The Nuts and Bolts of Financial Statement Fraud

Financial statement schemes continue to rank among the most-costly types of occupational fraud for all types of organizations. The costs frequently encompass more than just the loss of assets. Victimized companies also may suffer lost shareholder value, lower employee morale, premature tax liabilities and reputational damage. You may be able to help your clients minimize their risks and losses by understanding how and why financial statement fraud occurs, and how such schemes could be uncovered.

The High Cost of Financial Statement Fraud

The Report to the Nations on Occupational Fraud and Abuse published in 2016 by the Association of Certified Fraud Examiners (ACFE) found that only 9% of the fraud schemes in its survey involved financial statement fraud. However, those cases clocked the greatest financial effect, though, with a median loss of $1 million. Moreover, in about 76% of the financial statement schemes, the perpetrator was also engaging in at least one other form of occupational fraud, such as asset misappropriation or corruption.

What makes financial statement fraud especially problematic is that the costs can easily snowball out of control, far beyond what was initially contemplated. For example, when an executive fudges the numbers to make a company appear more profitable, the company will likely incur greater liability for taxes or dividends. It might be necessary to take on debt to make those payments, leading to higher interest costs. Or an acquisition of a healthy company might be pursued to hide the actual underperformance.

In keeping with the established bi-annual update cycle, the 2016 Report to the Nations on Occupational Fraud and Abuse was recently released. Contact PBTK if you’d like us to send you a courtesy copy by email.

Common Financial Statement Fraud Schemes

The ACFE defines financial statement fraud as “a scheme in which an employee intentionally causes a misstatement or omission of material information in the organization’s financial reports.” The methods for committing such fraud aren’t just limited to the overstatement or understatement of assets or revenues.

Some of the most prevalent schemes include:

Concealed liabilities. Here, liabilities or expenses are recorded improperly. For example, a fraudster might record revenue-based expenses as capital expenditures to increase net income and total assets for the current accounting period or omit significant expenses or liabilities to boost reported profits and working capital.

Fictitious revenues. Sales may be artificially reported or inflated. For example, perpetrators may record sales that are subsequently reversed in the next accounting period, or they may create phantom customers.

Improper asset valuations. Financial performance may artificially be enhanced by misstating the value of assets — such as failing to write off obsolete inventory — or inflating receivables by booking fictitious sales on account.

Improper disclosures. Fraud occurs when perpetrators fail to disclose material information to mislead users of the financial statements. For example, they may fail to report pending litigation, or a potentially material contingent liability.

Timing differences. Recording revenues in accounting periods different from those of their corresponding expenses can mislead investors.

Revenue recognition is a particularly ripe area for financial statement fraud. Early revenue recognition can be accomplished through several avenues, including 1) keeping books open past the end of the accounting period in respect to sales revenues, 2) delivering products early before sales have actually occurred that would otherwise be a liability, 3) recording revenue before full performance of a contract, and 4) backdating sales agreements. In addition, merchandise could be shipped to undisclosed warehouses and recorded as sales. In general, ask questions if a large percentage of revenue is recorded at the end of a period.

Causes of financial statement fraud

According to the ACFE, individuals who committed financial statement fraud were more likely to be under excessive organizational pressure compared with those who perpetrated corruption or asset misappropriation. Fraudsters may feel pressure to meet earnings expectations or satisfy certain conditions that are required to close a merger or acquisition. They might commit financial statement fraud in an attempt to make the company look more profitable than it truly is, thereby boosting share prices, fulfilling loan covenants or allowing them to earn bonuses.

Help your clients help themselves

Companies that fall prey to financial statement fraud can find their long-term survival severely threatened. By bringing in qualified forensic accountants, you can help these companies identify red flags, ferret out ongoing schemes and deter future fraudsters.

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Who Commits Fraud?

The latest Report to the Nations on Occupational Fraud and Abuse compiled demographic information on more than 1,400 fraudsters. The findings indicate that the majority of occupational frauds (78%) were committed by staff at the managerial or employee level. But, not surprisingly, the frauds committed by owners and executives had the highest median loss ($500,000).

Some 7% of the fraudsters were in their first year on the job, and 53% had been with their organizations for more than five years. The longer the fraudster was with the company, the larger the losses typically were. Similarly, 52% of perpetrators were ages 31–45, but older fraudsters tended to cause larger losses. These figures coincide with the finding that greater losses are associated with fraudsters with higher levels of authority — and, in turn, more opportunity to commit costly fraud schemes.

Vendor Fraud: Read the Warning Signs

Vendor fraud can be one of the worst violations of a business owner’s trust because it involves the collusion of an employee with an outside party or a conspiracy between two or more — often longtime — suppliers. Such collusion can be costly. According to the Association of Certified Fraud Examiners, the median loss in a fraud committed by a single person was $80,000, but when incidents involved two perpetrators, the median loss jumped to $200,000. When four or more perpetrators were involved, the median loss exceeded $500,000.

So it’s important that organizations know how to spot vendor fraud. Here are summaries of two common schemes.

Fix, Rig and Divide

Most people are at least somewhat familiar with the concept of price fixing. But contrary to popular belief, price fixing isn’t only an agreement among competitors to set the same price for goods or services. It also refers to competitors jointly establishing a price range or minimum price.

A similar fraud scheme is bid rigging, which involves collusion, where two or more vendors agree to steer a company’s purchase of goods or services. A bid-rotation scheme calls for all participating vendors to submit bids while taking turns as the low bidder. Under a bid-suppression scheme, two or more vendors illegally agree that at least one of the participants will withdraw a previously submitted bid or not bid at all. The intent is to ensure acceptance of one particular bid. Complementary bidding is marked by competing vendors submitting token bids with a high price or special terms that will make them unacceptable to the company.

Another way vendors cheat is through market division. This occurs when competitors agree not to compete in a specific segment of a market — whether based on geography or customer type. If bids are solicited by a customer in that segment of the market, the competitors either won’t bid or will submit complementary bids. A lack of competitive bidding functions to drive up the price for the soliciting company.

Overcharging Tricks

Vendors might involve an employee on the inside by paying that person kickbacks to facilitate his or her employer’s payment of a fraudulent invoice. The vendor typically incorporates the kickback amount in the price charged, thereby compounding the amount the company is overbilled.

Kickbacks aren’t the only vehicle for overbilling a company. Vendors can submit invoices for their goods and services that are inflated in several subtle ways. The price charged may exceed the prices agreed upon in the related contract. In other cases, the invoice might reflect charges for more goods than the customer actually received. Or a vendor could alter the date on a genuine invoice and submit for duplicate payment.

To Catch a Scheme

Train your management team about the types of vendor fraud that could be occurring in the organization. Although it’s difficult to recover damages once an incident has occurred, catching a scheme early can help limit losses. They might consider, for example, hiring an expert to conduct an analysis of vendor payments (broadly), often referred to as an integrity analysis. The analysis can focus on pre-selected vendors that represent a heightened risk whether by virtue of purchasing volume, relationships with organization management or tips received.

Better yet, encourage companies to put strong internal controls in place that will discourage their employees from attempting this type of theft. Further, organizations may consider instituting a bribery prevention policy, including prohibiting the acceptance of vendor gifts to employees and their families, or designing reporting and monitoring processes for any gifts or discounts received from a vendor.

Please contact us if you or a client may need such an analysis.

ACFE Chapter Leader Profile: Michael Rosten, CFE, CPA

“Let’s dive in, and get it done.” This motto has helped guide Mike Rosten’sprofessional career for more than 30 years. Mike has been the president of the Las Vegas Chapter since 2014. When he’s not working at Piercy Bowler Taylor & Kern, he’s likely spending time with his wife and three kids, grilling and hiking in the mountains.

What do you do for a living?
As a Principal, I help my clients solve problems by providing litigation, forensic and fraud investigation services. This includes suspected embezzlement investigations, economic damage assessments (lost profits, breach of contract, reasonability from a defensive perspective, etc.), alter ego analyses and asset tracing. I also develop business intelligence and insight for clients from financial data and public-source information.

Why did you decide to enter the anti-fraud field?
After working in both tax and audit, I saw the anti-fraud field as one of the most interesting and exciting parts of accounting. It’s the “rock and roll” part of our industry. I’ve always had an aptitude for solving problems and determining the substance of transactions. I find it very rewarding to locate the hidden or underlying picture/facts.

How has the CFE benefited your career?
The CFE has provided me recognition as an anti-fraud professional in the business and professional accountancy communities, and has opened many doors for me professionally and personally.

When I first became a CFE nearly 20 years ago, I recall explaining to various contacts that I performed forensic accounting and fraud investigations. At that time, I was commonly asked if I was performing accounting for deceased individuals!

We have certainly come a long way as a CFE community, and through our future leaders I hope the ACFE and its chapters continue to evolve in increasingly positive ways.

How long have you been involved with the chapter?
I joined the Las Vegas ACFE Chapter not long after relocating from the Dallas-Fort Worth area in 2004 as a way to network among the fraud prevention and detection community, and to obtain training. I received the CFE credential in 1997 and it was important for me to maintain my involvement with the ACFE as I had in Texas.

What has been a highlight during your time on the board?
Seeing the attendance increase at our quarterly training sessions has been very rewarding for me. When I first became president we averaged around 70-80 individuals. Now the current attendance level is 125-135 participants.

I have also enjoyed working with the various qualified and energetic personnel at the ACFE headquarters in Austin..

What goals would you like to help the chapter accomplish?
I would like our Las Vegas chapter to be a forum for training qualified personnel who will then go out and advance the mission of the ACFE using their diverse individual skills and knowledge. Our chapter should enable professional and personal networking among like-minded professionals and create a richer experience for everyone involved with fraud investigation, fraud prevention and forensic accounting work.

Do you have any advice for other chapter leaders?
Foster an environment of inclusion of the various chapters domestically and around the world by:
1. Keeping the organization ahead of personal agendas and emotions. Through your leadership, don’t get in the way, but instead be a facilitator.
2. Soliciting input from all factions of the local chapter membership. Consider polling members through Survey Monkey or other similar protocols. Add new blood to the chapter board of directors to gain additional points of view.
3. Implementing an official or ad hoc educational/training committee.
4. Keeping costs low — extraordinary cost does not necessarily make for an effective chapter. In Las Vegas, we have a turn-key pricing structure where all members pay a $175 flat fee, which can be prorated for new members based upon remaining training hours in a year; however, that fee covers all meals — full breakfast or lunch and attendance at all training events. There are no additional costs.

What do you consider your greatest achievement to date?
Being a father to three energetic children and a 29-year marriage to my wonderful wife.

What are your favorite activities and hobbies outside of work?
I enjoy grilling on my barrel smoker that survived the move from Texas 12 years ago and is still in use. Some favorites include chicken fajitas and teriyaki flank steak during our wonderful springtime weather in Nevada. I also spend a lot of my free time hiking and endurance trail running. Although Southern Nevada is a desert, the surrounding mountains stretch upwards to approximately 12,000 feet in elevation and the views are amazing!

ACFE Report to the Nations: Typical Organizations Lose 5 percent of Annual Revenue to Fraud Each Year

For Immediate Release                                                                                           

May 5, 2016

For More Information Contact:

Shannon Hiller, PBTK

Shiller@pbtk.com or 702-384-1120

 

ACFE Report to the Nations: Typical Organizations Lose 5 percent of Annual Revenue to Fraud Each Year

[LAS VEGAS, Nev] (May 5, 2016) – The Association of Certified Fraud Examiners (ACFE) published the results of its most recent global fraud survey in its highly anticipated 2016 Report to the Nations on Occupational Fraud and Abuse. Here are some of the key findings from the 92-page report (all values in U.S. dollars):

Fraud is incredibly costly. The total cost of the frauds reported in the study was over $6.3 billion, with 23 percent of the cases costing more than $1 million. The study respondents estimated that the typical organization loses 5 percent of its annual revenue to fraud each year. When applied to the 2014 estimated Gross World Product of $74.16 trillion, this translates to potential global fraud losses of up to $3.7 trillion.

Small businesses are especially at risk. The study found that organizations with fewer than 100 employees faced the same median cost per instance of fraud as companies with more employees. However, less than half of the smaller organizations had implemented some of the most basic anti-fraud controls like implementing a fraud hotline, and establishing a management review and code of conduct.

Hotlines are becoming an expected control in most companies. In the study, CFEs reported that 60.1 percent of the organizations they worked with had a fraud reporting hotline in place, an 8.9 percent increase from the findings reported in 2010.

Physical documents are still key components in fraud. For the first time, respondents were asked how fraudsters attempted to cover their tracks. Even in such a technologically driven world, fraudsters are still relying on creating fraudulent physical documents, altering existing physical documents or destroying those documents.

The Report to the Nations also details findings such as how fraud risks varied by industry, how the implementation of anti-fraud controls affected exposure to fraud, the breakdown of fraud statistics by geographical region and the most common behavioral traits observed among fraud perpetrators.

The 2016 Report to the Nations is available for download at www.ACFE.com/RTTN.

The first Report to the Nation was published by the ACFE in 1996. The ACFE has published subsequent editions in 2002, 2004, 2006, 2008, 2010, 2012, 2014 and now 2016. Over that time, the report has come to be regarded as the most authoritative statistical resource available on occupational fraud.

About Piercy Bowler Taylor & Kern

Piercy Bowler Taylor & Kern is a full-service accounting and business advisory firm that provides accounting and auditing, tax, consulting, valuation and litigation support services. Founded locally in 1990, the firm specializes in the casino gaming and leisure time industries, governmental and not-for-profit organizations, real estate development and construction industries and the legal and general business communities. Now with offices in Salt Lake City, Utah, and Las Vegas, Nevada, PBTK is one of the few independent accounting firms in its local markets to perform SEC audits. For more information on PBTK, visit pbtk.com or call Shannon Hiller at 702.384.1120.

 About the Association of Certified Fraud Examiners

Founded in 1988, the ACFE is the world’s largest anti-fraud organization and premier provider of anti-fraud training and education. Together with more than 75,000 members, the ACFE is reducing business fraud worldwide and inspiring public confidence in the integrity and objectivity within the profession. For more information, visit ACFE.com.

 

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