A Business’ Greatest Fear – Financial Statement Fraud

Fatihah Ramzi, DigitalCFO Asia | 28 October 2022

Although there are laws and policies in place, it also helps if businesses are aware of how to spot and stop financial statement fraud.

White-collar crimes like financial statement fraud are typically committed by managerial insiders to give a company’s finances a better impression. Fraudsters are driven by personal benefit, such as performance-based pay, the desire to improve the reputation of the company by deceiving potential investors, or the desire to purchase time until financial errors and losses can be adequately rectified.

Fraud on financial statements is an offense of opportunity. Businesses that lack adequate internal controls, use manual accounting procedures, or have dishonest and aggressive executives are more vulnerable. Preventing financial statement fraud from ever occurring is the key to countering it. If it cannot be stopped, it is crucial to locate it as soon as possible.

Financial statement fraud raises concerns with both present and potential shareholders and investors, regardless of the motivation. Large-scale reputational harm, severe regulatory penalties, and even arrests are all possible outcomes.

Some Types of Financial Statement Fraud

There are many different types of business fraud, such as bribery, kickbacks, and payroll fraud. When it comes to financial statement fraud, the majority of charges include willfully distorting accounting to make a company appear more successful through share prices, financial information, or other valuation techniques. Criminals falsify revenue, expenses, liabilities, and assets to present the business in a more favorable way. Here are a few typical methods:

  1. Inadequate or inappropriate disclosures. In order to avoid deceiving the viewer, financial statements must contain information that is both true and transparent. If accounting changes have an effect that materially affect the financial statements, they must be declared. Items including major events, related-party transactions, contingent liabilities, and accounting adjustments are hidden or left out of the financial statements when this kind of fraud is undertaken.
  2. Fabricating expenses.  When a business fails to accurately record all of its expenses, it commits another type of financial statement fraud. The company’s net income is overstated and costs are downplayed, which gives the impression that the company is making more money than it actually is.
  3. Misappropriations. Changing the financial statement to conceal theft or embezzlement by double-entry bookkeeping or the inclusion of fictitious expenses is a significant form of financial statement fraud. Unlike fraud meant to artificially exaggerate the company’s value to investors and the business world, this type of fraud is typically committed by an individual intending to profit themselves.

Warning Signs

1. Business

Business red flags. Potential fraud may be indicated by external circumstances including general industry downturns and extreme departures from peer business norms. An astute auditor will detect organizational behavior and business outcomes that don’t seem to follow the general trends in that sector, such as:

  • Operating margins that are not competitive with rivals in terms of profitability.
  • Large Investments made in volatile industries or during downturns in certain industries.
  • Periods of very high revenue and low expenses that are not seasonal.
  • Operating performance that is very susceptible to economic variables such as unemployment, interest rates, and inflation.

2. Behavioural

At least one behavioral red flag will be shown by fraudsters when they commit their offenses. These behavioral warning signs will manifest in the fraudster’s professional and private lives:

  • A manager or accountant who is struggling financially and/or living over their means.
  • Management behaviors that are dishonest, confrontational, aggressive, and unreasonable.
  • Control concerns, such as a reluctance to delegate responsibility for managing the company’s finances.
  • The management shows excessive concern for maintaining the company’s reputation.

Financial Statement Fraud Detection

The management of the company has the major duty of uncovering financial statement fraud. The best chance of preventing fraud is to have a strong team, including an executive board that will determine the company’s ethical standards and an audit committee made up of internal and external auditors. According to the standards on auditing, auditors are required to get an adequate confidence that financial statements are free from misstatement as a result of either fraud or error. Using the many tools and procedures at their disposal, the auditors’ duties include properly identifying, evaluating, and reacting to fraud risks.

Auditors seek for uneasy connections between financial data that call for further study. Analyzing the connections between the figures in financial accounts provides thorough insight into the financial health of an organization. Identifying the connections between specific financial statement balances is the basis of financial analysis since it enables auditors to spot discrepancies in the numbers.

For instance, a healthy business aims to consistently balance its assets and liabilities. A deviation from past patterns that is unexpected could be a sign that the company is trying to cover up something. A rise in the ratio can indicate hidden liabilities, while a decline might indicate that the business is using a lot of debt to fund operations.

Sales versus cost of goods or services sold is another important ratio to keep in mind (COGS). These figures typically fluctuate concurrently; the more things sold, the more resources and costs needed to generate them. Sales versus accounts receivable also have a direct proportional relationship. Accounts receivable should rise in tandem with sales. Further research is required when one of these numbers deviates from their proportionate connection.

These kinds of analyses, known as comparative ratio analyses, aid auditors in identifying abnormalities in the financial reporting by examining the relationship between two separate financial statement amounts. Figures from the present year are used to establish ratios, which are then contrasted to figures from earlier years, firms, industries, or economies. For the purpose of identifying suspected fraud, a more thorough investigation is needed when there are considerable differences between years or between businesses.

Percentage analysis, both vertically and horizontally, is another method fraud investigators employ to analyze a company’s standing. Vertical analysis looks at the connections between items on any financial statement throughout the course of a single reporting period. The percentages used to indicate the relationships between the components allow for comparison across time. 

The percentage change in each financial statement item from year to year is examined via horizontal analysis. Following changes are computed as percentages of the base period, with the first year serving as the base. Utilizing comparative analysis methods improves the likelihood of spotting fraud by assisting investigators in spotting financial irregularities.

Laws have been established by the authorities to ensure that businesses disclose their financial information honestly while safeguarding the interests of investors. Although there are safeguards in place, it also helps if businesses are aware of how to spot and stop financial statement fraud. By recognizing the warning signs, people can avoid being taken advantage of by dishonest actors trying to conceal losses, launder money, or otherwise deceive gullible investors.