Occupational Fraud Series

Part 3 of 3: Financial Statement Fraud

What is it?

Financial statement fraud, or “lying,” can be defined as the deliberate misrepresentation of an organization’s financial condition, consummated by intentionally misstating, omitting, etc. amounts within the financial statements to deceive others.  The main types of financial statement fraud are improper revenue recognition, overstatement of assets, understatement of liabilities, misappropriation of assets and improper disclosure. Revenue recognition is the most common type of financial statement fraud.  Out of the three major types of occupational fraud, financial statement fraud is the least common in terms of occurrence but has the highest monetary impact on the organization.  The amount of the actual fraud often pales in comparison to the loss in the market value due to the negative publicity received and reputational impact it has on the organization.

Who commits it?

All levels of personnel are guilty of committing financial statement fraud, however individuals in accounting departments make up the most common groups of people who perpetrate fraud due to their access to funds and accounting records. All levels of personnel have been guilty of the fraud, from employees to managers, to owner/executives; however, senior management is most likely to commit the fraud.  The higher the position, typically, the larger the average loss and the longer the fraud goes unnoticed. Small, private businesses are most vulnerable to this type of fraud as they typically have minimal segregation of duties, no internal audit function, and no audit committee to govern them.

Why do they do it?

Same as for asset misappropriation and corruption, the three main motives for financial statement fraud are pressures/incentives, opportunity and rationalizations.   Pressure/incentives can be created by personal financial struggles or negative relationships between the company and its employees while opportunities result from large sums of cash on hand or easily convertible assets.  Rationalizations can be created by a company’s disregard for monitoring or risk reduction or employees who feel wronged by the company.

What are the warning signs?           

The red flags for occupational fraud can be grouped into the following categories: behavioral, organizational, financial and business.  The biggest behavioral red flag is an individual living beyond their means.  Organizational red flags may consist of lack of or ineffective internal controls, frequent organizational changes, and/or a board of directors consisting predominantly of insiders.  Financial red flags may include deteriorating earnings quality, unusual financial results and rapid expansion.  Lastly, business and industry red flags may be significant investments in volatile industries or industry downturns.   How do you prevent/detect it?

Prevention of financial statement fraud is most effective with a strong team.  This team would consist of an audit committee and/or board of directors who set the right tone at the top and permeate an ethical culture throughout the organization.  Next, management would need to establish appropriate anti-fraud programs, a method of reporting fraud issues and a method to effectively investigate reported fraud to ensure it is thoroughly investigated.  Internal auditors, external auditors and fraud examiners can serve as a method of detection and deterrence.  Lastly, the employees of the organization play an important role as they need to be vigilant and report potential acts of fraud as they identify them. 

This is part 3 of a 3-part series on Occupational Fraud. To read more, please click on the links below.

Occupational Fraud Series Part 1 of 3: Asset Misappropriation

Occupational Fraud Series Part 2 of 3: Corruption Schemes

Occupational Fraud Series Part 3 of 3: Financial Statement Fraud