Part of the Problem or Part of the Solution?

Fraudulent financial statements may be the result of individual fraud or systematic management fraud.  A business owner may be part of the problem or may be a victim.  If you’re not part of the problem, you need to be part of the solution. You don’t want to be a victim of financial statement fraud because it may cause severe financial distress, loss of reputation, criminal or civil litigation and, ultimately, the loss of your company or worse.  Although limited only by imagination, there are certain areas and schemes which tend to attract more financial statement fraud than others. If you want to protect your company, you should be aware of some typical schemes so you can ask the right questions to protect your company.

Premature revenue recognition should be a top concern.  Sales should generally be recognized when the earnings and delivery process is complete. If your customer pays you for things you must deliver in the future, this should generally be treated as a liability or a deposit and generally should not be considered a sale.  “Channel stuffing” or selling goods to distributors at the end of an accounting period may be fraudulent if there are agreements, written or not, that the products may be returned after the period with no consequences.

Does your accounting staff strictly observe period cut-off dates? In general, products should only be billed when shipped and title passes.  Are unrecorded expenses properly accrued at month end if the service or product has been received even if you have not yet received an invoice?  Do you get calls from vendors claiming you don’t pay promptly?  Do you find out your firm has financial obligations which seem to only be recorded after someone complains? Does your staff have a line by line review of your balance sheet accounts?  Are there entries without documentation or large entries in round numbers that affect profit accounts? In some companies, the balance sheet becomes a junkyard which taints their financial statements and may be a sign of fraud. Do you know what’s in your balance sheet? What about your property accounts on the balance sheet?  Some large frauds have been perpetrated by criminals booking expenses into the property accounts.  Ask Bernie Ebbers, former CEO of WorldCom, who received a 25 year sentence for just such a scheme.

Other typical schemes include overstating ending inventory by fraudulent physical inventory counts, failure to write off bad debts, writing off large amounts of bad debt, or booking assets for equipment which are actually leased. What about “Cookie Jar Reserves,” which are taken when needed or built when you do better than expected.  This is not acceptable accounting.

Over time, your reported earnings and cash generation should run in tandem.  If you continually over long periods of time have much more earnings than cash flow, you need to be wary.  In the end, things that look too good to be true may be.