Accountants tend to be more familiar with fraud involving theft of cash or other assets than they are with fraudulent financial reporting.
While asset misappropriation was the most common type of fraud found in the 2012 Report to the Nations on Occupational Fraud and Abuse by the Association of Certified Fraud Examiners (ACFE) survey, those cases were the least financially costly at a median loss of $120,000. Fraudulent financial reporting remained relatively rare at 8% of the cases detailed by respondents, but those cases inflicted greater damage, with median losses of $1 million, the ACFE found.
In an AICPA survey, respondents from business and industry indicated that the majority (67%) of fraudulent financial reporting involved overstatements of accounts receivable, inventory, securities, or other assets. Detection of the fraud included methods such as physical inventory, a third-party tax adviser, and a new CFO performing a balance sheet review, according to the survey report.
The largest number (36%) of respondents from the forensic and valuation services community in the AICPA survey predicted in 2011 that revenue recognition would be the most prevalent issue in this area in the next two to five years, followed closely by valuation of assets carried at fair value (32%). Another 19% cited treatment of off-balance-sheet assets and liabilities, and 5% listed reserves for assets carried at cost or modified cost.
Here are 10 considerations for detecting or preventing fraudulent financial reporting:
- Senior management must create the right culture (i.e., tone at the top).
Probably the most important deterrent to financial fraud is that senior management creates a culture in the business that lets all employees know fraud will not be tolerated. Top managers need to go on record that they expect to work in an ethical environment and expect employees to conduct themselves in an ethical manner.
- Establish and promote an effective whistleblower program.
Providing the ability for employees to anonymously report questionable practices can lead to uncovering fraud before it affects financial reporting systems. Having an effective whistleblower program in place can deter fraud before it starts.
- Question financial results that are always on target.
No business is immune to market forces and fluctuations, and those fluctuations should be reflected in financial results. If the numbers are always on target, it may mean the financial information is being manipulated.
- Question auditor changes.
The Committee of Sponsoring Organizations of the Treadway Commission (COSO) prepared an analysis of fraudulent financial reporting occurrences between 1998 and 2007 and found that 26% of the firms that experienced fraudulent reporting also changed auditors between prior clean financials and the issuance of fraudulent financials. All of the changes happened in either the year of the fraudulent reporting or in the year just prior.
- Have skeptics on the board of directors.
Having a board of directors and specifically members of the audit committee who are knowledgeable about the business and the sector and willing to question when things seem outside the norm can prove to be a significant deterrent to fraudulent financial reporting.
- Question extraordinary or complex transactions.
Especially question extraordinary transactions, either positive or negative, that offset results from operations. One significant gain that would offset a bad year of results may be used to improve the bottom line.
- Analyze accounts receivable.
Revenue manipulation, a common form of financial fraud, will often affect receivable balances. Investigation of outlier activity in receivables, basis for uncollectible accounts, and receivable statistics in comparison to industry standards can help identify potential financial reporting problems.
- Question when cash flow does not match revenue growth.
Again because revenue manipulation is the among the most common forms of financial fraud, management should be able to justify if a revenue increase is not accompanied by a corresponding increase in cash flow.
- Analyze swings in assets or liabilities.
Manipulation of revenues or expenses will often involve unexplained swings in assets and liability balances. There should always be a logical explanation for significant changes in balance sheet accounts.
- Continue to educate yourself and urge others to do the same.
Accountants, management, employees, investors, and directors need knowledge to combat fraudulent financial reporting. By knowing the “red flags” of fraud and understanding the difference between aggressive but acceptable accounting and abusive and prohibited accounting, individuals can stop fraud before a company and its stakeholders are harmed by fraudulent financial information.
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Wray Rives CPA, CGMA, helps startup and small business owners compete and succeed in their local or global market as founder and manager of NeedaCFO.com and through his public accounting firm Rives CPA.