the fraudster, but is usually intended to mislead third parties (investors and creditors) about the profitability of the company.
The most common financial statement fraud scheme is improper revenue recognition. This can take place in two different ways: premature recognition of legitimate revenues or the recognition of fictitious revenue from fictitious sales or fictitious customers. Other common methods include the overstating of assets, the understating of liabilities and expenses, reporting revenues or expenses in the wrong period, and inadequate disclosures.
THE XEROX SCANDAL
A well-known case of premature revenue recognition is the Xerox scandal of 2002. On April 12th, 2002, the Securities and Exchange Commission (SEC) filed a civil fraud complaint against Xerox Corporation for alleging that they intentionally deceived the public, from 1997 to 2000, by prematurely recognizing revenues from copier machine leases on the signing date rather than over the life of the lease, as payment would become due. The issue was not with the validity of the revenues, but with their recognition. These fraudulent actions were intended to help the company meet its Wall Street expectations and to give the appearance of a healthy financial position. They did just that.
Over the four year period, these actions, most of which were in strict violation of generally accepted accounting principles (GAAP), prematurely increased revenues by $3 billion and pre-tax income by $1.4 billion. This was a bold move by the management of Xerox because by recognizing future revenues in the current period, it made it increasingly harder to meet earnings expectations in the future periods. In 2005, Xerox paid a settlement the Securities and Exchange Commission (SEC) and began efforts to regain the trust of its investors.
PREVENTING THE FRAUD
Management and the board of directors are responsible to take the necessary steps to deter fraud in financial reporting:
Setting a “tone at the top” that communicates their expectations for accurate reporting
Responding quickly, equitably, and proportionately to policy violations
Maintaining internal and external auditing processes independent of management’s influence
Ensuring a proper flow of critical information to the board and external parties
Establishing an adequate system of internal control
Investigating and remediating problems when they arise
To understand why a fraudster does what he does and to better deter future fraud attempts, an auditor must assess three variables that are present in virtually every fraud. These three concepts, collectively, make up the fraud triangle. These factors include:
Perceived incentive or pressure
In the case of the Xerox fraud, management probably felt pressure to accelerate revenue from future periods to the current period in order to meet Wall Street expectations in order to protect the financial position of the company. Pressures also may have stemmed from desires for personal benefit in the form of performance-based incentives such as bonuses or stock options. An opportunity must exist to commit fraud, and the fraudster must believe he can get away with it. Lastly, it is probably reasonable to assume that Xerox’s management did not expect to continue the fraudulent actions forever. It was probably considered a temporary fix, as both the risk of getting caught and the risk of maintaining the heightened revenues in future periods were both high. This rationalization is the final component of the fraud triangle.
DETECTING THE FRAUD
Perhaps the first challenge for the auditor in detecting the fraud is to recognize early any signs that material misstatement has occurred. Following is a list of steps, from SAS 99, designed to assist the auditor in identifying, evaluating, and responding to the risk of fraud:
Holding discussions among the audit team concerning fraud risk
Obtaining information relevant to the identification of fraud risk
Identifying the risk of material misstatement due to fraud
Assessing the identified risks, taking into account the internal controls designed to address those risks
Responding to the results of the assessment
Evaluating audit evidence
The Xerox fraud was executed in collusion with auditors, but certain analytical techniques, performed by the auditor, exist to help prevent financial statement fraud schemes like the known one from happening in the future. These include:
Horizontal analysis–comparison of the current period’s balances with those of prior periods.
Vertical, or common-size, analysis–comparison of each line item of the financial statements to
another line item, such as a percentage-of-sales comparison.
Comparison of the detail of a total balance with similar detail for the preceding years
Ratios and other financial relationships
In a fraud like the one with Xerox, where the timing of revenue recognition is manipulated, potential causes could be: pressure to meet revenue targets as the period comes to a close, a known or expected shortfall of sales transactions for the period, a known potential existence of sales that are expected but not achieved, and the opportunity to alter the dating of post period transactions in order to make them appear to have happened in the prior period.
Red flags that indicate this kind of fraud include:
Falsification or alteration of documents
Backdating or alteration of the dates of invoices
Alteration or falsification of other dating evidence that might reveal the true dates of the arrangement of delivery of the products or services rendered
Some unavoidable results of financial statement frauds like Xerox’s–including the premature recognition of revenues create a revenue deficit for the future periods. This problem causes a need to:
Make up the shortfall caused by “lending” revenues to the prior period
Cover the effects of any real decline in sales
Achieve the expected level of sales growth
When revenues are prematurely recognized and sales are declining, each period may require more and more fraudulent premature revenue recognition in order to keep up the appearance of good financial position.
INVESTIGATING THE FRAUD
To perform an investigation of the suspected fraud, the investigator must gather all of the necessary documents. These may include auditors’ working papers, internal audit reports, organizational charts, alleged smoking gun documents, electronic files, personnel listings, financial statements, public filings, e-mails, and internet postings.
Interviewing the suspect is necessary to obtain admission to the fraud. A few things to consider about the interview are the time, location, who should be present, and what type of interview should be performed. An information seeking interview is conducted to obtain information about the suspected crime. Interviewing starts with the periphery of interviewing candidates and continues moving inward until the subject is interviewed. Not all people interviewed for this type of interview are suspects. An admission-seeking interview differs by its intent and the people it interviews. The intent is to eventually get the suspect to admit to the alleged crime. Only suspects of the fraud are interviewed.
Often in an investigation, the forensic accounting investigator will provide a written report of investigation. Until sure whether or not a report will be requested, an investigator should always retain evidence and analyses necessary for the report.
1.Golden, Thomas W., Stephen L. Skalak, and Mona M. Clayton. A Guide to Forensic Accounting Investigation. Hoboken: John Wiley and Sons, Inc., 2006.
2.Financial Statement Fraud and Deterrence. 4/29/09. http://www.acfe.com/resources/fraud-101-accounting.asp.
3.The Wide-Reaching Impact of Financial Statement Fraud. 4/29/09. http://www.sequence-inc.com/index.php?option=com_content&view=article&id=41.
4.Common Financial Statement Frauds. 4/29/09. http://www.worrells.net.au/Fraud%20Awareness/tpf_financial_statement.htm.
5.Xerox Scandal. 4/29/09. http://www.corporatenarc.com/xeroxscandal.php.