Friday, February 6, 2009

Accounting and Financial Statement Fraud. Who Commits it? Common Reasons why senior management will overstate/understate business performance.

Recently, many big corporate fraud surfaced after their long-time careful concealment, notably Satyam Computer Services (India), Bernard Madoff (USA). In principle, financial fraud will be hard to detect/surface during booming/prosperous period, where constant revenue always exceed their 'concealed' loss. However, during current global financial crisis, where demand and revenue has been significantly dropped, it is difficult to cook the book to conceal their losses. So, expect more scandals being reported in 2009.

Financial statement frauds are caused by a number of factors occurring at the same time, the most significant of which is the pressure on upper management to show earnings. Preparing false financial statements is made easier by the subjective nature of the way books and records are kept. The accounting profession has long recognized that, to a large extent, accounting is a somewhat arbitrary process, subject to judgment. The profession also indirectly recognizes that
numbers are subject to manipulation. After all, a debit on a company’s books can be recorded as either an expense or an asset. A credit can be a liability or equity. Therefore, there can be tremendous temptation—when a strong earnings showing is needed—to classify those expenses as assets, and those liabilities as equity.

Who Commits Financial Statement Fraud?
There are three main groups of people who commit financial statement fraud. In descending order of likelihood of involvement, they are as follows:
1. Senior management. According to a 1999 study of approximately 200 financial statement frauds from 1987 to 1997 by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), senior management is the most likely group to commit financial statement fraud. The CEO was involved in 72 percent of the frauds while the CFO was involved in 43 percent. Either the CEO or the CFO was involved in 83 percent of the cases. Motives for senior
managers to commit financial statement fraud are varied and are described below.
2. Mid- and lower-level employees. This category of employees may falsify financial statements for their area of responsibility (subsidiary, division, or other unit) to conceal their poor performance or to earn bonuses based on the higher performance.
3. Organized criminals. This group may use this type of scheme to obtain fraudulent loans from a financial institution, or to hype a stock they are selling as part of a “pump-and-dump” scheme.

Why Do People Commit Financial Statement Fraud?
Senior managers (CEO, CFO, etc.) and business owners may “cook the books” for several key reasons:
 To conceal true business performance. This may be to overstate or understate results.
 To preserve personal status/control. Senior managers with strong egos may be unwilling to admit that their strategy has failed and that business performance is bad, since it may lead to their termination.
 To maintain personal income/wealth from salary, bonus, stock, and stock options.

We can better deter and detect fraud if we first understand the different pressures that senior managers and business owners can face that might drive them to commit fraud. If we understand the motivating factors behind these crimes, then it stands to reason we will be in a better position to recognize circumstances that might motivate or pressure people into committing financial statement fraud. We will also increase our likelihood of detecting these crimes by knowing the most likely places to look for fraud on an organization’s financials.
As with other forms of occupational fraud, financial statement schemes are generally tailored to the circumstances that exist in the organization. What that means is that the evaluation criteria used by those with power over management will tend to drive management behavior in fraud cases. For example, during the Internet boom, investors pressured dot-com companies to grow revenues rather than to achieve high profits. This type of pressure might drive senior managers
to overstate revenues, but without necessarily overstating earnings. Some Internet companies did this by recording advertising revenue from barter transactions even where no market value for the advertising could be identified. Tight loan covenants might drive managers to misclassify certain liabilities as long-term rather than current in order to improve the entity’s current ratio (current assets to current liabilities), without affecting reported earnings.

The following are some of the more common reasons why senior management will overstate business performance to meet certain objectives:
 To meet or exceed the earnings or revenue growth expectations of stock market analysts
 To comply with loan covenants
 To increase the amount of financing available from asset-based loans
 To meet a lender’s criteria for granting/extending loan facilities
 To meet corporate performance criteria set by the parent company
 To meet personal performance criteria
 To trigger performance-related compensation or earn- out payments
 To support the stock price in anticipation of a merger, acquisition, or sale of personal stockholding
 To show a pattern of growth to support a planned securities offering or sale of the business

Alternatively, senior management may understate business performance to meet certain objectives:
 To defer “surplus” earnings to the next accounting period. If current period budgets have been met and there is no reward for additional performance, corporate managers may prefer to direct additional earnings into the next period to help meet their new targets.
 To take all possible write-offs in one “big bath” now so future earnings will be consistently higher.
 To reduce expectations now so future growth will be better perceived and rewarded.
 To preserve a trend of consistent growth, avoiding volatile results.
 To reduce the value of an owner- managed business for purposes of a divorce settlement.
 To reduce the value of a corporate unit whose management is planning a buyout.

On the next post, I will share How Do People Commit Financial Statement Fraud.

For More information:
Financial Fraud Resources


1 comment:

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