Detecting Financial Statement Fraud by Richard Pollack
Posted on December 21, 2012 by Richard Pollack
Exposing Financial Statement Fraud
By Richard A. Pollack
The collapse of Enron, WorldCom and Tyco represent some of the largest and most widely recognized cases of corporate fraud. A decade later, despite a series of regulations intended to improve corporate reporting and prevent similar scandals, perpetration of deceptive accounting practices still occur.
Corporate fraud can take many forms. The most costly and damaging is financial statement fraud, which involves the deliberate manipulation of facts with the intent of exaggerating earnings and distorting a business’s true financial picture. Whether committed due to economic pressure, an opportunity to get around the system or a rationalization that it is in the best interest of the company and its stakeholders, the fraud can cause significant losses and have far-reaching effects. Not only can financial statement fraud bring down the business, it can also hurt the organization’s employees, clients, investors and third parties.
Because financial statement fraud often involves collusion among various parties within an organization, exposing it can be difficult, but not impossible. Gaining an understanding of some of the most common schemes and conducting a forensic examination of financial records can aid in detection.
Overstatement or falsification of revenue is the most common form of financial statement fraud. It can occur when a fraudster creates fictitious revenue or customers, records future sales in the current period, reports increased revenue without equally rising cash flow or records sales that never occurred.
Understatement of expenses and liabilities reduces a company’s debt on paper, thereby making the company look financially stronger. It can occur when a fraudster records expenses as assets or fails to record them at all. Additional ways to manipulate financial statements include leaving special purpose entities or subsidiaries off a parent company’s books or failing to report certain obligations as liabilities.
Improper asset valuation exaggerates a company’s assets and portrays the assets in a more positive financial light. It can involve improperly valuing inventory, investments (such as securities or other investments without a ready market for sale, for example thinly traded stock), fixed assets or accounts receivable. It may also involve creating fictitious receivables, not writing down obsolete inventory on a company’s balance sheet, manipulating the estimates of an asset’s useful life and overstating the residual value.
Related party transactions may create conflicts of interests. Therefore, it is critical to carefully analyze these transactions and identify them when investigating financial statement fraud.
Exposing financial statement fraud can be challenging whether it is committed on behalf of a large, multi-national company or a small business. Perpetrators typically take special care to conceal their actions in an elaborate paper trail with falsified records that can go undetected for years. Sometimes the fraud is buried in a series of complex transactions; other times it can be found in a single transaction fraudulently recorded in the accounting records. Detection can be accomplished with appropriate forensic procedures that include analysis of multiple years of financial records, analysis of public documents, background investigations, interviews of knowledgeable persons, and laboratory analysis of physical and electronic evidence. The forensic specialist can play an important role in assisting attorneys, regulators and others in detecting financial statement fraud.
About the Author:
Richard A Pollack is director-in-charge of Berkowitz Pollack Brant’s Forensic and Business Valuation Practice. He holds numerous business valuation and forensic credentials and has testified as an expert witness in federal and state courts.
Pollack and his team assist attorneys; bankruptcy courts; the SEC, FBI and other government agencies; and court-appointed receivers in various phases of litigation and discovery. For more information, call (305) 960-1214.