How Do You Identify Fraud on Financial Statements?

Financial statements are a critical part of the operations of any business. To the trained eye, financial statements offer a clear picture of what is going on in the business, whether it is turning a profit or falling into the red, and what changes might need to be made moving forward. Many of the important decisions that are made on a day-to-day basis are made with at least one eye on the various financial statements that the business produces.

Of course, everything we said above is only true if the financial statements are to be believed. Financial statement fraud occurs, and when it happens, it puts the entire future of a given business in jeopardy. Statement fraud can be hard to detect, which is why retaining the services of an experienced forensic accountant is so important. Whether improprieties are suspected or the business just wants to play it safe, further investigation by a forensic accounting firm is a smart move.

The article below is going to take a closer look at some of the techniques used to identify signs of fraud on financial statements. While the information below should be helpful, it is only an overview and won’t make you an expert in this space. For access to an expert who can help your business spot and prove statement fraud in one form or another, reach out to Space Coast Forensics today to learn more about our services.

What is Financial Statement Fraud?

Before you can go looking for financial fraud, you need to know what it is and how it is often committed. Unfortunately, there are plenty of different types of financial fraud, meaning it can be hard to track down even if it is suspected. The use of forensic accountants is so common in this area because the fraud can be hard to spot and prove, and an expert is needed to make the case.

For a simple definition, financial fraud can be considered the deliberate and deceptive manipulation of financial information for personal gain. To be sure, financial fraud is an umbrella term that can include countless various types of fraud in many different forms. Let’s take a look at a few of the many possibilities as it relates specifically to fraud that occurs on financial statements.

Misappropriation of Funds

Many companies face problems with financial statement fraud that comes in the form of misappropriation of funds. Anyone in the business with access to funds in one way or another could potentially divert some of that money for their own gain. Then, accounting manipulation is often used to hide those missing funds and make it less likely that they’ll be detected.

Financial statement frauds will sometimes go to incredible lengths to cover up their crimes and attempt to get away with the theft for an extended period. An example of this kind of misappropriation can be seen in billing schemes that create false invoices to direct money toward a shell company or another entity. With this kind of statement fraud, paying close attention to the incoming invoices and outgoing payments is important to spot inconsistencies.

If this type of financial statement fraud has been taking place for an extended time, the skills of a forensic accountant will likely be needed to unwind everything and figure out where the money has been going. The financial statement frauds committed over the years can blend in with legitimate transactions, and only someone with the necessary experience in this field will be able to use advanced techniques to sort everything out and help to determine who was responsible for the crime. Financial statement fraud detection is a critical job within an organization, and as such, it is best left to a fully qualified professional.

False Revenue

There are plenty of motivations for an organization to falsify revenue numbers on a financial statement. Most often, this type of financial statement fraud is motivated by the aim of attracting more investors. If a company’s financial statements don’t look particularly impressive, it might be hard to bring new money into the organization in an effort to grow in the market. With better financial statements, including higher revenues, it will be easier to convince investors that this is a business with a bright future.

Of course, falsifying revenue is financial statement fraud with serious implications. This is an illegal activity and it is almost certain to be caught after time passes and new investors start to ask questions about those revenues and why things don’t seem to be adding up. Even if the numbers of the income statement and balance sheet continue to be falsified, the company won’t have the revenues needed to pay investors back per the terms of their agreement and the fraud will gradually come to light.

Proving that financial statement fraud has taken place is best handled by a forensic accountant who has worked previously on cases of accounting fraud. Even if an investor or another related party believes that statement fraud has occurred, it will still need to be proven – and that’s where the forensic accountant can enter the picture and do the hard work of sorting everything out. Once it can be documented clearly that the revenue numbers for the business were never what was claimed, those who committed the financial statement fraud will no longer have anywhere to hide.

Overstating Assets

Another take on financial statement fraud is to overstate the value of the assets that are owned by a business. The value of an organization’s assets represents a significant portion of the value of that organization as a whole, so statement fraud of this kind can lead to a dramatic alteration in how the business is viewed by both investors and creditors.

For example, overstating assets could be done by overvaluing the inventory that is on hand. If a business claims to have far more inventory than it does, that will make the business more attractive to an investor, as it will seem to be in a stronger position financially to turn some of that inventory into sales and revenue. This could potentially encourage an investor to put money into the business that they would not have been willing to invest otherwise, or it might convince a creditor that the business is a risk worth taking.

Inventory is just one area where the financial position of the business can be inflated through overstating assets. Likewise, the company could intentionally overstate how much its property or equipment is worth. If the numbers in this area of the financial statement are just taken at face value and not investigated further, a distorted picture of the financial situation that the business is in will be created. One of the best ways to prevent financial statement fraud is to resist the temptation to just take financial statement accuracy for granted, and instead dig in a little further to make sure the numbers are in line with reality.

Concealments

The two types of financial statement fraud that we have highlighted above – false revenues and overstated assets – involve “padding” the books to make them look better than they are in reality. This is harmful financial statement fraud, but it is only one side of the coin. Concealments represent the other side of that coin, as this type of fraud involves hiding things from the financial statement so they don’t drag down the perceived worth of the business.

One way to conceal negative information from the financial statement is to simply not record some expenses. By hiding expenses and not allowing them to impact financial statement balances, the overall picture will look better than it should. Profits will be higher because the revenues won’t be offset as much as they should have been by the expenses that the company incurred along the way.

Falsifying financial statements in this way is again usually done to make the business look attractive to creditors and investors. Beyond hiding expenses, the company might also hide some liabilities, like a loan that was taken out to support operations at some point in the past. If a loan is kept off the books through concealment, it won’t be able to be considered by an investor or a creditor who might wind up working with the company.

The Power of Trends

Monitoring and catching financial fraud is a moving target. The schemes and crimes that worked a decade ago – or even a year ago – may no longer be working today. Financial fraud tends to go in waves, with a certain type of crime becoming popular, and even trendy, until businesses catch on and put methods in place to stop it. Then, other tactics will start to be used, and the whole process will start over again. It’s a cat-and-mouse game, and as a result, the field of fraud detection is one that is constantly evolving. Just when a business thinks it knows how to detect fraud and maintain the integrity of its financial data, something else will come along to pose a threat.

Without a doubt, the driving force in financial statement fraud trends today is technology. As more and more technology has made more and more information available to everyone, new and complex financial statement fraud schemes have been developed. Even if good internal controls are in place – more on that below – it could be possible for an individual to access a system or account that they are permitted to access simply by compromising an online platform or software system.

There are also the looming advancements in artificial intelligence and machine learning that will need to be addressed. How will AI capabilities make it easier for those hoping to commit financial statement fraud to compromise an established system and deceive investors, creditors, and even the company itself? If businesses think that financial statement fraud is a stationary target that can be monitored with the same old tools, they are sure to be victimized sooner rather than later. It’s the ongoing, consistent monitoring of the trends in this area of fraud that is going to lead to successful prevention, and teaming with a proven forensic accountant is a good start.

Examining the Internal Structure and Controls

A solid internal structure is the foundation on which good accounting practices can be built. In fact, when a company has a good internal structure in place, it will be far less likely to deal with financial statement fraud, simply because it will be harder for any one individual – or even a group of individuals – to execute a successful scheme. There are checks and balances and other restrictions within a good structure that make statement fraud far more difficult to execute.

With that said, no system is perfect, and no crime is impossible. Certified Fraud Examiners stay busy because even companies with great structures still occasionally face financial statement fraud and other related crimes. When this happens, it’s important for the forensic accountants who work on the case to examine the existing controls and see where they might need to be improved. Through this process of learning from mistakes and gaps in the system, the internal structure can be gradually improved over time and future crimes will be less likely to occur.

Listening to Whistleblowers

It’s often the words of whistleblowers that are the first signs that something is wrong. If statement fraud is occurring, and if it is done well, it might slide under the radar for an extended period without anyone being any the wiser. When someone does speak up about something they heard, saw, or noticed, it’s critical that the person is given a safe, comfortable platform on which to tell their story and explain what they know.

In some cases, it will be appropriate to connect a whistleblower to a forensic accountant who can listen to their testimony and decide how to proceed. If the input that this person provides points to signs of financial statement fraud, a full investigation may then be launched to see if any money is missing, and where it might be going.

One of the reasons that people are often hesitant to become whistleblowers is a fear of the repercussions they may face in the aftermath of their testimony. Companies need to make sure that an environment exists where people feel free to step up and do the right thing without worrying about it harming their career prospects in some way. For example, putting a formal fraud reporting system in place that has been designed to protect those who speak the truth, will go a long way toward preventing financial statement fraud.

Turn to Space Coast Forensics for Help

Financial statement fraud threatens the very existence of a business. If you have spotted something on a financial statement that doesn’t seem quite right, or if you want to make a standard practice of reviewing these documents to prevent financial statement fraud in the first place, get in touch with Space Coast Forensics today. Our experience in this space makes us perfectly qualified to carefully review your company’s financial statements and investigate anything that is out of place. We look forward to serving you!

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