Detecting Financial Statement Fraud: Part 1

Of the three types of occupational fraud – corruption, asset misappropriation, and fraudulent financial statements – financial statement manipulation has the potential to cause the greatest impact. Just as there are many motives to commit an intentional misstatement or omission of amounts on the face of the financial statements or in the note disclosures, there are also many items forensic accountants, and users of the financial statements, can look for to ensure that they are fairly presented. In this two-part post, I will review the basics of financial statement manipulation, motivations to commit this type of fraud, and how forensic accountants ensure that financial statements are fairly represented.

Motivations for Financial Statement Manipulations

It is first important to understand some common motivations behind the deliberate misrepresentation of the financial condition or results of operations of an entity. There are situational pressures, such as bonuses that are based on the economic performance of an organization; management may manipulate the financial statements in a way that generates the largest bonus. There may also be pressure to generate a certain financial outcome as required to obtain financing by either overstating the assets or understating the liabilities to appear more liquid.

Are the Statements Accurate?

The first item to verify with financial statements is that assets equal liabilities, plus equity. Of course, to find misrepresentation of statements you have to dig deeper. Below are several ways financial statements can be manipulated and simple ways to detect these misrepresentations:

  • Timing Differences: Revenues and expenses are both subject to timing differences. Misrepresentations occur when revenues are not being recorded in the period in which they were earned and expenses are not being recorded in the period to which they relate, or when the expense was incurred. Complex transactions are always a red flag, and should be looked at in detail. Ratios that are helpful in identifying timing differences are number of days’ sales in receivables (average AR/sales *365), and number of days’ purchases in accounts payable (average AP/cost of goods sold *365).
  • Fictitious Revenues: Reported Revenue can include non-existent sales to non-existent customers or legitimate customers, or the recording of the full amount of conditional sales as revenue for the current period. In an effort to identify fictitious revenues, auditors keep an eye on cash flows (negative cash flows in the same period that there is an increase in net income), expansive growth, and a large amount of sales to a new customer. Ratios that might be helpful to compare year to year are number of days’ sales in receivables (average AR/sales *365) and accounts receivable turnover (total net sales/average AR), which shows the number of times accounts receivable are paid and reestablished during the year.

These are just a few of the ways financial statement fraud is committed. The next post will detail additional misrepresentations including Concealed Liabilities and Expenses, Improper Disclosures, and Improper Asset Valuations, as well as how these manipulations are detected by forensic auditors.

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