Understanding financial statement fraud

As financial statement fraud is a significant problem for organizations, but it can be difficult to detect and even harder to prevent. We're sharing insights into the most common types of financial statement fraud, factors that increase risk, and how to prevent and detect these crimes. 

What is financial statement fraud?

Financial statement fraud refers to the deliberate or intentional misstatement or misrepresentation of an organization’s financial statements. Often, this is done by omitting or exaggerating information to make the organization’s financial position and performance look better or to hide evidence of embezzlement or similar crimes.

Solve the crime and earn CPE with Red Flag Mania

Types of financial statement fraud

Within Generally Accepted Auditing Standards (GAAS), an auditor is mainly concerned with fraud that leads to a material misstatement within the financial statement. There are two specific types of intentional misstatements that are relevant to auditors:

• Misstatements that result from fraudulent financial reporting, including omissions, misrepresentation or misclassifying amounts or disclosures in financial statements
• Misstatements resulting from misappropriation of assets 

More specifically, financial statement fraud may include: 

Revenue recognition fraud 

Revenue recognition fraud refers to when an organization falsifies or misrepresents their financial statements by improperly recognizing revenue. This may include recording fake sales, prematurely recognizing revenue, or inflating sales numbers. 

Liability and expense manipulation 

Expense manipulation occurs when the organization’s expenses are understated to increase profits (on paper). This may involve misclassifying expenses, delaying recognition of expenses or capitalizing costs that should be expensed. 

Improper asset valuation

An organization may inflate the value of their property, inventory or investments to inflate their net worth or underreport debt or obligations to make their financial position appear stronger. 

Improper disclosures 

An organization may misrepresent financial arrangements to cover risks or reduce their liabilities. They may also fail to disclose transactions, especially those with related parties like executives or subsidiary companies. 

Financial statement fraud risk factors 

There isn’t one reason why organizations stoop to financial statement fraud, but understanding the common fraud risk factors and motivations can help with detection and prevention. 

Financial pressure 

• Pressure from internal management or external stakeholders to meet financial targets such as revenue growth or profit goals 
• Pressure to avoid triggering loan defaults or other consequences if the organization reports their actual financial standing 
• Pressure on individuals to meet specific metrics to earn a bonus or other incentive 

Opportunities 

• Weak internal controls allow individuals to exploit weaknesses and commit financial statement fraud without detection 
• Complex accounting transactions create opportunities to misrepresent or manipulate information 
• A weak ethical structure or minimal focus on ethics contribute to an environment where unethical behavior, even fraud, may go unchecked. 

External influences 

• Pressure to meet market expectations or achieve industry benchmarks from analysts, investors, or even peers drive the organization to submit fraudulent financial statements to appear more competitive 
• Adverse economic conditions prompt the organization to commit financial statement fraud to project the appearance of stability and avoid stock price declines 

It’s important to note that while these are more organizational motivations behind financial statement fraud, sometimes, the motivation can be as simple as an individual acting in their own self-interest. 

Signs of financial statement fraud 

Often, it’s easier to determine an error rather than fraud, because those responsible are likely to do what they can to hide the evidence. But while it can be difficult to recognize financial statement fraud, there are some common red flags. 

Unusual trends or variations 

• Increases or decreases in revenue that are inconsistent with industry norms or economic conditions 
• Unexplained changes in gross margins that can’t be attributed to legitimate business factors 
• Significant variations in expense ratios or cost structures compared to either historical data or industry competitors 

Weak internal controls 

• Lack of adequate separation of duties that allow individuals within the organization to initiate, approve and record transactions without oversight 
• Opportunities for management or key personnel to override established controls without valid reasons 

Accounting irregularities 

• Unusual or undocumented journal entries; pay particular attention to those made near the end of reporting periods 
• Incorrectly categorized transactions may mask the reality of underlying economic events 
• Overly complex transactions or arrangements can be used to obscure information 

Performance outliers 

• Significant transactions or entities that deviate from typical business patterns or lack necessary supporting documentation 
• Instances of non-recurring or one-time items that inflate the financial performance

Behavioral indicators 

• Management avoids or is reluctant to provide transparent explanations of information when asked 
• Management shows lifestyle changes or behaviors that are out of alignment with the organization’s reported financial results 

Additional signs of financial statement fraud 

• Inconsistent or slow responses from third parties during confirmation procedures 
• Frequent or substantial adjustments made to account balances or financial statements with no reasonable explanation 
• Inconsistent or omitted financial disclosures, footnotes or supplemental information 

Preventing and detecting financial statement fraud 

The main responsibility for preventing and detecting fraudulent financial statement lies with both the organization’s governance and management. 

Under the oversight of governance, management should strongly focus on preventing fraud by reducing opportunities and deter it by increasing the likelihood of detection and punishment to those caught. This requires fostering a culture of honesty and ethics, actively supported by governance. 

Governance must also oversee these practices to prevent manipulation of financial reporting, like managing earnings to change how financial statements are viewed by users regarding the organization’s performance and profitability. 

Detecting fraud in financial statements 

As an auditor, these steps can help you detect financial statement fraud. It’s important to note that you should not make legal determinations of whether fraud has occurred, but simply follow GAAS to detect possible fraudulent activity. 

• Assessing the organization’s susceptibility to fraud and identifying risk factors 
• Assessing and testing internal controls 
• Conducting a comparative analysis to identify unusual fluctuations or trends in financial data 
• Analyzing financial ratios and comparing them to industry benchmarks 
• Testing transactions to verify the occurrence, completeness and accuracy of recorded transactions 
• Assessing management’s representations, including evaluating their integrity and interviewing key personnel 

Preventing financial statement fraud 

The auditor can help the organization prevent financial statement fraud by assisting in these measures: 

• Promoting ethical behavior 
• Recommending the implementation of whistleblower programs 
• Providing training on fraud risk, detection and ethical responsibilities 
• Assisting the organization to develop and implement fraud prevention programs 
• Making recommendations to strengthen internal controls 
• Advising management on the importance of maintaining effective internal controls 
• Communicating any fraud or material misstatements to those charged with governance 
• Complying with legal and regulatory requirements 

Learn more about financial statement fraud with CPE courses from Becker

 If you’d like to take the next step to learn more about fraud, ethics, and other topics, Becker has the CPE courses you need to expand your knowledge while meeting your state’s requirements. Check out these individual courses: 

• Analytical Procedures Used by Auditors
• Auditing Cash and Cash Equivalents
• Fraud Investigation
• Fraud Update 2024
• Financial Statement Fraud

With Becker's Prime CPE subscription, you'll get full access to our course catalog at an incredible value!