How to spot accounting fraud
The Enron scandal. The Worldcom scandal. When one thinks of accounting fraud, it is likely that these are some of the cases that come to mind. However, most cases of accounting fraud will not make news headlines and can happen in companies of all sizes and industries. Do you know how to spot it?
How widespread is corporate fraud?
A study on the pervasiveness of corporate fraud estimates that in an average year, 41 percent of companies are committing accounting violations, which are less severe than alleged securities fraud. Meanwhile, in an average year, 10 percent of large public corporations commit (alleged) securities fraud (i.e., a misrepresentation, information omission, or other misconduct). Researchers stated that, “In spite of all the regulation, roughly half of the US financial statements suffer from misreporting more serious than pure clerical errors.”
In today’s economic environment, which is riddled with rising costs and uncertainties, the risk of increased fraud remains high.
“The risk of accounting fraud is always heightened when there is pressure on companies to meet certain objectives. When we are in a downward economy there is always a heightened risk of fraud. Now, we are not officially in a downward economy, but I think there’s a lot of concerns about where the economy is going to go in the next few months, and so on, so that certainly increases the risk in terms of accounting fraud per se,” said Anne-Lise Dorry, Senior Director, Editorial for Thomson Reuters.
Clearly, it is important that accounting professionals have an understanding of accounting fraud and how to spot deceptive accounting practices.
What is accounting fraud?
When a person engages in accounting fraud, they are intentionally manipulating accounting records to make the company’s financial picture seem better than it actually is. When someone is found guilty of committing accounting fraud, they are subject to criminal prosecution.
Common types of fraudulent accounting
There are several types of accounting fraud that tend to be most prevalent. These include overstating revenues, understating expenses, and misappropriation or misrepresentation of assets.
Overstating revenues
To improperly inflate revenues, a company may post sales before they are made or prior to payment. They may not make proper provisions for returns, or sales made to related parties may not be properly recorded as revenues. Furthermore, keeping the books open for a few days past month-end in an effort to rake in additional sales transactions in the prior month is an overstatement of revenues.
Understating expenses
When understating expenses, a company may fail to accrue expenses for services consumed within the month but not yet billed to the business. They may improperly keep certain liabilities “off the books,” capitalize standard operating expenses, or fail to report accounts payable.
Misrepresentation of assets
Overstating the value of capital assets or not properly recording depreciation expenses are forms of accounting fraud. Furthermore, companies that overstate assets like accounts receivable and inventory are committing accounting fraud.
Additional forms of accounting fraud can also include:
- Misreporting tax liabilities to the IRS
- Filing false insurance claims or banking applications
- Improper timing of revenue recognition
What is an example of deceptive accounting?
It is important to keep in mind that accounting fraud isn’t always black and white. There are gray areas. What does this mean?
Convicted felon Andy Fastow, the infamous chief financial officer of Enron Corp., explained during a panel discussion on fraud that too often “companies are exploiting the accounting rules, accounting assumptions, and they’re using structured finance in order to make their financial statements look healthier than they really are.”
Fastow stressed that auditors must distinguish between “what is accurate according to the rules and what is accurate in reality.” To further explain, he provided the following example:
In 2014, the average price of oil was $95 per barrel. For most of the year, the price was $110, but it dropped to $50 at the end of the year. The rule at the time told companies exactly what number to use when they calculate their economically recoverable reserves. The company takes the price of oil on the first day of each of the 12 preceding months and averages it, or $95. But the price was $50 at year end. So the price was $50 when every oil and gas company released its financial statement.
“I can say with a high degree of certainty that at that point in time, none of those oil and gas companies had 95 on their 10-year forward price curve any longer,” Fastow said. “All of them followed the rule. They used 95. All of them massively overstated their economically recoverable reserves, which is perhaps the most important metric that Wall Street looks at when they evaluate independent oil and gas companies.”
How do you spot accounting fraud?
Here are some red flags that accountants should have on their radar in their day to day:
- Seeing a company report an increase in revenues at the very end of the year.
- Reversals of revenue transactions at the beginning of the following year is a red flag. For instance, there are returns, discounts, etc., being provided and not recorded, or not recorded in a timely manner, resulting in inflated revenues.
- If a company’s revenues are growing but the cash flows are not growing, that could be a red flag.
- If an industry is struggling and an entity within that industry is not being impacted, that could give reason for a closer look.
- Any unusual Q4 trends are worth investigating.
“What’s usually the most difficult to detect is the non-recording of a transaction because it is easy to check something that has been recorded and a lot harder to spot something that hasn’t,” said Dorry, pointing to the importance of internal controls. “And there’s always professional skepticism and experience that also comes into play. Some things you’re used to seeing that all of the sudden you’re not seeing, or the other way around, is always something that should alert you.”
There are also some behavioral red flags to keep in mind. According to ACFE research, behavioral red flags that have been exhibited by perpetrators include, but are not limited to:
- A person (e.g., a client) living beyond their means (39 percent)
- A person (e.g., a client) is facing financial difficulties (25 percent)
- A person (e.g., a client or employee) is unusually close with a vendor/customer (20 percent)
- A person (e.g., a client or employee) has control issues and is unwilling to share duties (13 percent)
What are ways to prevent accounting fraud?
Knowing the red flags to watch for is important, but it is ideal to prevent fraud before it happens. For companies, this involves setting the proper tone at the top, stressing their code of ethics, and ensuring proper internal controls are in place.
“I think when you’re talking about inside a [client’s] company, the tone of the talk is very, very important and [the company’s] code of ethics is also very important. That is part of your overall governance. Clearly, that is one of the key tools you have in your toolbox against fraud,” said Dorry. “Internal controls are there to prevent not just fraud but errors as well. Internal controls — if they are well thought out, well implemented, well tested and adjust to different conditions — they will certainly catch a lot.”
Preventing accounting fraud also involves having the right tools and resources in place, such as Thomson Reuters Checkpoint Engage audit methodology. Take action today to better serve your clients and help spot and stop deceptive accounting practices.
To read more about other problems in the accounting industry, read “Top accounting issues in 2023”.
