INTRODUCTION TO FINANCIAL STATEMENT FRAUD

Financial Statement Fraud (FSF) is any undisclosed intentional or grossly negligent

violation of generally accepted accounting principles (GAAP) that materially affects the
information in any financial statement. This definition is consistent with the classic legal
definition of fraud, which includes three elements:
1. Intentional Misrepresentation of fact by a perpetrator.
2. Reliance on the misrepresentation by a victim.
3. Injury to the victim resulting from reliance on the misrepresentation.
Regarding public financial statements, it is reasonable to presume that any undisclosed,
material intentional deviation from GAAP automatically involves all three fraud elements.
First, any undisclosed material deviation from GAAP is by definition misleading because
the lack of disclosure leads users to believe the statements comply with GAAP when in
fact they do not. Second, research shows that financial statements are linked to users’
decisions, so it must be presumed that users will rely on the misleading financial
statements. Third, the mere fact that users’ decisions are affected suggest injury.
WHAT IS FINANCIAL STATEMENT FRAUD
Financial statement fraud is the deliberate alteration of the company's financial
statements in order to mislead the users of financial information and create a rosy picture
of the company's financial position, performance, and cash flows. Typically, financial
statement fraud is propagated by management to achieve desired objectives. For
instance, management of a company that is obtaining bank approval for a loan may
misstate their financial statements to create an impression that they can very well pay
for such loan. Management of a firm may misstate financial statements to make their
stock attractive to investors and consequently, increase their stock price. Further,
management may misstate financial statements to justify their bonuses and increased
salaries. This usually happens when management compensation is tied to company
performance.
According to Fraser Sherman; Reviewed by Michelle Seidel,
(https://smallbusiness.chron.com/financial-statement-fraud-57182.html ) Financial
statement fraud is just what it sounds like – falsifying balance sheets, income statements
and cash-flow statements to fool the people who read them. The fraudster may be out
for personal gain, or is trying to keep the business afloat. False financial statements are
one of the many varieties of accounting fraud. They can involve multiple crimes, including
securities fraud and perjury.

Association of Certified Fraud Examiners (ACFE) defines Financial statement fraud 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. Financial statement fraud is
usually a means to an end rather than an end in itself. When people "cook the books"
they may doing it to "buy more time" to quietly fix business problems that prevent their
entities from achieving its expected earnings or complying with loan covenants. It may
also be done to obtain or renew financing that would not be granted or would be smaller
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if honest financial statements were provided. People intent on profiting from crime may
commit financial statement fraud to obtain loans they can then siphon off for personal
gain or to inflate the price of the company's shares, allowing them to sell their holdings
or exercise stock options at a profit. However, in many past cases of financial statement
fraud, the perpetrators have gained little or nothing personally in financial terms. Instead
the focus appears to have been preserving their status as leaders of the entity - a status
that might have been lost had the real financial results been published promptly.
FINANCIAL STATEMENT FRAUD SCHEMES.
The Committee of Sponsoring Organizations (COSO, www.coso.org) of the Treadway
Commission studied Financial Statement Frauds and developed a classification of these
schemes applicable to publicly traded companies. The COSO report identifies schemes
in the following areas:
1. Improper revenue recognition.
2. Overstatement of assets (other than accounts receivable related to revenue fraud).
3. Understatement of expenses/liabilities
4. Misappropriation of assets.
5. Inappropriate disclosure.
6. Other miscellaneous techniques.
About half of all FSFs involve overstating revenues and overstating assets, with
overstating revenues being the most common type of financial statement fraud.
Overstating Revenues. This type of financial Statement Fraud can be carried out in the
following ways:
1. Sham Sales. This scheme involves recording fictitious sales and frequently includes
falsified sales, inventory and shipping records. In some cases, company employees
go so far as to hide part of the inventory to make it appear that the hidden items
have been sold.
2. Premature revenue recognition. Process by which company employees record
sales after receiving customer orders but before shipping the goods.
3. Recognition of conditional sales. Process by which employees record sales for
transactions that are not yet complete because of unresolved contingencies. In
some cases, employees make secret agreements with the customer that alter the
terms of the sale. For example, a company could secretly agree that the customer
can return all unsold goods.
4. Abuse of cutoff date of sales. Normally, a company’s books are “closed” at the end
of each reporting period, and sales that occur after the closing date do not appear
on the current period income statement. Some companies keep the books open
after the closing date and include the next period’s sales on the current period
income statement.
5. Misstatement of the percentage of completion. Revenue from some types of
contractual work, such as construction, is considered to be earned according to the
estimated percentage of the project completed. In this scheme, employees
overstate the percentage that projects are completed and thus overstate
revenues.
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 6. Consignment sales. Employees ship goods to customers on a consignment basis
but record the shipments as normal sales. As with unauthorized shipments, this is
done at the end of the accounting period to record the sale in the current period.
When the goods are returned in the next period, they are charged against the next
period’s sales.
Over Stating of Assets. This is done using the following methods:
1. Inventories. The most common inventory fraud involves the overstatement of
ending inventories.
2. Accounts receivable. Accounts receivable are overstated by understating
allowances for bad debts or falsifying account balances.
3. Property, Plant, and Equipment. In this scheme, depreciation is not taken when it
should be, or property, Plant, and equipment is simply overstated. A
corresponding overstatement is made to the revenues.
4. Other overstatements. These involve other accounts such as loans/notes
receivable, cash, investments, and so on. In some cases, expenses may also be
understated.
Improper Accounting Treatment.
1. Recording an asset at market value or some other incorrect value rather than cost.
2. Failing to charge proper depreciation or amortization against income.
3. Capitalizing an asset when it should be expensed.
4. Improperly recording transfers of goods from related companies as sales.
5. Not recording liabilities to keep them off the balance sheet.
6. Omitting contingent liabilities (e.g. pending product liability lawsuits, pending
government fines) from the financial statements.
Fictitious and fraudulent transactions. This involves recording sham transactions and
legitimate transactions improperly. For example, the company purchases a machine for
N8,000,000 with cash but records it as follows:
Debit: Machine N10,000,000
Credit: Cash N8,000,000
Credit Sales N2,000,000
Fraudulent transaction processing. Intentionally misprocessing transactions to produce
fraudulent account balances. For example, accounting software is modified to incorrectly
total sales and accounts receivable so that all transactions in the account are real but the
total is overstated.
Direct falsification of Financial Statements. Producing false financial statement when
management simply ignores account balances.

CHARACTERISTICS OF FINANCIAL STATEMENT FRAUD

Financial statement fraud typically has certain known characteristics. Some of these
include the following:
1. Fraud tends to involve a misstatement of misappropriation of assets that is a
substantial portion of total assets. The median amount of the fraud is
approximately 25 percent of the median total assets.
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 2. Most frauds span multiple fiscal period with the average fraud time being
approximately two years.
3. Financial Statement Fraud is much more likely to occur in companies whose assets
are less than $100 million
4. Financial Statement Fraud is much more likely to occur in accompanies with
decreased earnings, earnings problems, or a downward trend.
5. In a large majority of cases, either the CFO or CEO is involved in in the fraud.
6. In many cases, the board of directors has no audit committee or one that seldom
meets, or none of the audit committee members has the required skills to perform
as intended.
7. The members of the board are frequently dominated by insiders (even related to
Managers) or by those with financial ties to the companies.

MOTIVES FOR MANAGEMENT TO COMMIT FINANCIAL STATEMENT FRAUD.

Management has various motives for committing Financial Statement Fraud. These
includes:
1. Poor Income Performance. Most Financial Statement Frauds, especially in large
companies, are committed to make the income statement look better. Poor
income performance can cause managers to loose their jobs/or salary bonuses as
well as devalue managers’ stock options or shares in the company.
2. Impaired Ability to Acquire Capital. Management produces fraudulent financial
statements to facilitate capital acquisition. Poor Financial results can impair a
company’s ability to raise capital through financing and other types of equity
offerings.
3. Product Marketing. Management seeks to hide financial problems to keep buyers,
who tend to shy away from companies that are having financial problems. Buyers
are often afraid of entering into long-term relationships with companies that could
be going out of business.
4. General Business Opportunities. Everyone likes to do business with a winning
company. This apply to opportunities such as joint ventures and mergers.
Managers sometimes commit financial statement fraud to make their company
look better and increase their access to business opportunities.
5. Compliance with Bond Covenants. Fraud is performed to hide the company’s
inability to meet bond or other covenant conditions.
6. Generic Greed. Management produces fraudulent financial statements as a way
to get ahead or keep their positions, increase salaries and other management
benefits, and meet terms of incentive based contracts.

EFFECTS OF FINANCIAL STATEMENT FRAUD ON COMPANY AND MANAGEMENT

Financial Statement Fraud affects the company and management in several ways. They
include the following:
1. In majority of cases, an enforcement action for Financial Statement Fraud is
bankruptcy or a change in ownership.
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 2. In many cases, companies are delisted from a national stock exchange. Delisting
tend to be associated with large declines in company’s Market Value.
3. Managers accused of Financial Statement Fraud are often named in class-action
civil suits.
4. Accused managers are often fined or their employment with the company is
terminated.
5. Offenders are permanently bar from serving as corporate officers or directors.

PREVENTION OF FINANCIAL STATEMENT FRAUD.

The Sarbanes-Oxley Act (SOX) Act of 2002 focuses on preventing financial statement
fraud. Compliance with this act is mandatory for publicly traded companies, but much of
its application can be useful for private companies. The U.S. Congress passed the
Sarbanes-Oxley Act of 2002 on July 30 of that year to help protect investors from
fraudulent financial reporting by corporations. Also known as the SOX Act of 2002 and
the Corporate Responsibility Act of 2002, it mandated strict reforms to existing securities
regulations and imposed tough new penalties on lawbreakers.

The Sarbanes-Oxley Act of 2002 came in response to financial scandals in the early 2000s
involving publicly traded companies such as Enron Corporation, Tyco International plc,
and WorldCom. The high-profile frauds shook investor confidence in the trustworthiness
of corporate financial statements and led many to demand an overhaul of decades-old
regulatory standards.

The general philosophy behind SOX is to minimize Financial Statement Fraud by

promoting Strong Corporate governance and organizational oversight through the
oversight of the following six organizational groups;

1. Board of Directors. A board of directors must have competent, experienced

members who actively participate in the company’s governance process. They
have the ultimate responsibility for the company. Board members should be
financially independent from the company except for board related compensation.
2. Audit Committee. The Audit Committee should consist of Board Members with
knowledge and experience in accounting and accounting systems. The committee
should work closely with the int4ernal auditors, external auditors and
management to ensure the integrity of external audit process. It should carefully
investigate any problems pointed out by management or external auditors.
3. Management. The CEO and CFO have the primary responsibility for implementing
enterprisewide internal control processes and ethics management. Both must be
actively involved in all major aspects of internal control process development.
4. Internal Auditor. Internal Auditors should report directly to the Audit Committee.
The goal of this requirement is for the Audit Committee to serve as an independent
check on top management and to independently ensure quality internal control
processes and compliance.
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 5. External Auditor. External Auditors should be independent of the company in both
fact and appearance. SOX prohibits external auditors from providing nonaudit
services to the company except within narrow constraints.
6. Public Oversight Bodies. Various public oversight groups can help in preventing
Financial Statement Fraud.

Among the six groups, the audit committee is the one that is the most critical in the
immediate sense. It has primary responsibility for selecting, hiring, and communicating
with the external auditor. These functions are critical because a good external audit is a
strong defense against financial statement fraud. The audit committee also oversees the
internal auditor(s), who provides one more layer of security against Financial Statement
Fraud.

If the audit Committee does its job well, Financial Statement Fraud can occur only if there
are three independent failures involving management, the internal auditor, and the
external auditor. This situation is unlikely if all three of these functions in fact operate
independently and the audit committee takes seriously its oversight function.
RED FLAGS/INDICATIONS OF POSSIBLE FINANCIAL STATEMENT FRAUD.
Research has identified a number of red flags associated with Financial Statement Fraud.
Some of these indicators are present in large percentage of Financial Statement Fraud
cases, although their presence in no way means that fraud is actually present in a
particular. The various red flags are:
1. Lack of independence, competence, oversight, or diligence. Lack of independence
between management, internal auditors, and external auditors will undermine the
basic structures designed to prevent Financial Statement Fraud. Any lack of
competence, oversight, or diligence on the part of the audit committee or the
internal auditor is a possible indication for Financial Statement Fraud.
2. Weak Internal Control Processes. Weak internal control processes or failure of top
management to participate actively in developing and overseeing internal control
and lack of corporate code of conduct with no related employee training and
awareness are indications for possible financial statement fraud.
3. Management Style. The following management styles can give room for financial
statement fraud: Excessive pressure on employees to perform; Excessive focus on
short-run performance, which could cause employees to cheat to achieve goals;
Excessively authoritarian style that can cause employees to blindly agree to
participate in fraudulent schemes; Excessive decentralization resulting in
management oversight that is too lax; etc
4. Personnel-Related Practices. These includes high employee turnover, especially
among top management; hiring unqualified employees or hiring without screening
the background of potential employees; inexperienced top management;
inadequate employee compensation; and low employee morale.
5. Accounting practices. These include restatements of prior year reports; aggressive
accounting methods; weak audit trials; losses of accounting records; weak or

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 poorly organized accounting information system; overly optimistic or inadequate
budgets; arguments with auditors or lack of cooperation with auditors or the audit
committee; late or last-minute financial reports; large or unusual end-of-year
accounting adjustment or transactions; frequent changes of the external auditor;
and large or frequent accounting errors.
6. Industry Environment and conditions. Volatility, especially when other firms in the
same industry have problems and a one-product company in a declining industry
are indications for a Financial Statement Fraud to be committed.

CASES OF FINANCIAL STATEMENT FRAUD

WorldCom: Boosting Earnings in a Big Way.
WorldCom improperly capitalized billion of dollars of costs that should have been
charged to the income statement as expenses. The company sought to conceal the fraud
by sprinkling the expenses over a large number of different capital accounts.
Nortel: The Ultimate Big Bath.
In one quarter, Nortel Networks Corporation announce that it was taking $18.4 Billion in
charges for restructuring costs, bad customers debts, and obsolete inventory. This
became the world’s record at the time for the largest big bath, and many argued that the
reserves relating to the restructuring were excessive. Nortel used the reserves over a
three-year period, improving income during that period.
McKesson & Robbins: Financial Statement Fraud.
This early fraud took place in 1930s. McKesson and Robbins was a drug company that
not only sold pharmaceutical alcohol to the mob but also created fictitious customers as
well as inventories in fictitious warehouses and sales.
Equity Funding: they made a movie about it.
This 1970’s fraud was so large and infamous that the story was made into a movie, The
Billion dollar Bubble. Equity Funding created and sold a large number of fake insurance
policies at their present value and misreported them on its financial statements. The
scheme lasted for nine years and involved as many as 100 company employees until one
employee blew the whistle. The result was a collapse of one of Wall Street’s darling
companies and billion of dollars in losses.
Cadent Corporation: Manufacturing Revenues
An ex-official of what is now Cadent Corp. (previously CUC International) was sentenced
to 10 years in prison and ordered to personally pay more than $3 billion in losses. The
alleged scheme involved the creation of $500 million in fictitious revenues. When the
accounting irregularities became public, the company’s stock price fell from its 52-week
high about $41 per share to nearly $13 per share.
The Great Salad Oil Swindle.
This is one of the most famous inventory fraud cases of all time. It happened during the
1960s when a vegetable oil company hired a highly respected accounting firm to audit it
inventory of 1.8 pounds of salad oil. The salad oil firm needed the inventory audit to be
able to use the inventory as security for bonds that it wanted to issue.

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The salad oil was in a large storage tanks. The auditors climbed to the top of each tank,
opened the hatches and put their fingers to verify the presence of the salad oil. The only
problem was that the tanks were full of water with only a thin layer of salad oil floating
on the surface. The auditors “passed” the inventory, the bonds were issued, and may
people lost a lot of money.
Cadbury false accounting
On April 11, 2008, Nigeria’s Security and Exchange Commission (SEC) imposed a fine of
N21.2 million (USD180,783) on Cadbury Schweppes’s local Nigeria Unit for falsifying its
accounts between 2002 and 2005. Cadbury is a leading maker confectionary in Africa’s
most populous country. An official internal review showed that the accounts was
overstated by n13.25 billion. The investigation showed that, Bunmi Oni, the managing
director in agreement with the board, between 2002 and 2005, used stock buy-back, cost
deferrals, trade loading and false suppliers stock certificates to manipulate its financial
reports that were issued to the public and filed with the commission, as reported by SEC.
the Investors in the Company lost heavily as the share price experienced a down turn
(Osaze, 2011).
SEC further reported that, Oni who was fired shortly after the fraud was discovered
manipulated the books of account with connivance of external auditors and the company
registrars. The regulator ban Oni and suspended several directors and senior employees
from dealing with the Nigerian Stock Market. The external auditor was ordered to pay a
fine of N20 million and the registrar N8.3 million within 21 days or forfeit their
registration with SEC.
Toshiba Institutional Misreporting
Following the financial meltdown of 2007/2008, Toshiba, one of the Japan’s oldest and
most respected companies, exhorted the leaders of its many business units to meet
aggressive targets for more revenue and profitability. When the circumstances could not
support the tall ambition, the managers altered the books to provide the illusion they
had met their performance goals. The findings of the investigation were released in 2015.
The accounting frauds took a long period and were perpetrated under a number of CEOs.
The key methodology was under the percentage-of-completion method for contract
work. Between 2008 and 2013, expenses were massively understated in earlier period
and overstated in later periods. The Company overstated its profit (2008 to quarter 3 of
2014) by over USD1.3 billion.
Enron and WorldCom Financial Statements Frauds
The Enron debacle revealed an overstated profit of over USD 586 million in four years
while in Worldcom, operating expenses of over USD 3.8 billion were capitalised, thus
overstating the profit . It was discovered in 2001. Bourke (2010) reported that in the
wake of high profile frauds in Worldcom and Enron, the average loss per case increased
to USD 400 million. The author reported that the Enron scandal led to the disintegration
of Arthur Anderson, an international accounting firm. The fraud in Enron that was
discovered in 2001 led to the formation of Sarbanes-Oxley committee, the
recommendations of the committee were codified in the Sarbanes-Oxley Act of 2002 of
the United State of America.
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 SUMMARY
Financial statement fraud is any international or grossly negligent violation of generally
accepted accounting principles (GAAP) that is undisclosed and materially affects any
financial statement. Fraud can take any forms, including hiding both bad and good news.
Research shows that financial statement fraud is relatively more likely to occur in
companies with assets of less than $100 Million, with earnings problems, and with loose
governance structures. In a large majority of cases, the CEO or CFO is involved.
Most Financial Statement Frauds involved revenue or asset overstatements; revenue
overstatement is the most common method. The two most common methods of revenue
overstatement involve sham sales and premature revenue recognition. Other
overstatement methods include recognition of conditional sales, improper cutoff of sales
dates, improper treatment of consignment and percentage of completion sales, and
channel stuffing. Other general methods include improper accounting treatments,
fictitious or fraudulent transactions, and fraudulent transaction processing.
Assets overstatement is the second most popular method of financial statement fraud;
the most common type is inventory overstatement because it requires only overstating
the count of ending inventories, but no fictitious transactions or elaborate cover-up
schemes.
Financial statement fraud frequently causes severe financial damage to investors and
creditors. Large frauds sometimes produce damages in billions of dollars. Managers
accused of financial statement are often named in class action civil suits, terminated from
their employment, fined, and sentenced to prison terms.
Frauds are committed for a variety of reasons such as to cover up poor performance to
obtain capital, market products, obtain business opportunities, and comply with bond
covenants. Other reasons relate to general greed and cover-up misappropriation of
company funds.
Financial statement fraud can best be prevented by a strong and diligent governance
structure that includes an independent audit committee, an independent internal
auditor, an independent external auditor, and a management that sets the appropriate
tone and culture from the top of the organization.
Various red flags can indicate an increased possibility of financial statement fraud. They
include declining net income, declining sales, lack of liquidity, governance structure, weak
internal control processes, autocratic management, overly detached management, too
much pressure to achieve immediate success, high employee turnover, low morale,
aggressive accounting methods, restatements of previous periods results, late financial
reports, and financial problems.

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 REFERENCES.
Hopwood, Leiner, & Young (2013). Forensic Accounting and Fraud Examination (2nd
Edition)
ACFE (2016). Report to the Nations on occupational Fraud and Abuse. Global Fraud Study,
Glossary of terminology.
Bourke, N. M (2006). Are Attributes of Corporate Governance Related to the Incidence of
Fraudulent Financial Reporting? Newzeland: The University of Waikato.
Investigation Report (2015). Summary Version: Independent Investigation Committee for
Toshiba Corporation (English translation version).
Osaze, E. (2011). The specificities of Value Melt Down in the Nigerian Stock 2008 – 2010.
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