FINANCIAL STATEMENT FRAUD

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Financial statement fraud is intentionally violating the Financial Accounting Standards Board’s Concept
Statement number one that states that financial statements are to provide information that is useful to decision makers.
Misrepresentations are not useful. Intentional misrepresentation constitutes fraud.
Legal recourse is available when the decision maker relies on the misrepresented information and injury results.
The injury is typically financial. Without intentional misrepresentation it is not fraud. For example, someone could make
decisions using financial statements that do not contain intentional misrepresentations and the decision results in loss
when profit was the goal. This is poor decision making and not fraud.

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FRAUD SCHEMES

Financial statement fraud schemes typically include overstatement of revenues and assets, understatement of
expenses and liabilities, asset misappropriation and inappropriate disclosure. Inventory manipulation has been very
popular and has been somewhat curbed by income tax law requiring that the inventory method used for tax be the same
as that used for financial statements. For example when prices were rising, corporations would use the first in first out
inventory method for financial statements and the last in first out inventory method for the tax reports. This resulted in a
much higher reported profit for financial statements than for tax reports.
Corporations would purchase extra inventory near the year end to increase the reported cost of goods sold for
tax reports and thereby decrease the actual tax due. Shortly after the beginning of a new reporting period, the corporation
would return the excess inventory to the suppliers.

This is just one of many examples where laws were passed requiring that financial and tax accounting methods
to be identical. These requirements were legislated due to extensive manipulations that borders on or crosses the border
into fraudulent financial statement reporting. This inventory illustration is an example of overstating assets for financial
reports and overstating expenses for tax reports. While financial examples focus on overstating revenues and under
stating expenses, there are other variations on the theme of fraud. These will be presented later in this lesson.

[hassan]

FRAUD CHARACTERISTICS
Typical characteristics of financial statement fraud include misstatement or misappropriation of assets. To keep
the balance sheet balanced, the liabilities and owners’ equity usually are misstated or impacted when assets are misstated
or misappropriated.
For example, when asset book values are overstated, the owners’ equity is usually overstated. This increases the
book value of owners’ equity and thereby protects the debt to equity ratio. If the debt to equity ratio is not maintained at a
certain level as prescribed by creditors, then the creditors can step in and increase the interest rate or speed up the
repayment schedule. Both of these actions have the potential of pushing an organization into bankruptcy and thereby
jeopardizing the organization’s status as a going concern.
Protecting the organization’s image as a going concern is one motivation for managers to commit fraud. More
motivations will be briefly presented shortly.
Most organizations that have fraudulent financial statements did not have an audit committee. Having an audit
committee is one of the requirements of the Sarbanes Oxley Act of 2002. The Sarbanes Oxley Act also explicitly puts the
responsibility for preventing and detecting and correcting fraud on the organization’s management and not on the
auditors.
Management’s motives to commit fraud are thought to focus on protecting a job or a potential bonus when
performance is evaluated relative to financial statement results. Managers have said that a motivation to commit fraud
was to make the organization appear to be a going concern so that the organization could acquire and keep excellent
employees, suppliers, customers, creditors and investors. The motivation almost sounds good enough to justify the fraud.
Another motivation to commit fraud what is called insider trading, which is discussed next.