Financial statement fraud, Part 1

By EVERETT E. COLBY, BSBA, CFE, FCGA

This is the first article of a three-part series by Mr. Colby on the topic of detecting and
deterring financial statement fraud to be carried on PD Net.

Introduction
Introduction
What is financial statement
fraud?
Why is it committed?
Warning signs

What do Enron, WorldCom, Tyco, Adelphia, Global Crossing, Xerox, and Parmalat all
have in common? They were all considered financial statement frauds. During the past
seven years, financial statement frauds have grown dramatically in both the number
occurring and the size of the losses. Fraudulent financial statements affect shareholders,
lenders, creditors, and employees. Consequently, many investors have lost confidence in
the credibility of financial statements. 59% of class-action securities lawsuits1 in US during
1997 alleged accounting abuses. This is up from 43% in 1996. In April 1998, Business
Week held its Forum of Chief Financial Officers. During that forum, the CFOs revealed
that 67% of them had been asked by senior company executives to misrepresent the
financial results of the corporation. Of those, 12% admitted that they had in fact actually
misrepresented the financial results! It is estimated that the average financial statement
fraud results in a $5,000,000 misstatement on the books. What is financial statement fraud
and why are so many people committing it?
The failure of accountants to recognize this type of fraud has lead to increasing criticism of
the profession in both the United States and Canada. As a result, new requirements have
been introduced that require the auditor to consider financial statement fraud when
conducting an audit. Internal accountants are also being asked why they did not recognize
what was going on.
Part 1 of this three-part series of articles looks at what financial statement fraud is and what
may be motivating people to commit it. Part 2 will provide some guidance for the
accountant(s) that may be asked to investigate such allegations. Finally, Part 3 will look at
some of the most common types of financial statement fraud and suggest methods that can
help to detect or prevent it. The goal of this series is to create an awareness amongst
professional accountants, new and experienced, internal or external, as to what the warning
signs may be that financial statement fraud could be occurring. Awareness, in terms of
common warning signs/red flags and ways to detect or prevent financial statement fraud, is
considered by most fraud experts to be the number one tool in fighting fraud. In many
fraud cases, especially those involving financial statements, it is very common to see that
those who should have noticed it did not because they were not aware of what red flags
or warning signs were present.

What is financial statement fraud?

The generally accepted definition of financial statement fraud is 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
in order to deceive financial statement users. Management fraud is normally considered
1

For further information, see http://www.sec.gov/news/speech/speecharchive/1998/spch245.txt.

synonymous with financial statement fraud because the production and presentation of
financial statements is managements responsibility. If financial statement fraud occurs,
management almost always has knowledge of the fact.
Financial statement fraud can take many different forms, but there are several methods that
are the most common. These include fictitious revenues, timing differences, concealed
liabilities or expenses, improper disclosure, related party transactions, and improper asset
valuations. From an accounting perspective, revenues, profits, or assets are typically
overstated, while losses, expenses, or liabilities are typically understated. Overstating
revenues, profits, or assets depicts a financially stronger company. Understating losses,
expenses, and liabilities depicts an increase in net worth and equity. Understating revenues or
overstating expenses is indicative of companies who want to reduce their tax liability. It is
evident from known cases that improper revenue recognition, including fictitious revenues
and timing differences, accounts for approximately half of all financial statement frauds.
Once financial statement fraud is committed, it is often necessary for it to continue over time.
If revenues are accelerated in the current year, they will be lower in the subsequent year. This
cycle often leads management to commit the same act the following year.

Why is it committed?
Why are financial statement frauds on the increase? Why are so many people committing
them? Experts point to a number of reasons that may be at the root of this increasing problem:
a good economy may have been masking many problems; an increase in the moral decay of
society; executive incentives such as stock option benefits; stock market expectations which
provided rewards for short-term behaviour; the nature of accounting rules in the United
States; and greed by investment banks, commercial banks, and investors.
Theoretically, there are three factors that appear to be present in every case of financial
statement fraud. These factors are an apparent situational pressure (such as the reasons
previously mentioned), a perceived opportunity to commit and conceal the dishonest act (for
example, the nature of the accounting rules in the United States), and some way to
rationalize the act as justifiable. In simple terms, there is something that prompts otherwise
honest people to consider dishonest acts (pressure), along with the perception that they can
get away with it (opportunity), and an ability to justify why their action was not dishonest
(rationalization). If all three of these factors are present, there is a high likelihood that a
fraud will be committed.

Situational pressure
Situational pressures will prompt an otherwise honest person to commit an illegal act often
because it is seen as the only option. It is typically as a result of an immediate problem or
pressure within either his or her internal or external environment. Examples of internal
pressures would include a sudden decline in revenues or market share that would negatively
impact the organizations performance or share value. Unrealistic performance expectations
or financial pressures from bonus plans that depend on short-term performance are very
common. Another often-cited pressure is the need to satisfy Wall Streets (or other stock
markets) demands for steady growth. External situational pressures are normally economic
pressures that affect the individual. Examples would include living beyond ones means, or a
tremendous feeling of failure from their emotional investment in the company, and the
inability to publicly admit the financial demise of their company.
Other examples of pressures include:

obtaining financing or more favourable terms on existing financing

encouraging investment through the sale of stock
demonstrating increased earnings per share or increased partnership profits thus allowing
dividend or distribution payouts
Financial statement fraud, Part 1 2

dispelling negative market perceptions

obtaining a higher purchase price for acquisitions or sales
demonstrating compliance with financing covenants
meeting company projections and investor expectations, receiving performance-related
bonuses
an overwhelming desire for personal gain
high personal debt
feeling that their pay is not commensurate with responsibility
a wheeler-dealer attitude
a strong challenge to beat the system
excessive gambling habits

Whether it is internal or external, some pressure will always be present. People normally
will not commit illegal acts just for the sake of doing it. There is going to be a reason.

Perceived opportunity
The opportunity to commit and conceal the dishonest act must exist. People do not normally
commit fraud believing they will be caught they do it because they think they can get away
with it. Management is aware of their authority to override controls and, it is often the case,
that controls are overridden in order to commit or conceal the fraud. The opportunity to
commit and conceal the fraud often involves the absence of, or improper oversight by, the
Board of Directors or Audit Committee, weak or nonexistent internal controls, unusual or
complex transactions, accounting estimates that require significant subjective judgment by
management, and ineffective internal audit staff. If there are reasons present that make it
appear to be relatively easy to commit and conceal the fraud, the likelihood of it occurring is
very high. If there is no perception that an opportunity exists, or the perception is that there is
very little opportunity, to commit and conceal the fraud, the likelihood of it occurring is
greatly minimized.

Rationalization
People who commit financial statement fraud are able to rationalize the act. Rationalization is
the ability to justify dishonesty and that is what makes the act possible. The individual must
first convince themselves that their behaviour will be temporary or is acceptable. He or she
might believe that the lies and deceit are for the betterment of the company. There is often the
belief that everything will eventually return to normal. Rationalizations are often dependent
upon the pressure that is present, which causes the individual to consider the dishonest act
in the first place. Rationalizations are also affected by managements tone and ethical
behaviour in running the company. If top management is not committed to integrity and
ethical values, the ability to rationalize dishonest behaviour will be greatly increased.
Top management is responsible for establishing the environment within which all operations
are conducted. Managements commitment to integrity and ethical values is perhaps the most
important factor in minimizing the ability to rationalize dishonest behaviour. Ethical values
and honesty must be stressed and top management must display these qualities. They cannot
just expect everyone else to display these qualities if they do not abide by these values and set
the example for others to follow. A commitment to enforcing integrity and ethical values will
greatly reduce the ability to rationalize the dishonest behaviour.

Warning signs
Historically, one of the principal roles of the auditor has been the detection and prevention of
errors. Recently, that role has been extended to include the detection and prevention of fraud.
It is interesting to note how things have come full circle. At the turn of the 20th century,
auditors were expected to detect and prevent fraud. This standard was attainable because
businesses generated significantly fewer transactions and it was feasible for the auditor to
Financial statement fraud, Part 1 3

vouch all transactions from cradle to grave. This allowed the auditor to be involved in the
detection and prevention of both fraud and errors.
As businesses grew, the volume and complexity of transactions continued to increase. Over
time, it became impossible for the auditor to scrutinize all the transactions conducted by the
organization. During this period, accrual accounting became common and, as a result,
reporting issues became the focus of the profession. By necessity, the practice of vouching
transactions from beginning to end, which helps to detect and prevent many frauds, was
stopped. This meant that fraud detection and prevention took on a secondary role and was no
longer a top priority. Well, the times have changed again!
With all the high profile financial statement frauds that have occurred in the past seven years,
the public and other investors are once again looking to the auditors to detect and prevent
fraudulent activity. Both the United States and Canada have enacted standards that require the
auditor to consider the risk of fraud when conducting assurance engagements. In the United
States, it is the Statement on Auditing Standards (SAS) no. 82 that provides the authoritative
reference and, in Canada, it is CICA Handbook sections 5130, 5135, and 5136. Under these
standards, it is stressed that the auditor must consider and assess the risk that fraud could be
present in the organization not just financial statement fraud, but any fraud. To help meet
this standard, the auditor is urged to use professional skepticism and analyse whether any
warning signs are present that might indicate the probability that fraud is occurring. The
following are some of the most common warning signs that it is highly probable that financial
statement fraud might be occurring. If any of these warning signs are present, it is incumbent
on the auditor to look further into the matter:

weak internal control environment

management decisions dominated by an individual or small group
managers who regularly assume subordinates duties
management has a very aggressive attitude
managers place great emphasis on earnings projections
consistently late reports
company profit lags the industry
company is decentralized without much monitoring
auditors have doubt about company as a going concern
company has many difficult accounting measurement and presentation issues
company has significant transactions or balances that are difficult to audit
company has significant or unusual related-party transactions
managers and employees tend to be evasive when responding to auditors inquiries
managers engage in frequent disputes with auditors
company accounting personnel are lax or inexperienced in their duties

These warning signs do not mean that fraud is occurring. They are indications that there is a
much greater risk that fraud could be occurring. As we have seen with the numerous
financial statement frauds in recent history, one of the first questions that is always asked is,
How did the auditors not see that? Generally, it has been felt that the auditors did not
recognize the warning signs and, therefore, did not undertake to conduct any procedures that
might help them ascertain whether in fact fraud was occurring within the organization. In
light of the United States SAS no. 82 and Canadas CICA Handbook sections 5130, 5135,
and 5136, the auditors must now make an assessment of whether any warning signs are
present and, if they are, perform procedures to determine whether fraud may actually be
occurring. In Canada, these provisions became effective for audits of financial statements and
other financial information relating to periods ending on or after December 15, 2002.
Management is ultimately responsible for the fair representation of the companys financial
statements, and they can increase the likelihood of detecting and preventing financial
statement fraud by implementing practices that will remove or limit one or all of the three
factors present in all frauds. These practices should include a management tone evoking fraud
Financial statement fraud, Part 1 4

deterrence (reduces ability to rationalize), strong internal audit functions (reduces perceived
opportunity), an independent Audit Committee (reduces perceived opportunity), and
designing and implementing a written code of corporate conduct (reduces ability to
rationalize).
Despite the fact that management is ultimately responsible for the fair presentation of the
financial statements, a greater responsibility has been placed on auditors to assess the risk that
fraud might be occurring within the organization. The first step to meeting this standard is to
become aware of and recognize common warning signs. If warning signs are present, the next
step is to perform procedures that will help you assess whether fraud is actually occurring
within the organization.

In part 2 of this three-part series of articles, Mr. Colby will help you develop a systematic
approach to conducting procedures to assist you in assessing if fraud is occurring. Part 3 will
discuss the most common types of financial statement frauds, thereby increasing your
awareness and enhancing your professional judgment in assessing whether financial
statement fraud may be occurring.

Everett Colby, BSBA, CFE, FCGA, is a public practitioner who owns one of the offices of
Porter Htu International consistently ranked by The Bottom Line as one of Canadas top
30 accounting firms. Everett also owns a forensic accounting firm, North American Forensic
Accountants and Fraud Investigators Inc. He is a member of CGA-Ontarios Board of
Governors, chairs CGA Canadas Tax and Fiscal Policy committee, and is a life member of
the International Association of Certified Fraud Examiners. Mr. Colby is a frequent seminar
presenter across Canada and internationally on topics including fraud, money laundering,
the Civil Penalties, and ethics in today's business environment.

Financial statement fraud, Part 1 5