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January 2015

Growing concerns with financial statement

By Yogen Vaidya Chartered Accountant
Reading Time 6 mins
The past few decades have seen frauds related to financial statements increase dramatically, both in terms of numbers and the size of the losses. This has resulted in turmoil in the capital markets, loss in shareholder value, and in some cases, companies filing for bankruptcy. Fraudulent financial statements affect shareholders, lenders, creditors, and employees. Although the regulators (under the Sarbanes-Oxley Act, 2002 and new Companies Act, 2013) have done significantly to improve corporate governance standards in an effort to deter fraud; financial statement fraud continues to remain a serious concern for investors and other capital markets stakeholders.

According to the ACFE’s “Report to the Nations on Occupational Fraud and Abuse, 2014”, it is estimated that only 9 % of cases involved financial statement fraud, but those cases had the highest financial impact, representing a median loss of $ 1 million.

What is financial statement fraud?
Financial statement fraud is deliberate misrepresentation, misstatement or omission of financial statement data for the purpose of misleading the reviewer and creating a false impression of an organisation’s financial strength.

The key causes of this increasing problem could be executive incentives such as stock option benefits, bonuses or justification for increased salaries; stock market expectations which provided rewards for shortterm behaviour; greed by investment banks, commercial banks and investors etc.

Such frauds can take different forms, but there are several methods commonly used by perpetrators. These include creating fictitious revenues, timing differences, concealed liabilities or expenses, improper disclosure, related party transactions, and improper asset valuations. From an accounting perspective, revenues, profits, or assets are typically overstated, while losses, expenses, or liabilities are understated in the books of accounts.

Some common approaches to project a false but improved appearance of financials include:

Overstatement or falsification of revenues is the most common fraud, wherein the perpetrator 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 or liabilities by shrinking the company’s debt on paper. This makes the company appear more profitable, while the fraudster records expenses as assets or even 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 company assets to deceive investors or to siphon funds for personal gains. It can involve improperly valuing inventory, investments, fixed assets or accounts receivable. It may also involve creating fictitious receivables, not writing down obsolete inventory on the company’s balance sheet, manipulating the estimates of an asset’s useful life and overstating the residual value.

Related party transactions; fraudulent transactions with the parent company and its subsidiaries and the ability to influence the policies of the other parties.

Warning bells
Red flags around financial statements are indicators of a possible fraud scenario and these warning signs should be addressed immediately. While they may not ascertain the actual occurrence of a fraud, they show that the company may be prone to fraudulent activities. Red flags are never sure signs but indicate that the organisation should ask for reasonable answers.

Warning signs related to financial statement fraud can be categorised into four broad categories:

(i) Tone at the top: aggressive style of management and over ambitious targets by the top management may lead to fraudulent activities at various levels. Concentration of powers in the hands of one or two individuals or an autocratic style of leadership also may lead to fraudulent activities.
(ii) Processes drawback: Lack of supervision and monitoring, lack of segregation of duties and excessive use of journal entries may motivate fraudsters as it opens up multiple avenues to manipulate the books of accounts.
(iii) Systems limitations: lack of system controls, manual (legacy) and disintegrated systems are easy to penetrate and could be manipulated by fraudsters.
(iv) Attitude of employees: Employees with mediocre calibre, ignorant mind-set, little responsibility and no willingness to question the management can create problems in preparing the financial statements.

There are certain indicators that organisations can analyse to proactively identify fraud risks.

• A spike in the revenue during the month/ quarter/ year closing without any collections.
 • Sales made to fake agents or customers or to small proprietary or partnership firms.
• Increase in debts being substantially higher than revenue growth.

• Preference given to a single vendor after receiving quotations from other vendors or contract given to vendors that are relatively unknown in the industry or are fictitious. In case of machinery, purchasing it from agents rather than other OEMs.
• Significant variation in the volume/ value of provision for expenses.
• Large unexplained JV or partnership.
• Consistent advances paid to certain parties whereas some creditors payments are delayed.

Cash and bank balances
• High cash withdrawals or deposits without necessary approvals.
• Large payments issued to certain contractors or vendors.
• Absence of physical bank statements.
• Transfer of large round amounts within different bank accounts.

Accounting records
• Large number of journal entries passed in books of accounts.
• Low end accounting software without audit trail mechanism.
• Large number of backdated entries.

If enough warning signs are in place, the next step will be to perform procedures that will help assess the actual occurrence of fraud. Exposing a fraudulent financial statement can be challenging–irrespective of the company size. Maryam Hussain, an investigator at EY, in her book titled “Corporate Fraud: the Human Factor”, states that every instance of fraud and corruption leaves a trail which is visible but often unseen until it is too late. Perpetrators typically take special care to conceal their wrongdoings in an elaborate fashion.

Sometimes the fraud is buried in a series of complex transactions; other times it can be found in a single transaction recorded in the accounting records. Detection can be accomplished with appropriate forensic procedures that include analysis of financial records, public documents, background checks, interviews with suspects and laboratory analysis of physical and electronic evidence.

Although listed above are common schemes used to commit financial statement fraud, it is imperative to be aware that it is not an exhaustive list. There are many ways to commit fraudulent or unethical activities. No matter what method is used, the fraudster typically tends to either overstate revenues, profits, or assets or understate losses, expenses, or liabilities.

Financial statement fraud is expensive, seemingly common in and typically involves one or more senior executives in the company. To conclude, the impact of such a fraud can be devastating to the organisation’s reputation among stakeholders and business ecosystem as a whole.

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