As the old adage goes, fool me once shame on you, fool me twice shame on me. Today we explore how to avoid being fooled by fictitious financial statements so, according to the lyrics of The Who, we don't get fooled again.
In the 2008 Report to the Nation fraud survey by the Association of Certified Fraud Examiners (ACFE), the top three detection methods for all types of occupational fraud were (in descending order): tips, by accident, and internal controls.
Tips
The hot tip in catching fraudsters is to have a tip hot-line. Public companies have long had fraud hot-lines in response to Sarbanes-Oxley so that employees and others can report suspected fraud. Private companies can emulate this approach.
Internal Controls
Internal controls are more than simply adequate segregation of duties, documented policies and procedures, and flowcharts. They are a proactive mechanism that is the responsibility of everyone in an organization to help fraud from occurring in the first place. Rather than pay lip service, management needs to lead by example and not circumvent or minimize their companies policies and procedures by creating two sets of rules.
Financial Statement Fraud
Financial statement fraud presents a particular challenge to organizations because the very people who are responsible for producing or reviewing the financials are the ones perpetrating the fraud. In fact, according to the 2008 ACFE report cited earlier, almost 60% of the cases of financial statement schemes were perpetrated by the owner, and 40% by managers. Unfortunately, for financial statement fraud, internal controls may not be of much help due to management override of the controls in place.
To help thwart financial statement fraud, companies can take at least two actions. They can perform background checks on anyone who has access to the financial records or who is a custodian of significant assets of the company. In addition, they should review all compensation and bonus plan structures on a regular basis to ensure that they are in the best long-term interests of the organization and all of its stakeholders. Focusing on people and incentives is key to warding off financial statement fraud.
The readers of financials need to do more than simply being skeptical. Analytics can be useful to make sure the story portrayed by the financials is reasonable. Ratio analysis can be used to examine trends over time and relative to industry norms. For example, an increase in day's sales outstanding can esult from recording fictitious sales. Disclosures should be reviewed with an eye towards what is missing and compared to the prior year and other known information such as press releases.
In the end, readers of financials should keep in mind that fraudsters are like drug addicts: they are believable liars. Knowing who you are doing business with is paramount. Simply calling mutual contacts or doing basic internet research might prevent a decision to extend credit, invest money, enter into a partnership, or join a company that could otherwise have long-term repercussions.
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