Spotting Financial Statement Fraud, Part 2: Ill-Gotten Gains

In the first segment of this article series, we examined a model, developed by Dr. Donald R. Cressey, that explains how and why a trusted individual might commit fraud, known as the Fraud Triangle. In Part 2 of this series, we explore common methods that are used to commit financial statement fraud.

The benefits of financial statement fraud seem obvious: as with everything else in business, it’s all about the money. Globally, according to the ACFE, businesses lose more than $3.5 trillion across the globe every single year to fraud, both internal and external.

Financial statement fraud, however, offers numerous opportunities for deception.

Among these are fictitious or overstated sales & revenue, with invented revenue streams or artificially inflated sales from fake customers, or exaggerated sales to real customers; and asset value manipulation, which involves substituting capital expenditures for operating expenditures, listing fictitious assets on a statement, or overstating the value of actual assets.

There’s also inflated company valuation, one of the more nebulous and common forms of fraud, precisely because it’s difficult to detect and can be a simple mistake or misjudgment rather than a crime. Nonetheless, it is highly dangerous and can result in huge profits from investors or severe punishment if detected by the Securities & Exchange Commission (SEC) or other regulators.

Next up is phantom revenue, defined as income and assets not based on real sales, services, or manufacturing. Consignment items can be listed as already sold; sales may be listed as paid when still pending; prebilling can be filled in for future sales; and past due accounts can be reinvoiced to look like new charges.

Altered accounting methods are perhaps the easiest way to commit financial statement fraud, as they can be as simple as improperly writing off expenses or failing to disclose liabilities or obligations—or as complex as keeping two sets of books, posting false transactions to conceal revenue or mask embezzlement, or failing to disclose transactions through subsidiaries, partners, or other related parties.

These were only a sampling of most common forms of financial statement fraud. A clever executive or owner, one with a deep knowledge of the company and the regulatory environment in which it operates, can find many ways to manipulate financial statements for personal gain or for the ‘good’ of the organization.

Having reported on the who, why and how of financial statement fraud, our third and final article in this series will provide methods to detect when it is occurring at your own business or with a trusted trading partner.