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FINANCIAL STATEMENT FRAUDS—AN
OVERVIEW
SUBMITTED TO
Prof. Savita Dahiya
Audit Practice and Secretarial Practice
SUBMITTED BY
Shriya Tandon
21011557
BCOM LLB
Section B
2nd Year, 1st Semester
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Overview of Financial Statement Frauds, Schemes and Mind Maps of Business Finance
An overview of financial statement frauds, including their characteristics, types, schemes, warning signs, detection, and prevention. It explains the major categories of schemes used in financial statement frauds, such as fictitious revenue, timing differences, improper asset valuation, concealment of liabilities or obligations, and improper disclosures. It also describes the fraud triangle, which consists of incentive/pressure, opportunity, and attitude/rationalization. The document highlights various warning signs that point to questionable business practices and arouse suspicion when inspecting financial statement fraud.
Typology: Schemes and Mind Maps
2020/2021
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FINANCIAL STATEMENT FRAUDS—AN
OVERVIEW
SUBMITTED TO
Prof. Savita Dahiya Audit Practice and Secretarial Practice
SUBMITTED BY
Shriya Tandon 21011557 BCOM LLB Section B 2 nd^ Year, 1st^ Semester
TABLE OF CONTENTS
- INTRODUCTION
- DESCRIPTION AND CHARACTERISITICS
- TYPES OF FSF
- FSF SCHEMES
- CHARACTERISTICS
- WARNING SIGNS
- DETECTION
- PREVENTION
- CONCLUSION
DESCRIPTION AND CHARACTERISITICS
As stated, financial statement fraud is a deliberate attempt on a firm’s part to defraud readers of published financial statements by creating and distributing materially misstated financial statements. In this section, we’ll be digging deeper into what financial statement fraud truly is.
TYPES OF FSF:
There are two types of misstatements^2 which are relevant to the auditor's consideration of fraud:
1. Misstatements arising from fraudulent financial reporting: these are defined as “ intentional misstatements or omissions of amounts or disclosures in financial statements designed to deceive financial statement users. ” The financial statements are not presented in accordance with generally accepted accounting principles (GAAP) in all relevant aspects because of the effect. The following are some ways that fraudulent financial reporting may be carried out: a. The falsification, alteration, or manipulation of accounting records or other supporting documentation used to produce financial statements. b. Events, transactions, or other key information intentionally misrepresented in the financial statements or omitted entirely. c. Misapplication of accounting standards regarding quantities, classifications, presentations, or disclosure that is done on purpose. 2. Misstatements resulting from asset misappropriation (also known as theft or defalcation): these entail the theft of an entity's assets when the result of the theft prevents the financial statements from being presented in a manner that is, in all material aspects, consistent with GAAP. Asset misappropriation can be carried out in many ways, such as through stealing assets, embezzling receipts, or convincing an institution to pay for services or goods that it has not yet received. To hide the truth that the assets are gone, misappropriation of assets frequently involves the creation of fraudulent or deceptive records or documentation (perhaps by circumventing controls), which indirectly results in irregular accounting in financial statements. (^2) Supra note 1
FSF SCHEMES:
Following are the major categories of schemes^3 used in financial statement frauds:
1. Fictitious Revenue: the scheme involves claiming the sale of services and goods that did not take place, like double-counting sales, creating fake or phantom customers, and inflating or altering invoices of legitimate customers to represent higher than genuine amounts. Several accounts are used in the scam. Sales that have conditions or terms that have not been fulfilled and where the buyer's rights to ownership and risk have not yet been transferred constitute another type of fictitious revenue. After the reporting period, fraudsters may undo the phony sales to cover up their deception. Example of such a scheme: employees of Wells Fargo in 2016 created millions of checking and savings accounts on behalf of their clients, without their consent, to meet impossible sales goals. 2. Timing Differences: another type of financial statement fraud is the purposeful recording of income or spending during unfitting periods. As a result, earnings can rise or fall as needed during desired times. Here, the revenue is underestimated in one fiscal period by setting aside funds that can be repaid in subsequent, less prosperous seasons. Other examples include pre-billing for future orders, reinvoicing past-due accounts, and publishing sales before they have been made or paid for. 3. Improper Asset Valuation : overstates (as well as understates) a company's assets and paints them in a more favourable financial light. This scheme takes place when a company fails to employ proper depreciation schedules or valuation reserves (e.g., inventory reserves). It can involve incorrectly valuing inventory, fixed assets, accounts receivable, investments (securities or other investments without a ready market for sale), and securities. Creating bogus receivables, not writing down obsolete stock on a firm's balance sheet, fiddling with appraisals of an asset's useful life, and exaggerating residual value are also examples of what it could entail. As a result, net income and retained earnings will be overestimated, inflating shareholders' equity. 4. Concealment of Liabilities or Obligations: financial statements can be manipulated to make a company appear more lucrative by understating obligations and expenses. Keeping liabilities or obligations off the financial statements to artificially increase equity, assets, or net earnings is known as concealment. Loans, warranties included with purchases, and improperly reported health benefits, salary, and vacation time are a few examples. Simply failing to record liabilities is the easiest technique for concealing obligations. Since missing transactions don't create an audit trail, they can be more difficult to find than incorrectly recorded ones. 5. Improper Disclosures: here, items including major events, related-party transactions, contingent liabilities, and accounting adjustments are hidden or left out of the financial statements. To avoid deceiving the reader, financial statements must disclose facts clearly and accurately. If accounting changes have an effect that materially affects the financial statements, they must be disclosed. (^3) Beaver, Scott. Financial Statement Fraud: Detection & Prevention. Oracle NetSuite, 8 Apr. 2022. https://www.netsuite.com/portal/resource/articles/accounting/financial-statement-fraud.shtml.
WARNING SIGNS
Forensic accountant searches for warning signs that point to questionable business practices and arouse suspicion when they inspect financial statement fraud. Management can reduce the chance of financial statement fraud and lower future risks by becoming familiar with these typical fraud indications^5 :
1. Financial Warning Signs: Certain patterns stand out to investigators as suspicious and unusual when someone has perpetrated an FSF, such as increasing sales without a commensurate increase in cash flow (most prevalent warning sign); a substantial and unexplained shift in either assets or liabilities; the book value of assets, such as inventory and receivables, unusually rising; frequent, convoluted third-party transactions that appear to offer no value, have no rational commercial purpose, and make it difficult to ascertain the true nature of a given transaction; destructive revenue recognition techniques, such as recognizing revenue before the product or service was sold or rendered, etc. 2. Behavioural Warning Signs: The Association of Certified Fraud Examiners (ACFE) reports that while performing their crimes, 85% of fraudsters showed at least one behavioural warning sign. These behavioural warning signs will manifest in the fraudster's professional and private lives. Examples: untrustworthy, confrontational, aggressive, and unreasonable management attitudes; a manager or accountant living beyond their means and/or experiencing financial issues; control issues, such as a refusal to delegate responsibility for managing the business' money, etc. 3. Organizational Warning Signs: A company's corporate structure and operational procedures can show whether there are favourable conditions for financial statement fraud. False or misleading information can stay uncontested in a setting where accounting processes and controls are lax and do not adhere to governance best practises. Examples include frequent organisational changes such as exceptionally high management or key accounting staff turnover; disproportionate or unexplained management bonuses based on short-term goals; excessive focus on achieving quantifiable goals, etc. 4. Business Warning Signs: Potential fraud may be indicated by external circumstances including general industry downturns and extreme departures from peer business norms. An astute auditor will notice business outcomes and organisational behaviour that appear to be at odds with the general industry trends, such as profitability and/or operating margins that are not in line with associates; significant investments in risky industries or during downturns in those industries; unusually high revenue and low expenses at times that cannot be accounted for by seasonality, etc. (^5) Supra note 3
DETECTION
Following are three popular methods that can help detect FSF^6 :
1. Vertical Analysis: total sales on the income statement serve as the base amount, and all other elements are then assessed as a percentage of that total. It highlights how statement items relate to one another during each accounting period. Statement anomalies can be identified using these correlations and historical averages. The analysis makes comparing financial accounts between companies and across industries considerably simpler. This is because account balance ratios are visible. Additionally, it facilitates the comparison of prior periods for time series analysis, which compares quarterly and annual numbers over the years to see whether performance indicators are increasing or declining. 2. Horizontal Analysis: compares historical data (like ratios or line items) from various accounting periods. It examines the annual percentage change in several financial statement components. The first year is regarded as the base year, and changes after that are calculated as percentages of the base period. It enables analysts and investors to identify trends and growth patterns and to understand what has been influencing a firm's financial standing over the years. Analysts can evaluate relative changes in various line items over time and predict them using this form of analysis. 3. Ratio Analysis: is a way of calculating the correlation between two figures on financial statements. To evaluate a firm's success, ratios are computed using the data from the current year and then compared to those from prior years, other businesses, the industry, and even the economy. Internal evaluations utilizing financial statement data are possible with ratio analysis. Its two main components are relationship and comparison. Financial statement ratios are compared to industry averages to gain additional insight. It becomes clear that there could be an issue when the financial ratios show a considerable change over the years. (^6) “How to Detect and Prevent Financial Statement Fraud.” General Techniques for Financial Statement Analysis , pp. 119 – 129. https://www.fraud-magazine.com/uploadedFiles/Shared_Content/Products/Self- Study_CPE/How%20to%20Detect%20and%20Prevent%20Financial%20Statement%20Fraud%202017_Chapte r%20Excerpt.pdf.
CONCLUSION
Financial statement fraud has many victims, including the public whose trust is betrayed by leaders who don't uphold standards, investors whose intentions are thwarted by false perceptions of success, firm personnel whose jobs and pensions are jeopardized when fraud is discovered, and investors themselves. The best course of action is to familiarise oneself with fraud's warning signs and detect it as early as possible. One must also apply stringent restrictions to suppress any surfaced desires of individuals who wish to conduct financial statement fraud.