Financial Statement Fraud

Financial Statement Fraud & How to Detect It

This guide explains financial statement fraud, the red flags to look for, and how to detect fraud before any damage is done.

It was almost inevitable that the global COVID-19 health crisis would increase fraud. 

A benchmarking report by the Association of Certified Fraud Examiners (ACFE) shows that 51% of organizations have uncovered more fraud since the onset of the pandemic. With changing consumer behaviors and shifts in business operations, it's likely to continue.

Identity theft alone spiked massively, with the Federal Trade Commission (FTC) receiving over 400,000 reports from individual victims. 

But that’s not all. ACFE found all other types of fraud increased since the pandemic hit. That includes financial statement fraud—the least frequently encountered yet most costly—which results in a median loss of $1 million per case and other unquantifiable losses.

This guide explains financial statement fraud, the red flags to look for, and how to prevent it before the damage is done.

What is financial statement fraud?

A finance professional reviews documents to detect any potential financial statement fraud.

Financial statement fraud is a deliberate scheme orchestrated by internal (employees or management) or external parties (vendors, customers, or other third parties) to create a more favorable impression of a company’s profitability and performance.

Such misrepresentation can happen through unethical and illegal omission or exaggeration of figures in a company’s financial statement to:

  • Keep the business afloat
  • Increase the value of the company’s stock
  • Comply with financial analysis projections
  • Maintain a leadership position within the organization
  • Justify large salary increments or bonuses (often tied to company performance)
  • Obtain approvals from lenders for loans or other credit lines

While financial statement fraud is the least frequent, the stakes are much higher.

Investors and creditors suffer untold losses, while employees may lose their jobs, morale, and loyalty to the company. Plus, it can cause reputational damage to the business and severe sanctions from the U.S. Securities and Exchange Commission and other regulators—or arrests.

Types of financial statement fraud

Unlike business fraud, which comes as kickbacks, bribes, or payroll fraud, financial statement fraud involves intentional manipulation or misrepresentation of economic data, such as:

  • Revenue 
  • Expenses
  • Assets
  • Liabilities  
  • Share prices
  • Company valuation

Financial statement fraud takes different approaches (based on omitted or overstated data) such as:

  • Exaggerated revenue: This happens when a company claims revenue before receiving the goods or services, creating a false impression of its fiscal health. 
  • Misappropriations: One of the serious forms of fraud perpetrated by individuals seeking personal gain, done by altering the financial statement with fake expenses or double-entry bookkeeping to mask theft or embezzlement. 
  • Fictitious revenue and sales: Some employees or managers create phantom customers, double-count sales, or alter existing customers’ invoices to claim sales didn’t occur or reverse false sales in their financial statements.
  • Differences in accounting periods: This type of fraud involves creating a reserve for the future, less robust periods, posting sales before they’re made or paid for, re-invoicing past due accounts, or pre-billing for future sales. The goal is to understate revenue in one accounting period. 
  • Overstated assets: When a company inflates its assets’ net worth, resulting in overstated net income and retained earnings. They may fail to apply ‌valuation reserves or depreciation schedules to inflate shareholders’ equity.
  • Concealment: Liabilities or obligations (loans, salaries, under-reported health benefits, and more) are omitted from financial statements to inflate assets, equity, and net earnings.
  • Falsified expenses: When a company exaggerates its net income and understates its costs and expenses, creating a false impression of the net income it earns.
  • Inadequate or improper information disclosure: Obscuring or omitting items like accounting changes, contingent liabilities, significant events, and other transactions from financial statements to disclose inaccurate or unclear information.

Financial statement fraud warning signs

Traditionally, you’d need multiple solutions to verify a customer’s identity—checking their documentation, regular screening, monitoring transactions, and reporting suspicious activity.

Traditionally, you’d need multiple solutions to verify a customer’s identity—checking their documentation, regular screening, monitoring transactions, and reporting suspicious activity. 

The Know Your Customer (KYC) process replaces that old, complex, expensive, and inefficient process, ensuring your clients are who they say they are. 

However, regulatory requirements go beyond onboarding. 

As a lender, you’re responsible for preventing financial statement fraud and related crimes throughout the buyer’s journey. That’s why you need to know the warning signs of financial statement fraud. 

Here are some major red flags that raise concern and signal suspicious business practices:

  • Increase in sales, revenue, or asset book values without corresponding growth/decline in inventory or cash flow
  • Missing or altered documents
  • Performance spikes in the final reporting period
  • Consistent sales growth, high revenues, and low expenses during industry turndowns or in a volatile industry while competitors are struggling
  • Unexplained items, outsized third-party transaction frequency, or changes in assets or liabilities 
  • Improper expense capitalization beyond the industry average
  • Disproportionate compensation amounts paid to management as short-term target bonuses
  • Frequent, complex transactions without logical purpose or value to the business

Real-world examples of financial statement fraud

Having understood what financial statement fraud is, let’s dive into some real-world examples that paint a clearer picture of the problem:

  • Wells Fargo: From 2002 to 2016, the company’s employees created millions of savings and checking accounts for clients—without their consent—forcing them into services like credit cards or bill payment programs, which they didn’t need, to meet impossible sales targets. The employees signed unwitting account holders, created fake personal IDs, forged signatures, and secretly transferred customers’ money.
  • Bernie Madoff: The late American financier who ran the Ponzi scheme collectively defrauded 4,800 clients of nearly $65 billion. Madoff falsified account statements to pay investors with money from new clients, not actual profits. Madoff’s company made exceptional returns, which the U.S. SEC found suspicious and opened investigations into the firm.
  • Enron Corp.: The energy behemoth’s head, Jeffrey Skilling, used market-to-market (MTM) accounting to hide the trading company’s financial losses and other operations and improve the appearance of its financial outlook. The Wall Street Journal discovered the firm’s egregious accounting fraud, leading to its widely publicized bankruptcy.

Tips to prevent financial statement fraud

The ability to quickly perceive, detect, and fight fraud or its warning signs helps lenders prevent it from happening‌ . 

Here are some tips to keep financial statement fraud at bay:

  • Institute strong internal accounting controls: Use passwords, electronic access logs, and lockouts to keep unauthorized employees out of the accounting system. Divide deposits, reporting, bookkeeping, and auditing responsibilities between different people to thwart attempts and opportunities to commit fraud.
  • Perform regularly accounting reconciliations and periodic audits: Test your financial statements for accuracy to uncover any weaknesses and ensure their controls prevent fraud effectively.
  • Use fraud detection software: An AI-powered fraud detection tool like Inscribe helps you understand if a financial document is fraudulent and know what’s been altered within seconds. Taking the human manual effort out of fraud detection reduces vulnerability points internal or external parties could use to wreak havoc in your organization.
  • Institute a formal fraud reporting system: Empower employees to report fraudulent activity. An ACFE report found that 43% of all fraud schemes were detected through tips, half of which came from employees. Whistleblowing hotlines help organizations detect fraud in 12 months, cutting media losses almost twice, compared to companies without them.

Safeguard against financial statement fraud

To protect your organization’s security and financial assets, you should be hyperaware of your financial transactions and implement measures to reduce and respond to fraudulent activities. 

Failure to do so could leave your company at a significant risk for financial statement fraud, which could incur high costs in fines, penalties, lawsuits, or closure, and severely damage your company’s reputation.

Fast-growing companies use Inscribe’s award-winning technology to identify and prevent fraudulent activities. 

Talk to one of  our experts to find out how Inscribe can help your organization combat financial statement fraud.

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