Introduction

 Financial statement fraud is the deliberate misrepresentation of

a company’s financial statements, whether through omission or
exaggeration, to create a more positive impression of the company’s
financial position, performance and cash flow.

 Usually committed by senior management, this crime is typically a

means to an end.

 The motives for perpetrating financial statement fraud include

personal gain, keeping the business afloat, and retaining status as a
leader in the organization.
 Introduction
 Fraudsters attempt to inflate the perceived worth of the company to
make the stock appear more attractive to investors, to obtain bank
approvals for loans and/or to justify large salaries and bonuses when
compensation is tied to company performance.

 Regardless of the motive, financial statement fraud causes problems

with current and potential investors and shareholders.

 It can result in large-scale reputational damage as well as serious

sanctions from regulators 
 Introduction
 According to the ACFE, financial statement fraud is the least common
type of fraud in the corporate world, accounting for only 10% of
detected cases.

 But when it does occur, it is the most costly type of crime, resulting in
a median loss of $954,000.

 Compare this to the most common and least costly type of fraud asset
misappropriation, which accounts for 85% of cases and a median loss
of only $100,000.

 Nearly one-third of all fraud cases were the result of insufficient

internal controls.
 Reason for Financial Statement Fraud
 The main and primary reason for committing Financial Statement
Fraud is make the position of the Entity look better on paper.

 To increase their Market Capitalisation of the listed stock.

 To show inflated Sales resulting into more earnings so that more

dividend can be distributed by the company.

 To avoid wrong perception of the market.

 Major reason is to get Finance for the entity and if it is already

financed to get better terms of finance.
 How Financial Statement Fraud Committed
 Overstatement of Assets to reflect a stronger company

 Overstatement of Revenue to show fictitious growth in the company

 Understatement of Expenses to inflate the profit of the company

 Understatement of Liabilities to show a better picture of the company

 Types of Financial Statement Fraud
 Overstating Revenue

 A company can commit fraud by claiming money as received before

the goods or services have been delivered.

 This can be done by prematurely recording future expected sales or

uncertain sales.

 If the company overstates its revenue, it creates a false picture of

fiscal health that may inflate its share price.
 Types of Financial Statement Fraud
 Fictitious Revenue and Sales

 Fictitious revenue involves claiming the sale of goods or services that

did not occur, such as double-counting sales, creating phantom
customers or overstating or otherwise altering the legitimate invoices
of existing customers.

 Perpetrators of this kind of fraud may reverse the false sales at the
end of the reporting period to help conceal the deceit.

 To meet impossible sales goals, employees created millions of

checking and savings accounts on behalf of clients but without their
consent.
 Types of Financial Statement Fraud
 Timing Differences

 This one involves understating revenue in one accounting period by

creating a reserve that can be claimed in future, less robust periods.

 Other forms of this type of fraud are posting sales before they are
made or prior to payment, reinvoicing past due accounts and
prebilling for future sales.
 Types of Financial Statement Fraud
 Inflating an Asset’s Net Worth

 This form of fraud occurs when a company overstates assets by failing

to apply an appropriate depreciation schedule or valuation reserve,
like inventory reserves.

 It will result in overstated net income and retained earnings, which

inflates shareholders’ equity.
 Types of Financial Statement Fraud
 Concealment of Liabilities or Obligations

 Concealment is a type of fraud where liabilities or obligations are kept

off the financial statements to inflate equity, assets and/or net
earnings.

 Examples of concealed liabilities can include loans, warranties

attached to sales and underreported health benefits, salaries and
vacation time.

 The easiest way to conceal liabilities is to simply fail to record them.

 Types of Financial Statement Fraud
 Improper or Inadequate Disclosures

 The information disclosed in financial statements must be accurate

and clear so as not to mislead the reader.

 Accounting changes must be disclosed if they have a material impact

on the financial statements.

 When this type of fraud is committed, items such as significant

events, related-party transactions, contingent liabilities and
accounting changes are obscured or omitted from the financial
statements.
 Types of Financial Statement Fraud
 Falsifying Expenses

 Another form of financial statement fraud occurs when a company

does not fully record its expenses.

 The company’s net income is exaggerated and costs are understated,

creating a false impression of the amount of net income the company
is earning.
 Types of Financial Statement Fraud
 Misappropriations

 A serious form of financial statement fraud is altering the statement

to mask theft or embezzlement through double-entry bookkeeping or
the inclusion of fake expenses.

 This form of fraud is usually perpetrated by an individual looking to

enrich themselves, as opposed to forms of fraud that are intended to
inflate the valuation of the company to investors and the business
community.
 Warning Signs
 Financial Warning Signs

 Rising revenue without corresponding growth in cash flow this is the

most common warning sign of financial statement fraud.

 Consistent sales growth while competitors are struggling.

 A spike in performance in the final reporting quarter of the year.

 A significant, unexplained change in assets or liabilities.

 Unusual increases in the book value of assets, such as inventory and

receivables.
 Warning Signs
 Financial Warning Signs

 Frequent, complex third-party transactions that have no logical

business purpose, don’t appear to add value and make it hard to
determine the actual nature of a particular transaction.

 Missing or altered documents.

 Discrepancies and unexplained items and/or transactions on

accounting reconciliations, such as invoices that go unrecorded in the
company’s financial books.
 Warning Signs
 Financial Warning Signs

 Aggressive revenue recognition practices, such as recognizing

revenue in earlier periods than when the product was sold or the
service was delivered.

 Growth in sales without commensurate growth in inventory or vice

versa.

 Improper capitalization of expenses in excess of industry norms.

 Warning Signs
 Behavioral Warning Signs

 A manager or accountant living beyond their means and/or having

financial difficulties.

 Dishonest, hostile, aggressive and unreasonable management

attitudes.

 Control issues, such as an unwillingness to share duties pertaining to

company finances.

 Management displays inordinate concern with managing the

reputation of the business.
 Warning Signs
 Behavioral Warning Signs

 Loans to executives or other related parties that are written off.

 Inexperienced or lax management and/or accountants.

 Sudden replacement of an auditor resulting in missing paperwork.

 Refusal to take time off for fear that their “pinch-hitter” will uncover
the scam.
 Warning Signs
 Organizational Warning Signs

 Frequent organizational changes, such as unusually high turnover in

management or key accounting personnel.

 Unexplained or disproportionate management bonuses based on

short-term targets.

 Operating and financial decisions dominated by a single person or a

few people acting in concert.

 A board of directors full of insiders.

 Warning Signs
 Organizational Warning Signs

 Undue emphasis on meeting quantitative targets.

 Sloppy or manual management/operational business processes, as

opposed to automated processes embodied in business software.
 Warning Signs
 Business Warning Signs

 Profitability and/or operating margins that are out of line with peers.

 Significant investments in volatile industries or during industry

turndowns.

 Unusually high revenue and low expenses at times that can’t be

explained by seasonality.

 Operating results that are highly sensitive to economic factors, like

inflation, interest rates and unemployment.