Financial Statement Fraud

Revenue Manipulation

Companies undertake several methods of perpetrating revenue fraud. Revenue can be artificially inflated by recording sales that have not been earned or recognising revenue prematurely. A fictitious trade receivable can be manufactured to create artificial sales. At times, companies inflate trade receivables in order to increase revenue. In addition, companies can record fictitious sales, or record revenue when risk and reward incident to the goods or services have not been transferred to the customers.

Overstating/ Understating Expenses

Expenses can be manipulated to achieve a predetermined objective. Management can increase expenses arbitrarily in order to reduce the company’s tax liabilities. For example, directors’ remuneration, marketing expenses, etc., can be inflated to achieve a lower profit, and in effect, resulting in a lower tax been paid. On the flip side, management can intentionally understate expenses by undercharging depreciation or any other specific expense line items to achieve high profit margin to mislead investors. Other methods include to defer legitimate expense to the next reporting period, capitalizing expenses, etc., all in a bid to increase reported profit.

Generally, companies engage in creative or gymnastic accounting practices by cooking or making their books appear so rosy than necessary to deceive investors. Though, the tax authorities are aware of these sharp practices, and that is why a company’s audited financial statements is being subjected to thorough scrutiny during tax audit.

Improper Asset Valuation

The valuation of assets in the statement of financial position can be materially manipulated to achieve intended results. Assets such as properties, plant, and equipment, goodwill, including inventories can be overvalued to misrepresent the company’s  financial position. For instance, when inventories are overvalued, the reported profit will be lower, and in effect, a lower tax liability will be paid. Misleading asset valuation can also arise when a company intentionally fails to write down impaired assets to their recoverable amount in consonant with the dictate of IAS 36 on impairment of assets.

Concealing Liabilities

Companies can omit or understate liabilities in order to present a healthier financial position in a particular period than they actually have. Concealing liabilities can arise when an entity’s management fail to disclose off-balance sheet items including operating leases or contingent liabilities. It can also occur when account payables are understated, or improper recording of warranty costs and loan covenants are carried out in the books.

At times, companies’ management can use “big bath” technique to manage their earnings by conducting a one-time write-offs in a reporting period to enhance future profit. Big bath is an unethical behaviour usually carried out by a company’s top level management when they realised that they cannot achieve the minimum earnings target in a given period. The management can then delay revenue realization, create big write-offs, or making prepay expenses in order to get big bonuses in the near future.

Fraudulent Disclosures

The information provided in the financial statements must be accurate, faithfully represented, and devoid of any ambiguity to enable users make informed business and investing decisions. Fraudulent disclosures involves intentional manipulation of facts by providing misleading or false information in the financial statements. Companies can omit material information, making overly optimistic estimates, or misrepresenting the nature of transactions or financial arrangements with third parties. To achieve an intended result or objective, information relating to contingent liabilities, related party transactions, accounting changes, or any material events, can either be obscured or omitted entirely in the financial disclosures or footnotes.

Round-Tripping

This is a fraudulent activities usually conducted between related entities where money is exchanged to create the appearance of a legitimate business transaction, where in reality, it is fake. This fraudulent act is usually perpetrated by the management to artificially inflate revenue, create fictitious transactions, or manipulate the financial information to mislead shareholders, investors, government, and other users of the financial statements. Generally, engaging in round-tripping can result in lawsuits, impair a company’s relationships with relevant stakeholders, and significantly damage its reputation once uncovered.

Related Party Transactions

Though, not necessarily a mechanism for fraud, but companies, including multinational entities, can use related party such as subsidiaries, affiliates, or their executives to perpetrate financial fraud. This is particularly possible when assets, goods, or services are exchanged between related parties at inflated prices. Contract prices, loan agreement, leases, and service agreement  between related entities can be manipulated to distort financial results. Because of potential conflict of interest, auditors, or regulatory authorities usually subject related party transaction to thorough investigation.

Timing Differences

This involves recording revenue or expenses inappropriately in different periods. Revenue or expenses can be shifted from one period to another in order to achieve a targeted or predetermined earnings. For example, if a company wants to report high profit in a particular period, it can delay closing of books to enable more sales to be generated or allow customers’ invoices to be paid before the books are finally closed for the reporting period or month.

Manipulating Reserves and Accruals

Companies can manipulate reserves and accruals, including warranty reserves, provision for doubtful debts to smooth earnings or create the appearance of financial stability.

Corruption

This involves conflict of interest, bribery, kickbacks, contract inflation, selling of proprietary information, economic extortion, money laundering, etc., often perpetrated by company’s management or its official in collusion with third parties.