Introduction

Fraud refers to the submission of wrong information to misguide another party for one’s benefits. It is usually used to conceal illegal or unethical behavior in the management positions. Many people engage in fraud for personal gain, with an aim to victimize others or conceal their incompetence in their areas of professionalism (Alexander and Britton). This paper will broadly discuss types of financial statement fraud’s detection methods and respective mitigation measures. Examples of companies and corporations where these fraudulent activities have been detected in the past will be also included to provide a complete and concrete overview of the subject

There are many forms of fraud, with financial fraud being among the major forms of the vice. Many managers have tried to conceal the poor image of their companies or businesses from the eyes of the public and investors to encourage them to invest in the company. Companies that make losses are often caught in fraudulent activities as they try to conceal their situation and ensure that the public has no idea about the financial position of the company.

Financial fraud can take place in many forms, but the main form that firms use is mutilation of the financial statements. Financial statements are usually prepared at the end of a financial period and they are used to show the financial strength possessed by an organization. The main ones include an income statement, a balance sheet, a shareholder's equity statement, and a cash flow statement (Alexander and Britton). The statements are used to lure investors into the system, and they are used to increase the value of the business in the stock market. When the position of a company is very good, investors are pleased, and in most cases, it improves and obtains new markets and expansions. The contrary is also true. Over the past few years, cases of financial fraud have increased significantly, making investors worry as they cannot surely know whether the companies’ statements are correct and accurate. A more worrying trend is the collusion between people to cheat on the public over the status of an organization by providing either incomplete statements or mutilating them to show a better position of their company in the industry.

The recent and well-known cases of fraud in large corporations include the WorldCom and Enron scandals. WorldCom was among the leading companies in the technology industry in the world and was a major benchmark for other players in the industry. Enron was also a mega company and was involved in fraudulent scandals. Fraud is a criminal offence and most countries have a well laid legal framework to work out such cases. If found guilty, heavy fines are imposed, professional licenses such as auditing are cancelled, companies are declared bankrupt, among others. The perpetrators may be condemned to serve jail terms.

Other companies that have been caught up in the fraud mires include Adelphia, Global Crossing, Xerox, Qwest, Waste Management, Cendant, Anicom, ESM, Lincoln Savings, Sunbeam, to mention a few. Since the 1980s, cases of fraud have been continually reported. The table below shows some of the major cases and the amount of money each case involved. The table shows that there are more cases reported in the recent past than in the earlier years.

Table: Some of the most popular financial statement fraud scandals since 1980s.

Company

Assets (Billions)

Date Filed

1. WorldCom

$103.9

July 2002

2. Enron

$63.4

Dec. 2001

3. Conseco

$61.4

Dec. 2002

4. Texaco

$35.9

April 1987

5. Financial Corp of America

$33.9

Sept. 1988

6. Global Crossing

$30.2

Jan. 2002

7. PG&E

$29.8

April 2001

8. UAL

$25.2

Dec. 2002

9. Adelphia

$21.5

June 2002

10. MCorp

$20.2

March 1989

A lot of money has been silently lost in the process of fraudulent behavior. Due to these cases of fraud, investors no longer have confidence in the financial statements of an organization. Collusions at all management levels have led to a situation where it is hard to determine which firm is telling the truth at the institution level. Many colleges have now introduced fraud detection as a course due to the rising cases..

Financial Statement Fraud is a deceitful manipulation of the debit and credit’s documents. The Association of Certified Fraud Examiners conducted a study which revealed that, among the white collar crimes, financial statement fraud took 10% of the fraudulent activities. They further defined fraud as “deception or misinterpretation that an individual or entity makes knowing that the misinterpretation could result in some unauthorized benefit to the individual or to the entity or to some other party.” Many companies that commit fraud in their accounting documents may do so in order to uplift the company’s financial image for growth or to succeed in a merger. This manipulation can be attributed to the cutthroat competition in the business world, especially when entering into the global market.

This fraudulent manipulation is exhibited in various forms. Their spread in a company’s system is rapid, and by the time they are detected, serious harm and, at times, irreversible damage may have been done. Once this is done, there has to be a series of malpractices in order to cover this up so the company has to forego most of the principles it had set. The financial statement fraud has been separated into five different categories that can be detected independently and each category has its own distinct red flags.

Concealed Liabilities and Expenses Fraud

Concealed liabilities and expenses fraud is a category of account manipulation employed. This involves the company giving an improper report of the company’s expenditures and other company’s liabilities. The expenses of one unit are deliberately shifted to another; alternatively, the liabilities are intentionally reclassified as assets. In some accounting cases, there are provisions that a company may not record everything that it has, but just refers to this as a footnote. This is the common case where the stock market and valuation is involved. In some cases, fraudulent companies use this excuse and do not post every detail in the financial reports. They use the footnotes, but, at times, unreliable information is provided. Some information may be vague and undisclosed, raising alarm about its authenticity. However, the fraudsters are smart and ensure that the loophole is well covered and there would be no questioning over the issue. These footnotes may be used to explain any form of misinterpretation in the financial statements, or the nature of an activity recorded in the statements.

A good example is the case with Enron, where the company posted very little information with regard to other activities it was involved in. At some point, the company stated that it earned a whopping 80% on its wholesale energy operations and services. This was a vague explanation, taking into account that it accounted for a very significant level of the company’s income. It was a cause to worry since these ‘wholesale energy operations and services’ were not the company’s main activity.

Other cases where the footnote could be used are where there could be misinterpretations and clearer and more concise explanations are needed. The schemes employed in this fraud include reporting the cost of sales as a non-operating expense. This is deliberately done to ensure that gross margin is not negatively affected.  When putting down records on the balance sheet, the operating expenditures are made the most by putting them under assets and evading the expense column on the income statement.

Another scheme that is manipulatively employed is eluding the recording of expenses completely and, in some cases, recording the expenses but not in their stipulated time. This ensures that the company has higher profits as the final difference between expenses and revenues is untrue. A good example was the case of WorldCom, which deliberately gave an improper report that $3.8 billion they had in expenses was capital expenditures. These fictitious numbers drove WorldCom into optimism and the scenarios extended to other companies. It was then reported that a number of companies withdrew from business during that period since the internet growth was going to cause internet traffic that doubled every 100 years. This was a great misfortune to the whole industry. This kind of fraud is mostly done by the management so as to make the condition of the company’s finance look better by raising the operating income and net income in their accounting books.

The red flags exposed by this category include the companies utilizing the services of different audio firms to work on different divisions or trade units. Another red flag is their failure to keep records of liabilities that are related to the warranty. When loans to executives or other parties are written off, then this is a warning signal that a fraud is underway. Failure to have records of invoices and other liabilities in the financial records of the company is an indicator of financial statement fraud. A conspicuous warning sign is when in the cash flow trend there is a significant recurrence of a negative in the operations or if there is a failure in creating cash flows of the operations whilst the company is reporting growth in the earnings. There may be also a significant rise in the fixed assets, which cannot be explained.

These warning signals may call for the management and shareholders to ask questions that touch on the following areas: the upsurge in the gross margin by the geographic area, locality and merchandise at the yearend in comparison with the previous year, and the budget estimate at the present. Corporations like this method because it is efficient even in the reduction of the tax payable by the corporation.

Improper Treatment of Sales

Another category is revenue recognition or timing schemes, also commonly referred to as the improper treatment of sales (Alexander & Britton). Most people are aware of this fraud as it is frequently practiced. This can be seen mostly when managers are trying to hide the results of one or a couple of quarters that have shown weak sales. The company may choose to record gross revenue rather that the net. The company may also pose as a “middleman” by posting revenues of other companies. Due to its ease in execution, companies like the idea. They present higher revenue in the financial statements than they actually made. This is done through the inflation of the profits. In most cases, corporations use the gross revenue as the net revenue, increasing the attractiveness of the corporation. Furthermore, they record sales that are yet to be made as they strive to get the best out of the public image. When companies get into supply contracts, there are several times when they can estimate the goods that they would deliver by the end of their tenure. Some estimate the sales that will be made by the end of tendered projects and post them in their financial statements. This improves the image, but the actual status is that the sales are yet to be made. In some cases, there are corporations that even record sales that have been ordered and would be collected in the financial period that followed. These, ideally, should not be included in the current year, but fraudulent organizations include them to deceive the people who go through the statements.

The warning signals that are associated with this category encompass violating the collection of rules, procedures, and conventions that outline the accepted accounting practice, GAAP. The violation is exhibited when the sales are posted way before their posting date; the sales record is always legit but the recording is done early. Another signal related to this one is when the sales record is posted before the sales have been made in reality, which is referred to as channel stuffing. This is exposed when there is a disproportionate quantity of successive period returns of commodities. They may also record sales of merchandise that are not in stock at that particular moment.

Fictitious Revenue

Fictitious revenue is another category. This has been in practice for ages and it is linked with the posting of sales that are not real or never happened, ghost sales. It is almost similar with the treatment of sales that increase the profit base of the corporation. In the case of Enron, this company is infamous for manipulating their financial statements so as to advance its appearance. It is exhibited that the company employed various methods to make the manipulation viable. It utilized off the balance sheet special purpose vehicles so as to hide their liabilities and increase the expansion of their earnings. This was a key method that the company used in the verge of its declaration of bankruptcy. Its managers wanted to elevate the company to high levels as well as ensure that there was confidence among investors. The company concealed its falling cost in the stock market and increased its value in its books. The experts who worked for the company were very smart, and investors could not detect the foul play. It was not until some skeptical personalities such as Jonathan Weil, Bethany McLean, and John Harold noted some inconsistencies and sensed an overvaluation of the company. The company did not provide very concise explanation on the sources of revenue.  On the contrary, the management team allowed the employees to do “anything they could” to post higher revenues, which was a very unprofessional move. This eventually led to the sharp fall of the company and to bankruptcy by the end of three years of their aggressive positioning in the market. During this period, the company employees worked individually and the revenues posted were always high and luring to any investor. Their share price in the stock market went very high, but eventually fell apart. Also, during this period, the company had branded itself as the “THE WORLD’S LEADING COMPANY.” This was a change from their previous declaration to be “The World’s Leading Energy Company.”

During this period, the company posted higher revenues and the table below shows the correct revenues and expenses against the reported figures in four consecutive years (between 1997 and 2000).

Year

Revenues

Income

Income (Restated)*

1997

$20.2 B

$105 M

$9 M

1998

$31.2 B

$703 M

$590 M

1999

$40.1 B

$893 M

$643 M

2000

$100.1 B

$979 M

$827 M

*Restated income is the correct income for the year.

The red flags for this kind of financial statement fraud include an uncommon rise in the assets. This is where there is another side of the entry which is used to conceal the fabricated incomes. When the “client” records are checked, they have a lot of key information omitted. The missing data may be the “client’s” physical address and phone number. The ratio patterns may have uncommon alterations, the revenues may show a sharp rise, which may be followed by a sharp decline, and there is proportionate rise in accounts receivable. When the end of a financial reporting period approaches, then there is a noteworthy highly complex transaction then this is a cautionary signal.

Improper Valuation of Assets

Another type of financial statement fraud is the improper valuation of assets. This is achieved by deceitfully inflating the value of the assets. This is the practice usually employed when the management wants to manipulate the profits. The schemes applied in this category include manipulating the investments; when required to take a reduction in the book value of an asset, then they flop, altering the assets’ beneficial lives and tampering with the approximations of the value in the fair market. Some of the methods that these fraudulent firms use include the exclusion of the provision for depreciation. This ensures that the corporation is valued higher than its actual rating. The process of asset over-valuation is done in collusion with the people in the corporation, including the top managers as well as the valuers or the people involved in the calculation of depreciation. Some may even claim to have a certain value for a scrap asset that has already exceeded its life. When all these are put together, the asset base of the corporation is overestimated and investors are deceived in the process.

The warning signals for this category consist of the defilement of the GAAP when one records the expense of the company as an asset. This leads to the false belief that the asset is going to generate an income, but in real sense, it is the expense of the company. When the customer demand shows a noteworthy deterioration and the business is failing in the industry and the economy at large, then this is a warning sign. Another red flag is the sporadic rise in the book worth of assets. The rise in assets like the receivables, long term assets, inventory, among others is seen very rarely. There is a display of peculiar patterns when relating the assets to other constituents found in the financial reports of the company. A case example is an unexpected variation in the ratio of receivables to income.

To deal with such a situation, the manager has to seek clarity of the effect of the overall economy on the client’s needs and the business in general. In all the areas that are covered by noteworthy approximations, the method used to regulate the estimate is also checked (Albrecht). The manager must also check on the available documents and if they are in line with the calculations.

Inadequate Disclosures

The other category is the inadequate disclosures. This style is used to disguise the financial statement fraud just after it has happened. This category reveals minimal information on the transactions of the parties involved, especially with the loans given to the management. Liabilities and other valuable information are not forwarded to the required people.

The red flags for this category encompass the detection of legal contingencies that were unrevealed. Another warning signal is when the actual nature of an event or a business transaction cannot be determined easily since the disclosure notes are hard to understand. There will be an authoritarian type of management and a sudden decision that requires the accounts to be “fixed.” Also, there will be counterparts that do not give details on the economic substance. The management will also resolve to endless memoranda that justify the fast-growing accounting practice.

Smoothing of Earnings, Improper Disclosure of Information Regarding the Related Party Transactions, and Loans to the ‘Big People in the Company’

Other general categories of these vices include smoothing of earnings, improper disclosure of information regarding the related party transactions, and loans to the ‘big people in the company’- the management and execution of highly complex transactions in the case of structured finance, bizarre counterparties, off-balance sheet structures, and special purpose entities.

The smoothing of earnings refers to the process of overestimating liabilities during the peak periods, when the businesses are doing quite well. This provides a leeway for such ill adjustments since it gives an illusion of keeping finances for future use in anticipated revenues slump.  This is indicated by the cases of management authoritarianism to conceal such malpractices. Another indication is procrastination of important bookkeeping activities from time to time. These loopholes are entry points for this situation frequently referred to as “cookie jar reserves.”

On the improper disclosure of information related party transactions, the vice usually occur as a result of conflict of interests where dealings of the related party are compromised; provisions of unnecessary cuts are common in such dealings (Rezaee and Riley). Red flags associated with this include increased related party transactions or unclear business ventures and inconsistent transactions, where what on the paper does not tally with what appear on tax results.

On the other hand, execution of highly complex transactions in the case of structured finance, bizarre counterparties, off-balance sheet structures, and special purpose entities occurs mostly in off balance sheet structures, whereby the unusual counterparties that cannot be captured capitalize on this to carry out highly complex transactions, too sophisticated to be traced or uncovered (Singleton and Singleton). This is usually indicated by a counterpart that is of no significant financial viability and numerous memos trying to downsize an insistent bookkeeping transaction that could conceal such an activity.

Conclusion

In many cases, fraud has contributed to the fall of many large corporations. It is believed that there are many people who are usually involved in the fall of a corporation through fraud. Most of these people claim to be “saving the company” from collapsing, but they end up leaving it in un-redeemable situations. For instance, the top manager of Enron was accountable for hiring Andersen to carry out auditing in the firm. His company was unethical and could be held responsible for the poor services of consultation. He was paid over $ 50 million for auditing services and failed to spot and bring to light the discrepancies that had already been made in the books. He failed to determine the internal controls with regard to the derivatives in the trading sector. These should have covered the period between 1998 and 2000. However, Andersen kept Enron, who was his second best client in terms of capital base. Both of these companies provided external and internal audits, yet no one ever detected the discrepancies until they became unmanageable. He was found guilty and indicted criminally, which led to his eventual exit from business.

Other institutions also had a stake in the process. Investment and Commercial Banks received money from Enron as fee which included payment for transaction for derivatives. Though they were good business partners, none of these financial institutions pointed out to Enron that there was a big problem in the derivative transactions of the company. They watched and even went ahead to receive hundreds of millions from the corporation that faced a large blip, yet they said nothing about it. They allowed investors to go on board and invest their money in a risky affair, and the whole process left some people who had invested there at a huge loss. Some people who had invested their retirement benefits in Enron faced personal bankruptcy since the corporation fell with their money. One single investor had put his whole life savings in the company by buying over 7,583,900 shares for a state. In fact, some of the institutions urged undecided investors to quickly buy shares there. In October 2001, as it was just about to fall, over 15 analysts termed the company as a strong buy or at least a worthy buy. Other significant players in the whole issue were the law firms. Enron paid a lot of money lo them to defend the company in different situations. They also failed to let the public know about the occurrences in the company and to warn them against the media hype.

Some Credit Rating Agencies received a lot of money from Enron. The three that topped the list included Standard & Poor’s, Moody’s and Fitch. They all helped the company conceal their unprofessional behavior. Even after all the hidden information had been highly publicized, and Enron was at the verge of being declared bankrupt, they still gave Enron high grades as an investment prospect. By this time, the stock was trading lowly at only $3 per share. These firms, however, enjoy the security from the state laws, hence could not be victimized of misleading the public.

When such frauds occur, it is evident that they involve institutions as well as individuals in the process. Therefore, it is issue of personal morality as more and more people are getting their hands into the dirty operations. More of the issues should be studied in schools and other institutions to avoid the occurrence of WebCom or Enron situations.

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