1.3 Nature of Financial Statement Fraud

Financial statement fraud, also referred to as management fraud, involves intentional deceit and concealment, often through falsified documentation, forgery, and collusion among management, employees, and third parties. Unlike other types of fraud, where employees and others fraudulently take advantage of the organization, when financial statement fraud takes place, management acts on behalf of the organization to make the organization appear more profitable than it actually is.

Like most types of fraud, financial statement fraud is rarely seen. When fraud does occur, fraud symptoms, indicators, or red flags are usually observed. Because these symptoms can also be caused by other, legitimate factors, the presence of fraud symptoms does not always indicate that fraud exists. For example, a document may be missing, a general ledger may be out of balance, or an analytical relationship may not make sense. However, these conditions may be the result of circumstances other than fraud. Documents may have been legitimately lost. The general ledger may be out of balance because of an unintentional accounting error; and unexpected analytical relationships may be the result of unrecognized changes in underlying economic factors. Caution must be exercised even when reports of alleged fraud are received, because the person providing the tip or complaint may be mistaken or may be motivated to make false allegations.

Fraud symptoms cannot easily be ranked in order of importance or combined into effective predictive models. The significance of red flags varies widely. Some of these factors will be present when no fraud exists; alternatively, a smaller number of red flags may exist when fraud is being perpetrated. It can even be hard to prove fraud once it is suspected. Without a confession, a number of repeated, similar fraudulent acts (so fraud can be inferred from a pattern), or obviously forged documents, it is very difficult to convict someone of fraudulent behavior. Because of the difficulty of detecting and proving fraud, accountants and auditors must exercise extreme care when conducting audits, performing fraud examinations, trying to quantify fraud, or performing other types of fraud-related engagements.

Financial statement fraud is just one of the many problems that have been plaguing corporate America during the past couple of years. In addition to misstated financial statements, here are other ethical lapses that have caused embarrassment for firms, corporations, and individuals:

  • The confession by Lance Armstrong that he had participated in an elaborate doping scheme, helping him to win the Tour de France on multiple occasions.

  • Massive Consumer and Investment Frauds: Examples include Bernie Madoff and Sir Allen Stanford.

  • Sub-prime greed resulting in loss of confidence in financial markets and failure of/or losses by many firms.

  • Financial Statement Frauds in Countries throughout the World: Most notably Satyam (India), but also Parmalat (Italy), Harris Scarfe and HIH (Australia), SK Global (Korea), YGX (China), Livedoor Co. (Japan), Royal Ahold (Netherlands), and Vivendi (France) to name just a few.

  • Executive Loans and Corporate Looting: Examples include John Rigas of Adelphia and Dennis Kozlowski of Tyco.

  • Insider Trading: Examples include Martha Stewart and Sam Waksal of ImClone.

  • CEO Retirement Perks: Examples of companies which suffered negative press because of excessive CEO retirement perks include Delta, PepsiCo, AOL Time Warner, Ford, GE, and IBM. (The perks included activities such as consulting contracts, use of corporate planes, executive apartments with meals, maids, etc.)

  • Exorbitant Stock Options for Executives: Bernie Ebbers, for example, in one year made significantly more – up to 40 times more – in exercising stock options than in cash and other compensation.

  • Backdating and other problems involving stock options: MonsterWorldwide, for example, backdated millions of dollars' worth of employee stock option grants to make it look as though they had been granted when Monsters' stock prices had been periodically low.

While many of these problems deserve serious consideration by anyone studying problems with corporate reporting, this course will focus specifically on financial statement misstatements.

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