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Fool me . . . Not: Avoiding financial statement fraud

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.

The Story of . . . Deceit?

Financial Statements Can Be a Work of Fiction

Financial statements are supposed to tell the story of a business. But sometimes that story is a lie. Although financial statement fraud is the least common type of occupational fraud committed, it results in the highest average loss, averaging $2 million per incident.

Who It Hurts

Those who rely on financials to provide accurate, relevant and timely information – investors, bankers and analysts – are not the only ones harmed by this type of fraud. Damage can extend to the employees, directors, customers, vendors, and professional service firms associated with the company that has falsified its financials.

Why They Do It

At the heart of this fraud is the desire to mislead, either to hide debts or expenses, to exaggerate revenues or assets, or to hide other illegal activity. The perpetrators – most usually management and/or members of the accounting department – are attempting to write a work of financial fiction. Their motivation is often to preserve their job or the jobs of others rather than to directly enrich themselves. On a psychological level, the motivation can be the desire to hide poor decision-making or to maintain or gain status.

Today's Fiction; Tomorrow's Headline

In this era of high unemployment, low or no revenue growth and decreased availability of capital it is not hard to imagine that there are many works of financial fiction that are labeled as financial statements. Regardless of whether they make the headlines,  most of these stories will not have happy endings and the damage they do will ripple through our economy. Behind these stories are authors that are trying to hide something to keep the game going.

How about you? Have you been misled by fictitious financials? In the next post we’ll look at how we can protect ourselves from being fooled.

A Tale of Two Businesses

For Washington state businesses it has been the best of times and the worst of times. Our state regularly ranks near the top of the list in new job creation. Less commonly known, Washington is among the highest of states in numbers of business closings. According to a report by the Washington Technology Center for 2006, although Washington ranked second for new jobs creation (Idaho was first), it ranked first for number of business closures. Undoubtedly, much of this churn stems directly from the high rate of new business creation and the subsequent discarding of some of the resulting products or services as they are exposed to the marketplace. But, some of these closures are a result of failure.

In a 2007 report on Washington small business survival to the governor, business failures were concluded to result from limited business experience and knowledge. This was evidenced by such symptoms as a failure to plan, overly optimistic assumptions, improper pricing, under capitalization, and employee theft. In fact, most business turnaround leaders cite internal reasons such as bad management or a non-participative  board as the root cause for business failure the majority of the time.

This situation need not be! Our state can do better, and in so doing create a more vibrant and healthy business community. The key is for business owners and managers to recognize their weaknesses before it is too late. Among other things, this might mean bringing on the necessary financial talent to ensure adequate cash flow planning, product costing, or accurate financial reporting. Whether the solution involves adding board strength, hiring or replacing a CFO, or adding interim financial talent, the resources exist to fix these problems. In today's challenging economy it is more important than ever for businesses to increase their probability of success rather than letting inertia stand in the way.

Welcome to the Thoughts from the Fork in the Road Blog!

More than ever, businesses, management teams and boards are under increasing stress to perform through a prolonged economic downturn. This current business climate is exposing weaknesses while removing resources. On this blog I will share useful information to help companies stabilize, grow and succeed from a CFO's perspective. We'll focus on issues ranging from project and interim CFO work, to business valuation and financial fraud investigation. So, come along for the ride, get informed and always feel free to share your own experiences.