Module 5
Management Fraud
a. The Problem of Financial Statement Fraud
The significance of stock and bond markets within a capitalist economy cannot be
overstated. These markets serve as vital conduits for the allocation of capital, facilitating
the flow of funds from investors to businesses in need of financing. The efficiency,
liquidity, and resiliency of these markets are paramount to the functioning of the broader
economy, as they enable businesses to raise capital for expansion, innovation, and
investment in productive assets.
At the heart of these capital markets lies the trust and confidence of investors,
lenders, and regulators in the accuracy and reliability of financial information provided
by businesses seeking capital. Financial statements play a central role in this regard,
serving as the primary means by which organizations communicate their financial
performance, position, and prospects to external stakeholders. These statements offer a
comprehensive view of a company's past performance, current financial condition, and
future outlook, enabling investors and creditors to make informed decisions about
allocating capital.
It is widely recognized that the integrity and transparency of financial statements
are essential for maintaining the trust and confidence of capital market participants. Most
organizations strive to prepare financial statements with integrity, adhering to the
principles of transparency, accuracy, and completeness. These statements are prepared in
accordance with generally accepted accounting principles (GAAP), which provide a
standardized framework for recording, reporting, and disclosing financial information.
GAAP encompasses a set of principles, standards, and guidelines established by
accounting standard-setting bodies such as the Financial Accounting Standards Board
(FASB) in the United States and the International Accounting Standards Board (IASB)
internationally. These principles ensure consistency and comparability in financial
reporting, allowing investors and creditors to assess the financial performance and
position of different companies on a like-for-like basis.
Furthermore, financial statements are subject to rigorous scrutiny and oversight
by independent auditors, who provide assurance on the accuracy and fairness of the
information presented. Auditors conduct thorough examinations of a company's financial
records, internal controls, and accounting practices to verify the reliability of its financial
statements and detect any material misstatements or irregularities.
Despite the overall reliability of financial statements prepared in accordance with
GAAP, it is important to recognize that occasional instances of financial reporting fraud
or manipulation may occur. In such cases, companies may intentionally misrepresent
their financial performance or position in order to deceive investors, creditors, or other
stakeholders. These fraudulent activities undermine the integrity of financial markets and
erode investor confidence, highlighting the importance of robust regulatory oversight and
enforcement mechanisms.
In conclusion, financial statements are essential tools for assessing the financial
performance and position of businesses operating in capital markets. Prepared with
integrity and adherence to GAAP, these statements provide investors, lenders, and
regulators with valuable insights into the financial health and prospects of organizations
seeking capital. While the vast majority of financial statements are reliable and
transparent, ongoing vigilance and scrutiny are necessary to detect and prevent instances
of financial reporting fraud and ensure the continued integrity of capital markets.
Financial statement fraud, characterized by intentional misrepresentation of a
company's financial position and performance, poses significant challenges and
consequences for capital markets, investors, and the broader economy. This type of fraud
involves manipulating, falsifying, or altering accounting records to deceive stakeholders
about the true financial health and prospects of an organization. The repercussions of
misleading financial statements are far-reaching and can have profound impacts on
market integrity, investor confidence, and economic stability.
One of the most immediate and apparent consequences of financial statement
fraud is the financial losses incurred by investors and stakeholders who rely on the
accuracy and reliability of financial information for decision-making. When financial
statements are intentionally misstated, investors may make investment decisions based on
false or misleading information, leading to losses in the value of their investments.
Moreover, stakeholders such as creditors, suppliers, and employees may suffer financial
harm as a result of relying on inaccurate financial statements in their business dealings
with the company.
Beyond the immediate financial impact, misleading financial statements erode
trust and confidence in the market and the accounting profession as a whole. Investors
and stakeholders rely on financial statements to assess the financial health and
performance of companies, allocate capital efficiently, and make informed investment
decisions. When financial statements are found to be fraudulent or unreliable, it
undermines the credibility of financial reporting and diminishes trust in the integrity of
capital markets.
Moreover, financial statement fraud can have broader implications for market
stability and economic growth. In cases where fraudulent financial statements are
widespread or systemic, they can contribute to market volatility, investor panic, and
systemic risks to financial stability. The revelation of financial statement fraud may
trigger market sell-offs, credit downgrades, and liquidity crises, further exacerbating the
economic fallout and undermining investor confidence.
In addition to the financial and market-related consequences, financial statement
fraud often leads to litigation, regulatory enforcement actions, and reputational damage
for individuals and organizations involved. Investors who suffer losses as a result of
misleading financial statements may pursue legal action against the company and its
executives for securities fraud, breach of fiduciary duty, or other violations of securities
laws. Regulatory authorities may also initiate investigations and enforcement actions
against companies and individuals implicated in financial statement fraud, leading to
fines, sanctions, and regulatory scrutiny.
Furthermore, individuals and organizations associated with financial statement
fraud may face reputational damage and loss of trust within the industry and among
stakeholders. Executives, auditors, and other professionals involved in preparing or
auditing fraudulent financial statements may suffer reputational harm, career setbacks,
and loss of credibility in their respective fields.
In conclusion, financial statement fraud has serious and far-reaching
consequences for capital markets, investors, and the economy as a whole. From financial
losses and market instability to erosion of trust and reputational damage, the impacts of
misleading financial statements are profound and enduring. Preventing and detecting
financial statement fraud requires robust regulatory oversight, effective internal controls,
and a commitment to transparency, integrity, and ethical conduct in financial reporting.
b. Financial Statement Fraud in Recent Years
During the years 2000–2002, numerous revelations of corporate wrongdoing,
including financial statement fraud, in the United States created a crisis of confidence in
the capital markets. The crisis led to a $15 trillion decline in the market value of all
public company stock. Before focusing on financial statement fraud, we include an
overview of several abuses that occurred during this time period to paint a more complete
picture of why corporate America experienced such a severe crisis.
In 2006, many companies were investigated by the SEC for backdating stock
options. Stock options are a common method of providing executive compensation by
allowing top management to purchase stock at a fixed share price. If the stock rises above
that price, then holders of the options can use them to profit from the increased stock
price. Backdating is a practice where the effective dates on stock options are deliberately
changed for the purpose of securing extra compensation for management. By backdating
option agreements, management of several companies received stock grants at the lowest
prices of the year. Then, management was able to sell the stock at a higher price and
profit by the difference in price.
Academic researchers became aware of backdating as they observed that the
statistical probability of granting an option at the lowest price of the year was much lower
than the frequency of such occurrences. This apparently extraordinary timing by
numerous companies granting options, dated at times when share prices hit yearly lows
(for some companies, this occurred year after year), led the SEC to investigate the issue.
Approximately 270 companies admitted to backdating their options agreements.
Backdating options led to millions of dollars in increased compensation for company
executives at the expense of shareholders, and also resulted in misstated financial
statements, which were subsequently restated. Companies that provided executives with
backdated stock options also violated income tax rules because the difference in the grant
price on the backdated dates and the market prices on the date the options were actually
granted should have been taxable income to the executives.
Even more recently, the subprime lending crisis that led to the “great recession”
was accompanied by a massive financial statement fraud at Satyam Computer Services in
India. In January 2009, Satyam chairman, Ramalinga Raju, confessed to having falsified
billions of dollars of assets on Satyam’s books. Although the details of how this fraud
was carried out have not been made public, we do know that a cash balance was inflated
by over one billion dollars! In addition to Satyam, the collapse of Lehman Brothers
Holdings, Inc. in 2008 has also been associated with financial statement manipulation
that allegedly involved financial statement fraud. Lehman’s bankruptcy was the largest
bankruptcy in the history of the United States, with roughly $691 billion in assets.
Although financial statement fraud appears to have been rampant around the turn of the
millennium, this devastating problem has not gone away.
c. Why These Problems Occurred
Each of the problems discussed earlier represents an ethical compromise. The
explanations covered previously about why people commit other frauds apply to financial
statement fraud as well. Recall that three elements come together to motivate all frauds:
(1) a perceived pressure, (2) a perceived opportunity, and (3) the ability to rationalize the
fraud as acceptable. Whether the dishonest act involves fraud against a company, such as
employee embezzlement, as we have already discussed, or fraud on behalf of a company,
such as financial statement fraud that we will now discuss, these three elements are
always present.
Every fraud perpetrator faces some kind of perceived pressure. Examples of
perceived pressures that can motivate financial statement fraud are financial losses,
failure to meet Wall Street’s earnings expectations, or the inability to compete with other
companies. Also, executive compensation in the form of stock options is often much
higher than any other form of compensation and can be in the tens of millions of dollars.
As such, executives had enormous pressure to boost their stock value since a small
increase in the stock price could mean millions of dollars of compensation for
management.
Fraud perpetrators must also have a perceived opportunity or they will not commit
fraud. Even with intense perceived pressures, executives who believe they will be caught
and punished rarely commit fraud. On the other hand, executives who believe they have
an opportunity (to commit and/or conceal fraud) often give in to perceived pressures.
Perceived opportunities to commit management fraud include such factors as a weak
board of directors or inadequate internal controls and the ability to obfuscate the fraud
behind complex transactions or related-party structures. Some of the main controls that
could eliminate the perceived opportunity for financial statement fraud include the
independent audit and the board of directors. Because management can override most
internal controls, the audit committee of the board of directors and the independent
auditor often provide final checks to prevent financial statement fraud.
Finally, fraud perpetrators must have some way to rationalize their actions as
acceptable. For corporate executives, rationalizations to commit fraud might include
thoughts such as “we need to protect our shareholders and keep the stock price high,” “all
companies use aggressive accounting practices,” “it is for the good of the company,” or
“the problem is temporary and will be offset by future positive results.” The fraud
triangle provides insights into why recent ethical compromises occurred. We believe
there were nine factors that came together to create what we call the perfect fraud storm.
In explaining this “perfect storm,” we will use examples from recent frauds.
The first element of the perfect storm was the masking of many existing problems
and unethical actions by the booming economy of the 1990s and early 2000s. During this
time, most businesses appeared to be highly profitable, including many new “dot-com”
companies, which were testing new (and many times unprofitable) business models.
These booming economic conditions allowed fraud perpetrators to conceal their actions
for longer time periods. Additionally, the advent of “investing over the Internet” for a few
dollars per trade brought many new inexperienced people to the stock market, and many
investors made nonsensical investment decisions. History has now shown that several of
the frauds that came to light around the turn of the millennium were being committed
during the boom years while the economy hid the fraudulent behavior.
The booming economy also caused executives to believe their companies were
more successful than they actually were and that their companies’ success was primarily
a result of good management. Academic researchers have found that extended periods of
prosperity can reduce a firm’s motivation to comprehend the causes of success, raising
the likelihood of faulty attributions. In other words, during boom periods, many firms do
not correctly ascribe the reasons behind their successes. Management usually takes credit
for good company performance. When company performance degrades, boards often
expect results similar to those in the past without new management styles or actions.
Since management did not correctly understand past reasons for success, it incorrectly
thinks past methods will continue to be successful. Once methods that may have worked
in the past because of external factors fail, some CEOs may feel increased pressure. In
some cases, this pressure contributed to fraudulent financial reporting and other dishonest
acts.
The second element of the perfect fraud storm was the moral decay that has been
occurring in recent years. Whatever measure of integrity one uses, dishonesty appears to
be increasing. For example, numerous researchers have found that cheating in school, one
measure of dishonesty, has increased substantially in recent years. Whether it is letting
someone copy work, using a cheat sheet on an exam, or lying to obtain a job, studies
show that these numbers have drastically increased over the years. While cheating in
school is not necessarily directly tied to management fraud, it does reflect the general
decay of moral values in society at large.
The third element of the perfect fraud storm was misplaced executive incentives.
Executives of most fraudulent companies were endowed with hundreds of millions of
dollars in stock options and/or restricted stock that put tremendous pressure on
management to keep the stock price rising, even at the expense of reporting accurate
financial results. In many cases, this stock-based compensation far exceeded executives’
salary-based compensation. For example, in 1997, Bernie Ebbers, the CEO of
WorldCom, had a cash-based salary of $935,000. Yet during that same period, he was
able to exercise hundreds of thousands of stock options, making millions in profits, and
received corporate loans totaling $409 million.1 These incentive packages caused the
attention of many CEOs to shift from managing the firm to managing the stock price,
which, all too often, resulted in fraudulent financial statements. As mentioned earlier, in
addition to managing stock prices, executives also defrauded shareholders by backdating
options so as to maximize their compensation.
The fourth element of the perfect storm, and one closely related to the last, was
the often unachievable expectations of Wall Street analysts that targeted short-term
behavior. Company boards and management, generally lacking alternative performance
metrics, used comparisons with the stock price of “similar” firms and attainment of
analysts’ expectations as important de facto performance measures. These stock-based
incentives compounded the pressure induced by the analysts’ expectations. Each quarter,
the analysts, often coached by companies themselves, forecasted what each company’s
earnings per share (EPS) would be. Executives knew that the penalty for missing Wall
Street’s forecast was severe—even falling short of expectations by a small amount would
drop the company’s stock price by a considerable amount.
Some believe that another element of the perfect storm was the nature of U.S.
accounting rules. In contrast to accounting practices in many countries such as the United
Kingdom and Australia, generally accepted accounting principles (GAAP) in the United
States are more rule based than principles based.3 One potential result of having rule-
based standards is that if a client can find a loophole in the rules and account for a
transaction in a way that is not specifically prohibited by GAAP, then auditors may find it
hard to prohibit the client from using that method of accounting. Unfortunately, in some
cases, the auditors helped their clients find the loopholes or gave them permission to
account for transactions in ways that violated the principle of an accounting method but
was within the rules. The result was that specific rules (or the lack of specific rules) were
exploited for new, often complex financial arrangements, as justification to decide what
was or was not an acceptable accounting practice.
As an example, consider the case of Enron. Even if Arthur Andersen had argued
that Enron’s special purpose entities weren’t appropriate, it would have been impossible
for the accounting firm to make the case that Enron violated any specific rules. Some
have suggested that one of the reasons it took so long to get plea bargains or indictments
in the Enron case was because it was not immediately clear whether GAAP or any laws
had actually been broken.
A seventh element of the perfect fraud storm was the opportunistic behavior of
some CPA firms. In some cases, accounting firms used audits as loss leaders to establish
relationships with companies so they could sell more lucrative consulting services. In
many cases, audit fees were much smaller than consulting fees for the same clients, and
accounting firms felt little conflict between independence and opportunities for increased
profits. In particular, these alternative services allowed some auditors to lose their focus
and become business advisors rather than auditors. This is especially true of Arthur
Andersen, which had spent considerable energy building its consulting practice, only to
see that practice split off into a separate firm. Privately, several Andersen partners have
admitted that the surviving Andersen firm and some of its partners had vowed to “out
consult” the firm that separated from it and they became preoccupied with that goal.
The eighth element of the perfect storm was greed by executives, investment
banks, commercial banks, and investors. Each of these groups benefited from the strong
economy, the many lucrative transactions, and the apparently high profits of companies.
None of them wanted to accept bad news. As a result, they sometimes ignored negative
news and entered into bad transactions.4 For example, in the Enron case, various
commercial and investment banks made hundreds of millions of dollars from Enron’s
lucrative investment banking transactions, on top of the tens of millions of dollars in loan
interest and fees. None of these firms alerted investors about derivative or other
underwriting problems at Enron. A Forbes article noted that “even as late as Nov. 8, the
date of Enron’s disclosure that nearly five years of earnings would have to be
recalculated, 11 of the 15 [stock analysts covering Enron] recommended buying the
stock.” 5 Enron’s outside law firms were also making high profits from Enron’s
transactions. These firms also failed to correct or disclose any problems related to the
derivatives and special purpose entities, but in fact helped draft the requisite associated
legal documentation. Finally, the three major credit rating agencies, Moody’s, Standard
& Poor’s, and Fitch/ IBC—who all received substantial fees from Enron— also failed to
alert investors of pending problems. Amazingly, just weeks prior to Enron’s bankruptcy
filing— after most of the negative news was out and Enron’s stock was trading for $3 per
share—all three agencies still gave investment grade ratings to Enron’s debt.
Finally, the ninth element of the perfect storm involved several educator failures.
First, educators had not provided sufficient ethics training to students. By not forcing
students to face realistic ethical dilemmas in the classroom, graduates were ill equipped
to deal with the real ethical dilemmas they faced in the business world. In one allegedly
fraudulent scheme, for example, participants included virtually the entire senior
management of the company, including but not limited to its former chairman and chief
executive officer, its former president, two former chief financial officers, and various
other senior accounting and business personnel. In total, it is likely that more than 20
individuals were involved in the schemes. Such a large number of participants points to a
generally failed ethical compass for this group.
Consider another case of a chief accountant. A CFO instructed the chief
accountant to increase earnings by an amount somewhat over $100 million. The chief
accountant was skeptical about the purpose of these instructions but did not challenge
them. Instead, the chief accountant followed directions and allegedly created a
spreadsheet containing seven pages of improper journal entries—105 in total—that he
determined were necessary to carry out the CFO’s instructions. Such fraud was not
unusual. In many of these cases, the individuals involved had no prior records of
dishonesty—and yet when they were asked to participate in fraudulent accounting, they
did so quietly and of their free will. A second educator failure was not teaching students
about fraud. One author of this book has taught a fraud course to business students for
several years. It is his experience that most business school graduates would not
recognize a fraud if it hit them between the eyes. The large majority of business students
do not understand the elements of fraud, perceived pressures and opportunities, the
process of rationalization, or red flags that indicate the possible presence of dishonest
behavior. And, when they see something that doesn’t look right, their first reaction is to
deny that a colleague could be committing dishonest acts.
A third educator failure is the way we have taught accountants and business
students in the past. Effective accounting education must focus less on teaching content
as an end unto itself and instead use content as a context for helping students develop
analytical skills. As an expert witness, one of the authors has seen too many cases where
accountants applied what they thought was appropriate content knowledge to
unstructured or different situations, only to find out later that the underlying issues were
different than they had thought and that they totally missed the major risks inherent in the
circumstances. Because these financial statement frauds and other problems caused such
a decline in the market value of stocks and a loss of investor confidence, a number of new
laws and corporate governance changes have been implemented by organizations such as
the SEC, PCAOB, NYSE, NASDAQ, and FASB.
d. Nature of Financial Statement Fraud
Financial statement fraud, like other frauds, involves intentional deceit and
attempted concealment. Financial statement fraud may be concealed through falsified
documentation, including forgery. Financial statement fraud may also be concealed
through collusion among management, employees, or third parties. Unfortunately, like
other fraud, financial statement fraud is rarely seen. Rather, fraud symptoms, indicators,
or red flags are usually observed. Because what appear to be symptoms can be caused by
other legitimate factors, the presence of fraud symptoms does not always indicate the
existence of fraud. For example, a document may be missing, a general ledger may be out
of balance, or an analytical relationship may not make sense. However, these conditions
may be the result of circumstances other than fraud. Documents may have been
legitimately lost, the general ledger may be out of balance because of an unintentional
accounting error, and unexpected analytical relationships may be the result of
unrecognized changes in underlying economic factors. Caution should be used even when
reports of alleged fraud are received, because the person providing the tip or complaint
may be mistaken or may be motivated to make false allegations
Fraud symptoms cannot easily be ranked in order of importance or combined into
effective predictive models. The significance of red flags varies widely. Some factors will
be present when no fraud exists; alternatively, a smaller number of symptoms may exist
when fraud is occurring. Many times, even when fraud is suspected, it can be difficult to
prove. Without a confession, obviously forged documents, or a number of repeated,
similar fraudulent acts (so fraud can be inferred from a pattern), convicting someone of
financial statement fraud can be very difficult. Because of the difficulty of detecting and
proving fraud, investigators must exercise extreme care when performing fraud
examinations, quantifying fraud, or performing other types of fraud-related engagements.
How often financial statement fraud occurs is difficult to know since some frauds
have not been detected. One way to measure it is to look at some of the SEC’s
Accounting and Auditing Enforcement Releases (AAERs). One or more enforcement
releases are usually issued when financial statement fraud occurs at a company that has
publicly traded stock.
Several studies have examined AAERs. One of the first and most comprehensive
was the Report of the National Commission on Fraudulent Financial Reporting, issued by
the National Commission on Fraudulent Financial Reporting (Treadway Commission).
The Treadway Commission report found that while financial statement frauds occur
infrequently, they are extremely costly. The Treadway Commission studied frauds that
occurred during a 10-year period ending in 1987.6 This study examined 119 SEC
enforcement actions that occurred during the period 1981 through 1986. In 1999, the
Committee of Sponsoring Organizations (COSO) released the first of two studies they
sponsored on fraudulent financial statement frauds investigated by the SEC that occurred
during the period 1987–1997.7 This study found that approximately 300 financial
statement frauds were the subject of SEC enforcement releases during the period.
Shortly after the 1999 COSO study there was another study performed by the
Securities and Exchange Commission directed by Section 704 of the SarbanesOxley
Act.8 The requirement was that the SEC study all of its enforcement actions filed during
the period July 31, 1997 through July 30, 2002 that were based on improper financial
reporting, fraud, audit failure, or auditor independence violations. Over the study period,
the SEC filed 515 enforcement actions for financial reporting and disclosure violation
involving 164 different entities.
Like the previous studies, this study found that the SEC brought the greatest
number of actions in the area of improper revenue recognition, including fraudulent
reporting of fictitious sales, improper timing of revenue recognition, and improper
valuation of revenue. The second highest category involved improper expense
recognition, including improper capitalization or deferral of expenses, improper use of
reserves, and other expense understatements. Other categories were improper accounting
for business combinations, inadequate Management’s Discussion and Analysis
disclosure, and improper use of off-balance-sheet arrangements.
Like the previous studies, this study also found that CEOs, presidents, and CFOs
were the members of management most often implicated in the frauds, followed by board
chairs, chief operating officers, chief accounting officers, and vice presidents of finance.
In 18 of the cases, the SEC also brought charges against auditing firms and individual
auditors.
These findings are consistent with a study conducted in the United Kingdom by
the Auditing Practices Board (APB) of England. This study found that the majority of
financial statement frauds are committed by company management and that financial
statement frauds do not involve actual theft and are unlikely to be detected by statutory
auditors. Sixty-five percent of the cases involved misstatement of financial data to boost
share prices or disguise losses.9 The most recent study of financial statement fraud
AAERs was released in May 2010 by COSO.10 This study updates the prior COSO study
and covers the period 1998–2007.
In addition to these dramatic declines in stock prices, both COSO studies showed
that firms that engaged in fraud incurred serious long-term negative consequences soon
after the fraud came to light, including bankruptcy and delisting from a stock exchange.
While the percentage of fraudulent financial statements that come to light is relatively
small, the damage caused by even one set of such statements is often devastating to
employees, shareholders, auditors, bankers, and business partners of all kinds. Consider,
for example, the Phar-Mor fraud. In this case, the COO, Michael “Mickey” Monus, was
sentenced to nearly 20 years in prison. The fraud resulted in more than $1 billion in
losses and the bankruptcy of the 28th largest private company in the United States. Phar-
Mor’s former auditor, a Big 5 firm, faced claims of more than $1 billion, but it ultimately
settled for a significantly lower amount.
e. Motivations for Financial Statement Fraud
The motivations behind the issuance of fraudulent financial statements are
complex and multifaceted, often stemming from a combination of financial incentives,
personal gain, and organizational pressures. As highlighted in the perfect storm analysis,
these motivations can vary widely depending on the circumstances and objectives of the
individuals or entities involved.
One common motivation for issuing fraudulent financial statements is to support a
high stock price or facilitate a bond or stock offering. In today's competitive and dynamic
financial markets, companies may feel pressure to meet or exceed market expectations
and demonstrate strong financial performance to attract investors and access capital.
Falsifying financial statements to artificially inflate earnings, revenue, or other key
metrics can create the illusion of financial health and stability, thereby bolstering investor
confidence and driving up the company's stock price. Similarly, fraudulent financial
statements may be used to enhance the perceived creditworthiness of the company and
facilitate the issuance of bonds or stock offerings at favorable terms.
Another motivation for financial statement fraud is to increase the company's
stock price or maximize executive bonuses. Incentive compensation structures tied to
financial performance metrics, such as earnings per share (EPS) or stock price targets,
may create incentives for management to engage in fraudulent reporting to achieve or
exceed performance targets and unlock substantial bonus payouts. In some cases,
executives may prioritize short-term financial gains and personal enrichment over the
long-term sustainability and integrity of the company's financial reporting practices.
Furthermore, in companies where top executives own significant amounts of
company stock or stock options, changes in the stock price can have profound effects on
their personal net worth. As a result, there may be strong incentives for executives to
manipulate financial statements to artificially inflate the company's stock price, thereby
increasing the value of their stock holdings and stock options. The potential for
substantial personal gain can create powerful incentives for executives to engage in
fraudulent financial reporting practices, even at the expense of shareholder interests and
the company's long-term viability.
Moreover, organizational pressures, such as aggressive growth targets,
competitive pressures, or impending regulatory requirements, can exacerbate the
motivations for financial statement fraud. In environments where performance
expectations are high and resources are limited, executives and employees may feel
compelled to resort to fraudulent reporting practices to meet unrealistic targets, maintain
market share, or avoid regulatory scrutiny.
In summary, the motivations behind fraudulent financial statements are driven by
a complex interplay of financial incentives, personal gain, organizational pressures, and
market dynamics. From supporting a high stock price to maximizing executive bonuses
and personal net worth, the motivations for financial statement fraud can have significant
implications for shareholders, investors, and the broader financial markets. Effective
corporate governance, robust internal controls, and ethical leadership are essential in
mitigating the risks of financial statement fraud and preserving the integrity and
transparency of financial reporting practices.
The case of Phar-Mor illustrates the complex interplay of pressures, incentives,
and consequences that can drive managers to engage in financial statement fraud.
Division managers, under pressure to meet company expectations and achieve aggressive
growth targets, may resort to overstating financial results as a means of masking
underlying challenges or failures. In the pursuit of short-term success or to avoid the
stigma of failure, managers may succumb to the temptation to manipulate financial data,
misrepresent performance, or engage in deceptive practices.
In the case of Phar-Mor, Mickey Monus's desire to accelerate the company's
growth led to the implementation of a risky pricing strategy aimed at gaining market
share and expanding the company's footprint. By lowering prices on hundreds of "price-
sensitive" items, Monus sought to attract new customers and drive sales growth.
However, the aggressive price cuts resulted in selling products below cost, leading to
unsustainable losses for the company. Faced with mounting losses and the prospect of
failure, Monus resorted to concealing the losses and falsifying financial statements to
maintain the appearance of profitability.
The motivations behind Monus's actions may have been driven by a combination
of factors, including the pressure to meet growth targets, the desire to maintain a positive
image of the company, and personal incentives tied to the company's performance. As a
result, Monus engaged in fraudulent reporting practices to mask the true financial
condition of Phar-Mor and avoid the consequences of failure.
The consequences of financial statement fraud can be severe and far-reaching,
with adverse impacts on the company, its principals, investors, and other stakeholders. In
the case of Phar-Mor, the fraudulent reporting practices ultimately led to significant
losses for the company, jeopardized its financial viability, and eroded investor trust and
confidence. Moreover, the revelations of financial misconduct tarnished the reputation of
the company and its executives, leading to legal and regulatory scrutiny, litigation, and
reputational damage.
Beyond the immediate financial and reputational costs, financial statement fraud
can have broader implications for market integrity, investor confidence, and the stability
of the financial system. Instances of fraud undermine the integrity of financial reporting
practices, erode trust in corporate governance, and contribute to market inefficiencies and
distortions. Moreover, the fallout from financial statement fraud can extend beyond the
company itself, impacting suppliers, creditors, employees, and other stakeholders who
rely on accurate and reliable financial information for decision-making.
In summary, while the motivations for financial statement fraud may vary, the
consequences are consistently detrimental to the company, its principals, and its
investors. By understanding the underlying drivers of fraudulent behavior and
implementing robust controls and oversight mechanisms, companies can mitigate the
risks of financial misconduct and uphold the integrity and transparency of their financial
reporting practices. Ethical leadership, accountability, and a commitment to sound
corporate governance are essential in fostering a culture of integrity and preventing
financial statement fraud.
f. A Framework for Detecting Financial Statement Fraud
Identifying fraud exposures is one of the most difficult steps in detecting financial
statement fraud. Correctly identifying exposures means that you must clearly understand
the operations and nature of the organization you are studying as well as the nature of the
industry and its competitors. Investigators must have a good understanding of the
organization’s management and what motivates them. Investigators must understand how
the company is organized and be aware of relationships the company has with other
parties and the influence that each of those parties has on management. In addition,
investigators and auditors should use strategic reasoning when attempting to detect fraud.
Strategic reasoning refers to the ability to anticipate a fraud perpetrator’s likely
method of concealing a fraud. Because external auditors are charged with the
responsibility for detecting material financial statement fraud, we take the perspective of
how an external auditor should engage in strategic reasoning. However, this reasoning
process can also occur when internal auditors, the audit committee, fraud investigators, or
others are considering efforts to detect management fraud. Knowing that an auditor’s
duty is to assess the fairness of the financial statements, a fraud perpetrator will attempt
to conceal his or her fraud from the auditors. Thus, fraud is strategic in nature such that
management’s propensity to commit fraud is affected by the anticipated audit, and the
auditor’s approach to detecting fraud is affected by the potential for management to
commit fraud. Similar to a chess match where one must consider the potential moves of
his or her opponent while the opponent is doing likewise, an auditor seeking to detect
fraud is most effective when he or she considers how management is viewing the
potential audit approach.
This type of audit planning is different from that required to discover
unintentional errors in financial statements. The thinking involved in a strategic setting
such as the detection of financial statement fraud is based on game theory. Game theory
seeks to predict behavior based on an individual’s best response given that individual’s
motivations and the individual’s beliefs regarding the likely behavior of his or her
opponent(s). The auditor’s consideration of an auditee’s response to auditor choices is
referred to as “strategic reasoning.” Academic research suggests that effective auditors
need to engage in strategic reasoning to predict an auditee’s response but that doing so
becomes progressively more difficult as the auditor considers more levels of potential
strategic behavior.
Several levels of strategic reasoning exist in the audit setting. These levels are
zero-order reasoning, first-order reasoning, and higher-order reasoning. Zero-order
reasoning occurs when an auditor and auditee consider only conditions that directly affect
themselves but not the other party. When engaged in zeroorder reasoning, the auditor
simply considers his or her own incentives, such as audit fees, sampling costs, and
penalties. First-order reasoning means that the auditor considers conditions that directly
affect the auditee. In this case, auditors assume auditees use zero-order reasoning and
develop audit plans that consider the auditee’s incentives. For example, if the auditor
expects the concealment of fraud, he or she will modify the audit plan accordingly to
uncover this concealment of fraud. In this approach, the auditor does not consider
whether the auditee has anticipated the auditor’s behavior. Higher-order reasoning occurs
when the auditor considers additional layers of complexity, including how management
may anticipate the auditor’s behavior. For example, an auditor using higher-order
reasoning may adjust the audit plan by introducing unexpected audit procedures in
response to what the auditor believes management may be doing to conceal a fraud based
on management’s strategic reasoning.
Given the difficulty of engaging in high levels of strategic reasoning, it is
fortunate that auditors probably can make significant improvements in their audit
approach by engaging in first- or second-order strategic reasoning. Currently,
management can often accurately predict what procedures will be performed in an
independent audit because they are often aware of what the auditor has done in prior
audits. When this happens, financial statement fraud schemes are developed so that the
auditor’s typical audit approach will fail to detect the scheme. An effective auditor will
use strategic reasoning —specifically high-order reasoning or, at a minimum, first-order
reasoning—to effectively detect this fraudulent activity. This will lead the auditor to
perform unexpected procedures and use tests that management has not seen before.
Academic research suggests that engaging in such reasoning leads auditors to perform
more rigorous procedures when comparing audit plans with expert fraud examiners’
recommended procedures.
Fraudulent financial statements are rarely detected by analyzing the financial
statements alone. Rather, financial statement fraud is usually detected when the
information in the financial statements is compared with the real-world referents those
numbers are supposed to represent, and the context in which management is operating
and being motivated. Fraud is often detected by focusing on the changes in reported
assets, liabilities, revenues, and expenses from period to period or by comparing
company performance to industry norms. In the ZZZZ Best fraud case, for example, each
period’s financial statements looked correct. Only when the change in assets and
revenues from period to period were examined and when assets and revenues reported in
the financial statements were compared with actual building restoration projects was it
determined that the financial statements were incorrect.
In addition to the typical analyses of financial statements (e.g., ratio, horizontal,
and vertical analyses), research suggests that auditors, investors, regulators, or fraud
examiners can benefit by using nonfinancial performance measures to assess the
likelihood of fraud. This was illustrated in former HealthSouth CEO Richard Scrushy’s
trial, when prosecutors argued that Scrushy knew something was amiss with
HealthSouth’s financial statements because there was a discrepancy between the
company’s financial and nonfinancial performance. The prosecutor noted that revenues
and assets were increasing while the number of HealthSouth facilities decreased. “And
that’s not a red flag to you?” asked prosecutor Colleen Conry during the trial. Conry
pointed out that financial statement fraud risk was high at HealthSouth because the
company’s financial statement data were inconsistent with its nonfinancial measures. The
use of financial and nonfinancial data for detecting fraud is one of four key
considerations in a framework for detecting fraud. We label this framework the “fraud
exposure rectangle.”
Academic research on nonfinancial performance measures has shown that
companies engaging in revenue fraud will have increases in revenues that are not
consistent with their nonfinancial performance measures.12 This research shows that
even basic nonfinancial performance measures, such as the number of employees, can
signal that a company’s revenues are fraudulent. Because these basic nonfinancial
performance measures are publicly available, investors, auditors, and others can use them
to identify fraud risk. This makes it more difficult for fraud perpetrators to conceal their
fraud since they now have additional data to manipulate. Often individuals who are not
working with management on the financial fraud report the nonfinancial measures. This
compounds management’s challenges in concealing a revenue fraud since they may need
to expand the pool of individuals who are reporting fictitious data. For these and other
reasons, nonfinancial performance measures hold significant potential as a red flag for
fraud.
l data to assess fraud risk, auditors can identify fraud risk exposures by examining
four groups of fraud exposures. On the first corner of the rectangle are the management
and directors of the company. On the second corner are relationships the company has
with other entities. On the third corner are the nature of the organization being examined
and the industry in which the organization operates. On the fourth corner are the financial
results and operating characteristics of the organization.
Although CPAs and others have traditionally focused almost entirely on financial
statements to detect financial statement fraud, each of these four areas should be
considered to effectively assess the likelihood of fraud. We now examine each of these
four areas individually.
g. Management and the Board of Directors
As shown in the statistics presented previously, top management is almost always
involved when financial statement fraud occurs. Unlike embezzlement and
misappropriation, financial statement fraud is usually committed by the highest
individuals in an organization, and often on behalf of the organization as opposed to
against the organization. Because management is usually involved, management and the
directors must be investigated to determine their involvement in and motivation for
committing fraud. In detecting financial statement fraud, gaining an understanding of
management and what motivates them is at least as important as understanding the
financial statements.
With respect to backgrounds, fraud investigators should understand what kinds of
organizations and activities management and directors have been associated with in the
past. With the Internet today, it is very easy to conduct simple searches on individuals.
One very easy way is to type the individual’s name in Google or another search engine.
The search engine will quickly list all the references to the person’s name, including past
proxy statements and any 10-Ks (the corporate reports filed with the SEC) of companies
the person has been affiliated with, newspaper articles about the person, and so forth.
Also, if this simple search is not sufficient, it doesn’t cost very much to hire a private
investigator or to use investigative services on the Web to do a search.
An example of the importance of understanding management’s background is the
Lincoln Savings and Loan fraud. Before perpetrating the Lincoln Savings and Loan
fraud, Charles Keating was sanctioned by the SEC for his involvement in a financial
institution fraud in Cincinnati, Ohio, and, in fact, had signed a consent decree with the
SEC that he would never again be involved in the management of another financial
institution.
Another example where knowledge of management’s background would have
been helpful was Comparator Systems, a Los Angeles–based fingerprinting equipment
company accused of securities fraud in 1996. CEO Robert Reed Rogers grew up in
Chicago, majored in chemistry in college, and became a college lecturer in business and
economics. He worked short stints at the consulting firm of McKinsey & Co. and Litton
Industries. In information sent to investors, he boasted of many accomplishments,
describing himself as founder and president of various companies developing products or
processes. Missing from Rogers’ biographical sketches is the fact that, in the mid-70s, he
was president of Newport International Metals. Newport was involved in the speculative
rage of the period—precious metals. The company claimed to have the “exclusive right”
to a certain mining process for producing jewelry. The company received $50,000 in
securities from investors John and Herta Minar of New York to serve as collateral to
secure start-up funds. In 1976, Newport was cited by the state of California for unlawful
sale of securities and was ordered to stop. The Minars sued and won a judgment for
$50,000. In 1977, a warrant was issued for Rogers’ arrest for failure to appear in court in
connection with a lawsuit filed by investors in another company managed by Rogers.
Certainly, Rogers had a tainted background that would have been of critical interest to
anyone investing in or doing business with Comparator Systems.
What motivates directors and management is also important to know. Is their
personal worth tied up in the organization? Are they under pressure to deliver unrealistic
results? Is their compensation primarily performance-based? Do they have a history of
guiding Wall Street to higher and higher expectations? Have they grown through
acquisitions or through internal means? Does the company have debt covenants or other
financial measures that must be met? Is management’s job at risk? These questions are
examples of what must be answered in order to properly understand management’s
motivations. Many financial statement frauds have been perpetrated because management
needed to report positive or high income to support stock prices, show positive earnings
for a public stock or debt offering, or report profits to meet regulatory or loan restrictions.
Finally, management’s ability to influence decisions for the organization is
important to understand because perpetrating fraud is much easier when one or two
individuals have primary decision-making power than when an organization has a more
democratic leadership. Most people who commit management fraud are firsttime
offenders, and being dishonest the first time is difficult for them. For two individuals to
simultaneously be dishonest is more difficult, and for three people to simultaneously be
dishonest is even more difficult. When decision-making ability is spread among several
individuals, or when the board of directors takes an active role in the organization, fraud
is much more difficult to perpetrate. Most financial statement frauds do not occur in
large, historically profitable organizations. Rather, they occur in smaller organizations
where one or two individuals have almost total decision-making ability, in companies
that experience unbelievably rapid growth, or where the board of directors and audit
committee do not take an active role. An active board of directors and/or audit committee
that gets involved in the major decisions of the organization can do much to deter
management fraud. In fact, it is for this reason that NASDAQ and NYSE corporate
governance standards require that the majority of board members be independent and that
some of the key committees, such as audit and compensation, be comprised entirely of
independent directors.
h. Relationships with Others
Financial statement fraud often involves complex schemes and arrangements with
other entities, both real and fictitious, to manipulate financial reporting and conceal the
true financial condition of a company. One notorious example of such fraud is the case of
Enron, where special purpose entities (SPEs) played a central role in perpetrating the
fraud.
SPEs are business entities formed for specific purposes, such as financing
projects, managing risks, or holding assets, and are commonly used in corporate finance
transactions. While SPEs themselves are not inherently illegal, they can be exploited for
fraudulent purposes when used to conceal debt, inflate earnings, or manipulate financial
statements.
In the case of Enron, the company used SPEs as a vehicle to offload debt, inflate
revenues, and artificially boost profits, thereby presenting a misleading picture of its
financial health to investors and stakeholders. Enron's executives, including CFO Andrew
Fastow and others, orchestrated a series of complex transactions involving SPEs to
deceive investors and analysts about the company's true financial condition.
One key aspect of the Enron fraud was the improper accounting treatment of
certain SPEs, which should have been consolidated onto Enron's balance sheet according
to accounting standards. However, Enron failed to disclose its significant financial
obligations and liabilities associated with these SPEs, thereby understating its debt and
overstating its financial performance.
Furthermore, Enron's executives, particularly Andrew Fastow, exploited their
positions of influence and control over both the company's operations and the SPEs to
siphon off millions of dollars for their personal gain. Fastow, in particular, profited
immensely from his involvement in designing and managing Enron's SPEs, using them as
a means to enrich himself at the expense of shareholders and investors.
The Enron scandal exposed serious deficiencies in corporate governance,
accounting practices, and regulatory oversight, prompting widespread reforms and
increased scrutiny of corporate financial reporting. The Securities and Exchange
Commission (SEC) launched investigations into Enron's fraudulent activities, leading to
criminal charges, civil lawsuits, and regulatory enforcement actions against the
company's executives and auditors.
The Enron case serves as a cautionary tale about the dangers of financial
statement fraud and the need for robust internal controls, transparency, and accountability
in corporate governance. It underscores the importance of vigilant oversight by
regulators, auditors, and investors to detect and prevent fraudulent practices that can
undermine market integrity and investor confidence.
In conclusion, financial statement fraud involving SPEs, as exemplified by the
Enron scandal, highlights the sophisticated nature of modern financial crimes and the
challenges they pose to corporate governance and regulatory enforcement. By learning
from past failures and implementing effective controls and safeguards, companies can
mitigate the risks of financial statement fraud and uphold the integrity of financial
reporting for the benefit of shareholders, investors, and the broader economy.
i. Revenue – Related Fraud
By far, the most common accounts manipulated when perpetrating financial
statement fraud are revenues and/or receivables. The Committee of Sponsoring
Organizations (COSO)-sponsored studies found that over half of all financial statement
frauds involved revenues and/or accounts receivable accounts. These studies also found
that recording fictitious revenues was the most common way to manipulate revenue
accounts and that recording revenues prematurely was the second most common type of
revenue-related financial statement fraud. Other studies have found similar results. In
fact, because of the frequency of revenue-related financial statement frauds, the American
Institute of Certified Public Accountants (AICPA) published “Audit Issues in Revenue
Recognition” on its Web site (www.aicpa.org) in January 1999. This publication
contained authoritative and nonauthoritative auditing guidance to help financial statement
auditors identify and respond to warning signals of improper revenue-recognition. It
focuses on issues related to the sale of goods and services in the ordinary course of
business. The publication also discusses management’s responsibility to report revenues
accurately and follow appropriate revenue-recognition policies. There are two reasons for
the prevalence of revenue-related financial statement fraud. One is the availability of
acceptable alternatives for recognizing revenue, and the other is the ease of manipulating
net income using revenue and receivable accounts.
Just as organizations are different, the kinds of revenues they generate are
different, and these different types of revenues need different recognition and reporting
methods and criteria. A company that collects cash before delivering goods or performing
a service, such as a franchiser, needs to recognize revenue differently than a company
that collects cash after the delivery of goods or the performance of a service, such as a
manufacturer. A company that has long-term construction contracts needs different
revenue-recognition criteria than a company whose revenue is based on small, discrete
performance acts. Numerous questions arise about when to record revenue, such as
whether the company has shipped a product, completed a service, collected payment,
fulfilled service obligations, and so forth. In many cases, it is difficult to identify one
event that should trigger the recording of revenue.
Consider, for example, a company that explores, refines, and distributes oil. When
should revenue be recognized for this company—when it discovers the oil in the ground
(for which there is a ready market and a determinable price), when it refines the crude oil
or condensate into products such as jet and diesel fuel, when it distributes the oil to its
service stations for resale, or when it actually sells the refined oil to customers? Similarly,
consider a company that performs clinical trials on new drugs produced by
pharmaceutical companies to determine whether the drugs should be approved for sale
and distribution to the public by the Food and Drug Administration. Suppose a contract
with a pharmaceutical firm states that the drug will be tested on 100 patients over a
period of six months, and each patient will be observed and tested weekly. Further
assume that the testing company is to be paid $100 per patient visit for a total of $2,600
(26 visits) per patient and a total contract amount of $260,000 ($2,600 per patient × 100
patients). Because the pharmaceutical company does not want to be billed every time a
patient is tested, it specifies that the testing company can submit bills for payment only
when certain “billing milestones” have been reached, such as 25 patient visits, 50 patient
visits, 75 patient visits, and 100 patient visits. In this case, when should the revenues be
recognized—at the time the patient visits take place, at the time bills can be submitted to
the pharmaceutical company, when all visits have taken place, or at some other time?
These are difficult issues that require significant judgment. In these and many
other settings, both conservative and liberal methods of recognizing revenue can be
applied. Even financial reporting experts do not always agree when an organization has
had sufficient performance to recognize revenue and what the major revenue-recognition
criteria should be. In numerous cases, these and other difficult revenue-recognition issues
have been debated and have been the focus of financial statement fraud lawsuits.
Specifically, the companies started out using liberal ways of recognizing revenues and
when those weren’t sufficient, management started committing fraud. In the oil company
case mentioned earlier, the company fraudulently recognized sales on fictitious ships that
were supposedly sailing the oceans. In the medical testing case, contracts with drug
companies that were shown to the auditors were altered to inflate the amount of revenue
per patient.
These differences in revenue-recognition and performance criteria across
organizations make it very difficult to develop revenue-recognition rules for the
numerous business models in today’s economy. Indeed, in many situations, significant
judgment must be exercised to determine when and how much revenue to recognize. This
provides opportunities for managers who want to commit financial statement fraud.
The second reason why revenue-related frauds are so common is because it is so
easy to manipulate net income using revenues and receivables accounts. In the video
Cooking the Books, produced by the Association of Certified Fraud Examiners, Barry
Minkow, mastermind of the ZZZZ Best fraud, states, “Receivables are a wonderful thing.
You create a receivable and you have revenue.” When you have revenue, you have
income. An easy way to inflate net income is to create revenue and some corresponding
receivables. Additionally, revenues and receivables can be manipulated in several other
ways. For example, an organization can inflate its revenues by including revenues in the
current period that should be recognized in the next period. This scheme is often referred
to as early or premature revenue-recognition or abusing the cutoff.
Revenues can also be recognized early by misstating the work completed in a
company with long-term construction contracts where revenue depends on a project’s
percentage of completion. Companies can also create fictitious documents, sales, or
customers to make it appear that actual sales were higher than they really were for the
period. Alternatively, contracts upon which revenue is based can be altered or forged. Or,
in the most egregious cases, topside journal entries that create revenues and receivables
without underlying documentation can be created.
Revenue-related fraud exposures should be considered in every business. The
exposures involve any schemes that can be used to misstate revenue and often misstate
receivables, too. One of the best ways to understand how revenue frauds could be
perpetrated is to understand the various revenue transactions in the company. One of the
first tasks in this regard is to analyze and diagram the various transactions between an
organization and its customers. Then, by analyzing the accounts involved in each
transaction, an investigator or auditor can determine how each transaction could be
misstated. In this regard, revenue transactions for a typical company might be
diagrammed.
Once the revenue transactions are diagrammed, a good way to understand the
various financial statement fraud schemes is to relate the accounts involved in each
transaction with the potential manipulations. The numbers provided in the diagram to
identify the transactions can be used to prepare. However, before we discuss the various
revenue-related fraud schemes, we would like to list and briefly explain some of the more
common ones.
j. Inventory and Cost of Goods Sold Frauds
Besides revenue-related fraud schemes, the next most common financial
statement fraud schemes involve the manipulation of inventory and cost of goods sold
accounts. Several high-profile financial statement frauds have involved the overstatement
of inventory. For example, Phar-Mor significantly overstated the value of its inventory
and then moved inventory back and forth between stores so that it could be counted
multiple times. A more recent example of inventory fraud was Rite Aid Corporation.
Although Rite Aid committed several different types of fraud, one of the most prevalent
was overstating net income by managing the value of its inventory. Specifically, senior
management allegedly failed to record millions in shrinkage of its physical inventory due
to loss or theft. The CFO also made topside journal entries to lower the cost of goods
sold.
Historically, inventory frauds have been such a significant problem that a few
years ago The Wall Street Journal featured a front-page article titled “Inventory
Chicanery Tempts More Firms, Fools More Auditors.” 5 To understand why inventory-
related fraud schemes are so common, you should understand how inventory accounts
affect the income statement. The calculations on a typical income statement. From this
analysis, you can see that if inventory is overstated, cost of goods sold is understated, and
gross margin and net income are overstated by an equal amount (less the tax effect). To
better understand the effect of cost of goods sold on inventory, consider how cost of
goods sold is calculated.
This analysis shows that the overstatement of ending inventory in period 1 has an
effect on cost of goods sold in both periods 1 and 2. Furthermore, cost of goods sold can
be understated by either understating purchases or overstating inventory. It can also be
understated by overstating purchase returns or purchase discounts. Of these alternatives,
overstating the ending inventory tends to be the most common fraud because it increases
net income and recorded assets, making the balance sheet look better. The previous
analysis also illustrates why overstating inventory is a fraud that is very difficult to
maintain without getting caught. In the first period, when ending inventory is overstated,
cost of goods sold is understated, making gross margin and net income overstated.
However, that overstated ending inventory becomes the beginning inventory in period 2,
meaning that further overstatements of ending inventory must be made or cost of goods
sold in period 2 will be overstated and gross margin and net income will be understated.
This offsetting effect from one period to the next makes it necessary for perpetrators to
overstate ending inventory in period 2 by an even larger amount in order to both offset
the effect of having an overstated beginning inventory and to commit additional fraud.
Perpetrators who are smart should commit other types of financial statement fraud other
than overstating inventory because of this compounding effect from period to period.
As with revenues, all of these fraud schemes can be used to increase net income.
Additionally, it is possible to commit inventory fraud by understating inventory and net
income. However, this is a rare situation that may arise in a privately owned company
that wants to decrease the amount of income taxes paid to the government. Because it is
so rare, we ignore this situation in our discussion. As stated earlier, inventory
overstatement frauds are much more difficult for perpetrators than revenue frauds. With
revenue-related frauds, reported revenues are overstated in the current period, and
accounts receivable are overstated on the balance sheet.
However, a reversing effect does not automatically occur in the subsequent period
as it does with inventory. With inventory frauds, the “overstated ending inventory” of one
period becomes the “overstated beginning inventory” of the next period and causes net
income to be understated in the second period.
Thus, if a dishonest management wanted to continue the fraud and overstate net
income in a second period (most frauds are multiple-period frauds), it would have to
perpetrate a fraud of an equivalent magnitude just to offset the overstated beginning
inventory and then commit an additional fraud if they again wanted to increase net
income. The results are larger misstatements of inventory and a fraud that is much easier
to detect. Fortunately, most financial statement frauds are perpetrated because of
desperation. As such, a perpetrator generally worries only about how income can be
overstated in the current period, with no thought of the problems it creates in subsequent
periods.
