Part 3 in a 4 part series: “Fraud, Embezzlement & Thievery: Oh, My!”
Part 2 of the fraud series discussed the most common type of fraud: asset misappropriation schemes. This time we are going to take a look at the most costly type of fraud scheme, otherwise known as financial statement fraud or “cooking the books.” The Association of Certified Fraud Examiners (ACFE) 2012 Global Fraud Study reported that financial statement fraud schemes caused a median loss of $1 million, exceeding corruption median loss of $250,000 and asset misappropriation median loss of $120,000.
Financial statement fraud schemes are defined as the deliberate misrepresentation of the financial condition of a company through the intentional misstatement or omission of amounts or disclosures in an organization’s financial reports. These types of schemes are broken into five categories:
- Fictitious revenues – recording the sales of goods or services that did not occur.
- Timing differences – recording of revenues or expenses in improper periods to reach a desired earning amount.
- Improper asset valuations – assets are written up to current market value violating the “lower of cost or market rule.”
- Concealed liabilities and expenses – purposely omitting or understating so that the financials appear more profitable.
- Improper disclosures – not providing all the necessary information to prevent the financial statement user from being misled.
Financial statement fraud can be a slippery slope. If an organization’s internal controls fail to prevent one of these five schemes from occurring, there is the possibility that the organization can easily find itself subjected to a combination of schemes. This is what happened to Bally Total Fitness during the years of 1997 through 2003. As discussed in the 2012 ACFE Fraud Examiner Manual, Bally’s alleged improprieties involved all five categories of financial statement fraud schemes which caused Bally to understate its 2002 net loss by $92.4 million and to understate its 2003 net loss by $90.8 million.
To prevent your company from falling victim to one or more financial statement fraud schemes, be aware of a few general red flags:
- Aggressive or unrealistic profitability expectations created by management.
- Ineffective communication and support of the organization’s ethical values by management.
- Recurring negative cash flows from operations while reporting earnings and growth.
- Rapid growth or unusual profitability especially compared to that of other companies in the same industry.
- Significant, unusual, or highly complex transactions especially close to a period’s end.
Large and small companies alike can implement internal controls to help prevent these red flag situations and potentially save themselves from the significant losses and embarrassment that come with these types fraud schemes.