Altered Statements: Are More Accounting Frauds on the Horizon?

By Scott Patterson, CFE December 2014 It’s been more than a decade since a slew of large accounting scandals rocked the financial world, including Enron, WorldCom and Tyco, among others. Enron in particular grabbed the nation’s attention like few cases before it: The tale of hubris, cover-ups and, sadly, financial ruin for many of the corporation’s employees and shareholders was splashed across news networks and journals worldwide. It was a case study explored in bestselling books and film, galvanizing public sentiment into a chorus somewhere along the lines of: “How could this happen?”

By Scott Patterson, CFE

December 2014

 

It’s been more than a decade since a slew of large accounting scandals rocked the financial world, including Enron, WorldCom and Tyco, among others. Enron in particular grabbed the nation’s attention like few cases before it: The tale of hubris, cover-ups and, sadly, financial ruin for many of the corporation’s employees and shareholders was splashed across news networks and journals worldwide. It was a case study explored in bestselling books and film, galvanizing public sentiment into a chorus somewhere along the lines of:  “How could this happen?”

In the wake of Enron – and while the other large scandals were still coming to light – work began in earnest to bring new regulation that could catch the next big financial fraud. Extensive congressional hearings on the Enron fiasco resulted in the passage of 2002’s Sarbanes-Oxley Act, intended to increase oversight and accountability among public companies in an effort to mitigate the risks of future accounting frauds.

As a result of Sarbanes-Oxley, the Public Company Accounting Oversight Board (PCAOB) was created, whose mission “is to oversee the audits of public companies in order to protect the interests of investors and further the public interest in the preparation of informative, accurate and independent audit reports.” Along with creating new auditing standards through the PCAOB and a host of other regulatory measures, Sarbanes-Oxley introduced a key provision that earned a lot of attention among CEOs and watchdogs alike: executives were now required to sign off on financial reports, negating a company chief’s ability to plead ignorance as a defense of leading a corporation through a maze of fraud.  

While there hasn’t been a case to rival Enron among public corporations since the passage of Sarbanes-Oxley 12 years ago, financial statement fraud is still on the radar for many fraud experts. Among the reasons: increased stock-market pressure with an emphasis on bottom-line results; and stepped-up enforcement in this area by the SEC (leading to the exposure of more schemes).

 

What is Financial Statement Fraud?

In the ACFE’s 2015 Fraud Examiners Manual (FEM), financial statement fraud is defined as “the deliberate misrepresentation of the financial condition of an enterprise accomplished through the intentional misstatement or omission of amounts or disclosures in the financial statements to deceive financial statement users. Note that financial statement fraud, much like all types of fraud, is an intentional act.”

Of the three major types of occupational fraud (the other two being asset misappropriation and corruption), financial statement fraud is the most rare – but by far the most costly. According to the ACFE’s 2014 Report to the Nations on Occupational Fraud and Abuse, the median loss for a single case of financial statement fraud is $1 million. And yet, as we know from monstrous cases like Enron, damage can reach up to the tens of billions.

There is another aspect of financial statement fraud that tends to set it apart from other types of fraud. Generally speaking, a person commits asset misappropriation or engages in corruption to enrich themselves. In a case of financial statement fraud, however, the motivation is often something different. It could be meant to cover-up company losses or inflate earnings potential. The deception could be designed to help open new lines of credit or other financing options that would not otherwise be made available to the corporation.

In short, the perpetrator of a financial fraud scheme often has nothing to gain directly from the fraud; rather, it is the company that stands to benefit. To be clear, the fraudster may still reap some indirect benefits themselves, such as: the approval of their superiors, with possibilities for career advancement; bonuses for meeting financial targets; increased portfolio value if they hold company stock and the stock increases as a result of the deception.

There are two primary financial statement fraud schemes: overstated assets or revenue, and understated liabilities and expenses. Both are committed in an effort to reflect a stronger financial situation for the company than is the reality. The following are the five classifications of financial statement fraud schemes, as listed in the FEM:

Fictitious revenues

Timing differences (including improper revenue recognition)

Improper asset valuations

Concealed liabilities and expenses

Improper disclosures

 

Still a Concern, Experts Say

While Sarbanes-Oxley added more controls for preventing financial statement fraud, experts are still looking for the next big accounting scandal – convinced that it may only be a matter of time before another Enron fills the news pages. Speaking at the 24^th Annual ACFE Global Fraud Conference in Las Vegas in 2013, ACFE founder and Chairman Dr. Joseph T. Wells, CFE, CPA, mentioned the pervasive nature of this type of fraud.

“[A] fraud trend we’ll see over the next few years is a continuation of large financial statement manipulations by insiders of corporations,” Wells said. “Interestingly, a long time ago I predicted Enron and WorldCom before they had names. I simply said that, in the space of a few decades, the nature of investing had changed. No longer did people buy and hold stock because they believed in a company and its products. Share price became king. And it still is.”

Wells said that technology is playing a role in shaping an environment where employees of large corporations might feel pushed into a corner and, in turn, become more likely to commit financial statement fraud.

“Computerized trading using complex programs can buy and sell large blocks of stock in the blink of an eye,” Wells said. “The quest for share price has in turn placed enormous pressure on company insiders to perform. It is this pressure, not inherent dishonesty, which is the root cause of financial statement manipulations. And in our quest to trim the cost of government, we’ve provided for fewer watchdogs at the exact time we need more.”

ACFE Regent Gerard Zack, CFE, Managing Director – Global Forensics for BDO Consulting, also predicts more accounting scandals on the horizon, as schemes become exposed through stepped up enforcement by the SEC.

“[The SEC] announced last year and earlier this year that they have begun devoting more resources to financial statement fraud, after so many resources being diverted to investigate economic crash-related issues for several years,” said Zack, author of Financial Statement Fraud: Strategies for Detection and Investigation. “They also announced they have begun using some new expanded tools for data mining of the text parts of the submissions – the MD&A sections, footnotes, etc., for signs of deception based on their studying of past fraudulent and nonfraudulent financial statement [cases].”

 

What Fraud Examiners Need to Know

While audits are important as an internal control method, they are not a catch-all for fraud. In fact, ACFE statistics still overwhelming show that more frauds are detected through tips (42.2 percent) than by any other means. With this in mind, it is important that fraud examiners know exactly what to look for as signs of statement manipulation. The information should be shared with clients and colleagues who are in a position to review financial statements, and especially for those corporate leaders who are responsible for signing off on them. From the FEM, the following are red flags associated with fictitious revenues:

An unusually large amount of long-overdue accounts receivable

Outstanding accounts receivable from customers that are difficult or impossible to identify and contact

Rapid growth or unusual profitability, especially compared to that of other companies in the same industry

Recurring negative cash flows from the operations or an inability to generate positive cash flows from operations while reporting earnings and earnings growth

Significant transactions with related parties or special purpose entities not in the ordinary course of business or where those entities are not audited or are audited by a separate firm

Significant, unusual or highly complex transactions, especially those close to the period’s end that pose difficult “substance over form” questions

Unusual growth in the days’ sales in receivables ratio (receivables/average daily sales)

A significant volume of sales to entities whose substance and ownership is not known

An unusual surge in sales by a minority of unites within a company or in sales recorded by corporate headquarters

 

Conclusion

While Enron might feel further and further away in time for some anti-fraud professionals (especially the greener ones), it is clear that there is no room to be complacent about the threat of financial statement fraud. Increased pressure competing with increased regulation and enforcement seems to point toward a new fraud headline sometime in the future. Zack sums it up thusly: “We haven’t had an Enron or WorldCom for several years … we are simply due.”