Detecting financial statement fraud: What every corporate manager needs to know

Fast forward a few years later. The “perp walks” have taken place, Congress has enacted the Sarbanes-Oxley Act, former high-flying executives have been brought to trial and sentenced to lengthy prison terms, and affected companies have either emerged from bankruptcy, sold off assets, or disappeared altogether. And lawmakers, regulators, and late-night comedians have moved on to more timely topics.

Although corporate fraud is not currently dominating the headlines, it is still a top of mind concern for corporate executives. One in five of the companies interviewed for Ernst & Young’s most recent Global Fraud Survey experienced significant corporate fraudulent activity in the past two years.

From 1999 to 2003, the number of Securities and Exchange Commission (SEC) enforcement cases relating to financial statements and reporting alone more than doubled. In fact, the sweeping regulations of Sarbanes-Oxley, designed to help prevent and detect corporate fraud, have exposed fraudulent practices that would have gone undetected before. And more corporate executives are paying fines and serving prison time than ever before. Energy companies have not been immune to fraudulent situations and the negative publicity that swirls around it.

The implications for management are clear: every organization is vulnerable to fraud, and managers must know how to detect it - or at least when to suspect it.

Fraud: What it is and how it happens

Before examining the most common types of fraud and how to detect them, it’s worth reviewing what fraud is, why it happens, and how it manifests itself in corporations.

Defining fraud is the easy part. According to the Association of Certified Fraud Examiners (ACFE), fraud is “deception or misrepresentation that an individual or entity makes knowing that the misrepresentation could result in some unauthorized benefit to the individual or to the entity or some other party.” In other words, mistakes are not fraud.

Why does fraud happen? A useful model for this discussion is the “fraud triangle” described by Donald R. Cressey, a criminologist who studied embezzlers.

Cressey said three factors are typically present when a fraud occurs: rationalization, opportunity, and pressure. While discussion of rationalization is best left to psychology textbooks, opportunity and pressure are directly tied to today’s corporate environments and can be influenced significantly by management.

Opportunity can arise from lack of organizational controls and security; a company deficient in these areas is creating ample opportunity for fraud to occur. Pressure can be created by the demands to hit numbers that meet Wall Street expectations and that can increase compensation under management incentive plans.

Most important, this pressure can affect the “tone at the top,” or the implicit messages that management sends to employees by virtue of emphasis, proportion, and frequency. A tone that places a disproportionate emphasis on financial results or stock price may send the message that cutting corners is acceptable. Management would be well-advised to examine both the opportunities and pressures that exist in their organizations.

Corporate fraud generally falls into one of three categories. The first, and by far the most common category, is asset misappropriation - essentially, stealing. According to the 2006 ACFE Report to the Nation on Occupational Fraud & Abuse, asset misappropriation accounted for 91.5% of corporate fraud in the cases studied. In a distant second place, accounting for about 30.8% of the fraud cases studied, is the catch-all category of corruption. Corruption can include conflicts of interest, bribery, and extortion. The least-frequent form of fraud cases in the study is fraudulent financial statements - fudging the numbers. (Note: percentages sum to greater than 100% because some cases represented more than one fraud category.)

Misstatements: The toll in dollars and damage

It is this last category that should receive the most attention from public company managers because it is by far the most expensive, in terms of both absolute dollars and long-term damage. According to ACFE, the median loss of a fraudulent statement incident is $2 million, compared with $538,000 and $150,000 for corruption and asset misappropriation, respectively.

When taking into account the loss of investor confidence, as well as reputational damage and potential fines and criminal actions, it should be clear why financial misstatements should be every manager’s worst fraud-related nightmare.

Moreover, Ernst & Young’s most recent annual Global Fraud Survey suggests that companies doing business in emerging markets - and, given the global nature of the oil patch, there are few energy companies that don’t - may be underestimating the risk of financial statement fraud. While respondents to the survey considered bribery and corruption as the greatest fraud risk in emerging markets, our experience demonstrates that lack of management and controls can cause significant financial statement errors in business units at remote locations.

Schemes, red flags, and questions to ask

While opportunity for misstatement exists on each line of every financial statement, a handful of culprits account for the majority of cases. It’s incumbent upon managers to be familiar with them and to know which “red flags” might indicate their presence. Of course, red flags are not sure-fire signs of fraud. Rather, they are signs that questions need to be asked - and that reasonable answers need to be found.

To help managers know when to raise eyebrows and start asking questions, the Association of Certified Fraud Examiners has developed a list of common accounting fraud schemes and associated red flags. More details are available in the ACFE’s publication Fraud and the CPA: Understanding Why Employees Commit Fraud. The ACFE’s schemes and red flags are listed below, along with a series of questions that managers should ask when the red flags appear.

Overstating revenues

Starting at the top is always a good idea - and in a very literal sense when it comes to the income statement. Overstating or improperly recognizing revenues is a common form of financial statement fraud.

Schemes

• Recording gross, rather than net, revenue
• Recording revenues of other companies when acting as a “middleman”
• Recording sales that never took place
• Recording future sales in the current period
• Recording sales of products that are out on consignment

Red flags

• Increased revenues without a corresponding increase in cash flow, especially over time
• Significant, unusual, or highly complex transactions, particularly those that close near the end of a financial reporting period
• Unusual growth in the number of days’ sales in receivables
• Strong revenue growth when peer companies are experiencing weak sales

Questions to ask

• Why did revenues increase sharply during the end of the period compared with prior-year and current-year results and the budget forecast?
• How does revenue growth compare with that of peers during the same period? If substantially higher, does the explanation make sense?
• Did receivables increase due to a particular customer? If so, should a reserve be established?

Understating expenses

Another common number-fudging technique is understating expenses, which leads to increased operating income and net income.

Schemes

• Reporting cost of sales as a nonoperating expense so they do not negatively affect gross margin
• Capitalizing operating expenses, recording them as assets on the balance sheet instead of as expenses on the income statement
• Not recording some expenses at all or not recording expenses in the proper period

Red flags

• Unusual increases in income or income in excess of industry peers
• Significant unexplained increases in fixed assets
• Recurring negative cash flows from operations while reporting earnings and earnings growth
• Allowances for sales returns, warranty claims, etc., that are shrinking in percentage terms or are otherwise out of line with those of industry peers

Questions to ask

• Why did gross margin (by location, product, and geographic area) increase during year-end or period-end compared with the prior-year and current-year budget forecast? Does the explanation make sense?
• How does the company compare to competitors in terms of net income during the same time period?
• What were the major additions to fixed assets during the year? Is the treatment of recording assets consistent with that of prior years?

Improper asset valuations

This is an area that is particularly relevant to energy companies. Highly publicized asset write-downs following the disclosure of faulty reserve reports should make all energy company managers pay special attention to how they report their most important hard assets.

Schemes

• Manipulating reserves
• Changing useful lives of assets
• Failing to take a write-down when needed
• Manipulating estimates of fair market value

Red flags

• Recurring negative cash flows from operations while reporting earnings and earnings growth
• Significant declines in customer demand and increasing business failures in either the industry or the overall economy
• Assets, liabilities, revenues, or expenses based on significant estimates that involve subjective judgments or uncertainties that are difficult to corroborate

Questions to ask

• How is the overall economy affecting customer demand and business? Declines in both could be a signal that there might be an asset impairment issue involving inventory or allowance reserves.
• For areas where there are significant estimates, what is the method used to determine the estimate?
• Is this method consistent with that of prior periods?
• What supporting documentation is available to support the calculation?

Other common areas for financial statement fraud

The following are also schemes used frequently to “cook the books” and make results look better than they really are.

Schemes

• Smoothing of earnings. Often referred to as using “cookie jar reserves,” this involves overestimating liabilities during “good” periods, storing away funds for future use against declining revenues
• Disclosing information improperly, especially concerning related-party transactions and loans to management
• Executing highly complex transactions, particularly those dealing with structured finance, special-purpose entities and off-balance sheet structures, and unusual counterparts

Red flags

• Domineering management
• Decision to fix accounting in the next period
• No apparent business purpose
• “Reality” of transaction differs from accounting or tax result
• Significant related-party transactions
• Counterparts that lack economic substance
• Multiple memos rationalizing an aggressive accounting treatment

Questions to ask

• Is there an overly aggressive push by management to meet previously disclosed revenues or earnings targets?
• Can management explain the business purpose for entities that are outside the consolidated financial statements?
• Were there significant adjustments made at the end of the period?
• Has there been an unusual focus on achieving a certain accounting treatment?
• Does the business purpose make sense?
• Does the preferred accounting treatment allow the company to meet certain targets?
• Has there been a change in the method of calculating the reserve estimates for any item from that used in the prior quarter or prior years? If so, why?

When fraud is suspected

Ideally, questions that are prompted by red flags will result in answers that make perfect sense. But when they don’t, it’s time to consider two actions: notifying the audit committee and calling in the forensic accountants.

Forensic accountants are the crime scene investigators of the financial world. They have extensive experience examining the DNA of financial statements, sifting through e-mail records, documents, and data entries, and conducting extensive interviews to uncover and explain the most complex financial statement fraud. They’re also trained to uncover and preserve evidence to make it admissible in court should the need arise.

When engaging forensic accountants, it’s important to consider three qualifications. The first is forensic accounting experience. The abundance of corporate scandals of the last few years has created a forensic accounting boom, and many accountants with other backgrounds have established themselves as forensic accountants. It’s important to find out how long they have been practicing forensic accounting and whether the personnel who will be examining your red flags have appropriate credentials (e.g., are they CPAs or CFEs [Certified Fraud Examiners]?).

The second qualification is industry experience. This is particularly important for energy companies. A forensic accountant fluent in financial statements for a manufacturing or retail company might be lost trying to navigate the engineering and geophysical components of an investigation into the possible overstatement of oil and gas reserves.

The third qualification is the breadth of services offered by the firm and its global reach. While a forensic accounting specialty shop might be able to conduct a solid, professional investigation of a small matter, it may not be able to address the issues that led to the fraud in the first place-issues like inadequate financial controls, insufficient or nonexistent processes, or weak information technology infrastructure and security.

A full-service firm, on the other hand, can move from a fraud investigation to the fraud prevention initiative that should follow. For energy companies operating internationally, a firm that can operate seamlessly on a global basis is critical to ensure that all elements of activity can be included in the investigation.

Trust your judgment

Although red flags almost always accompany fraud, many financial misstatements are either reported too late to prevent major damage or aren’t reported at all. Sometimes that’s because managers aren’t paying attention. But sometimes it’s because they’re afraid to act.

This can be the result of not wanting to know the truth. But often, it’s a result of not trusting one’s judgment or intelligence. Managers may think there’s a simple explanation for a red flag and that asking about it will reveal their ignorance or lack of financial sophistication. But any company’s accounting should be understood by its management. If it’s not, it may be due to questionable or fraudulent accounting rather than unsophisticated managers.

Managers should always trust their judgment and intelligence when considering accounting red flags. Sometimes they will have legitimate explanations. But other times they may be only the tip of an iceberg of financial statement fraud.

About the authors

Barry Mabry [[email protected]] is a partner in Ernst & Young’s Fraud Investigation & Dispute Services (FIDS) group, responsible for the Gulf Coast area. He also serves as the practice and service line leader of Energy, Chemical, and Utilities (ECU). He has more than 30 years’ experience in litigation support, business valuations, corporate restructurings, and corporate finance. A licensed arbitrator, CPA, management accountant, and fraud examiner, Mabry has testified as an expert witness in numerous state and federal courts.

Sheri Toivonen [[email protected]] is a partner in Ernest & Young’s FIDS group. She has more than 20 years’ experience in public accounting, specializing in financial fraud services, forensic account services, and lost profits disputes. Additionally, she serves on the FIDS leadership team as the national practice leader for people initiatives. In this role, she oversees recruiting, retention, and education of all FIDS personnel. Toivonen is a CPA and fraud examiner.