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Financial Statement Fraud Schemes
By: James Provenzano, CPA, CFE, CFF |
Effective expert assistance whether in litigation support consulting, depositions, or prevention requires a thorough knowledge of the nature of financial statement fraud, its purpose and associated red flags. Financial statement fraud does not necessarily lead to immediate losses but is often a means to an end. A common definition is "the deliberate misrepresentation of the financial condition of an enterprise accomplished through the intentional misstatement or omission or amounts or disclosures in the financial statements to mislead financial statement users." Often these schemes can buy more time, comply with loan covenants, obtain loans, or inflate value of equity shares.
Perpetrators of financial statement fraud are looking to gain by encouraging investment of equity stock; hiding negative cash flows; obtaining new or enhanced financing; selling the Company for a higher price; complying with dividend payout and loan covenants and increasing performance related bonuses. These are some of the common goals but are not all-inclusive. By fraudulently improving the financial position or by omitting negative information or contingent liabilities third parties would be more encouraged to buy stock, lend money or otherwise benefit the Company.
Types of Financial Statement Schemes
Following is a discussion of the types of financial statement schemes. Major categories are as follows:Fictitious revenues Timing differences Improper asset valuations Concealed liabilities and expenses Improper disclosures This article will focus in detail on fictitious revenues, timing differences and concealed liabilities. Refer to Financial Accounting Standards Board ("FASB") Accounting Standards Codification ("ASC") for more discussion of improper asset valuations and improper disclosures.
Fictitious revenues
This can involve fake or phantom customers. The scheme involves using various accounts. For example, Company "A" wishes to record $100,000 in fictitious sales to a non-existing customer. The initial accounting entry is debit (increase) accounts receivable and credit (decrease) sales for $100,000. At a similar time, the Company records a debit (increase) fixed assets and credit (decrease) cash for $100,000. Then the Company records another entry to debit (increase) cash and credit (decrease) accounts receivable for the same amount. Thus, the cash and accounts receivable entries cancel each other. That leaves the fictitious fixed assets and revenue, one being an asset and the other profit increase. Since fixed assets and revenues usually are significant, amounts these fictitious amounts will go unnoticed unlike cash and accounts receivable. More involved schemes would be to use legitimate customers and inflate or alter invoice to reflect higher than actual amounts. Another form of fictitious revenues involves sales with conditions or terms than have not been completed and rights of risk of ownership have not passed to the purchaser. These are not sales according to generally accepted accounting principles.Timing Differences
Deliberate recording of revenues or expenses in improper periods is another form of financial statement fraud. This results in increasing or decreasing earnings as desired in certain periods. One of the significant abuses over the years has involved compliance with accounting rules over revenue recognition. Financial Accounting Standards Board ("FASB") Accounting Standards Codification ("ASC") Topic 605 governs the accounting rules in this area. The four criteria are as follows:
- Persuasive evidence of an arrangement exists;
- Delivery has occurred or services have been rendered;
- The seller's price to the buyer is fixed or determinable; and
- Collectibility is reasonably assured.
Some of the above criteria govern the sales with conditions discussion in the previous section.
Persuasive Evidence of arrangement (following indicates non-existence)
James Provenzano, is a Certified Public Accountant, Certified Fraud Examiner and Certified in Financial Forensics by the AICPA. Mr. Provenzano's accounting and financial background (over 20 years experience with Big 5 audit firms and sole proprietor of a full service San Francisco based CPA firm for eight years) make him uniquely qualified to lend his expertise on Complex Accounting, Financial Analysis, Auditing, and Financial Reporting in a wide variety of industries including, financial services, mortgage banking, technology and software, manufacturing and not for profit.
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