The 5 Red Flags of Fraudulent Financial Statements

larrivaFraudulent Financial Statements fall under the fraud category of “Occupational Fraud and Abuse,” which is defined by the ACFE as “an employee, manager, officer, or owner of an organization committing fraud to the organization’s detriment.” According to a research study performed by the ACFE, fraudulent financial statement fraud accounts for approximately 10% of white collar crime incidents. Although, other “Occupational Fraud and Abuse” crimes, such as, asset misappropriation and corruption tend to occur at higher frequency, the financial impact of those crimes is less severe. Financial statement fraud can occur in many different forms and as CPAs we have to be able to identify those common approaches or “Red Flags”:

  1. Overstating sales: Overstating revenues is one of the most common approaches used in fraudulent financial statements. One of the red flags in this area would be having a growth in revenues without a corresponding increase in cost of goods sold account or a reduction in inventory. These accounts are related and should move more or less together. Another red flag would be to have a continuous growth in sales by a company while competitors are struggling. The Madoff case is an example of this common approach, while the stock market was decreasing Madoff was still delivering high returns to his investors.
  2. Understating expenses: Understating expenses is not a very common approach in manipulating financial statements. However, when used, it is normally executed by upper level management or officers, who want to show that the company maintains consistent profits. The reasons associated with underreporting expenses could be that bonuses are directly related with profitability ratios or with company’s performance compared to its competitors.
  3.  Incorrect asset valuations: This occurs when management knowingly uses incorrect asset valuations. Management might need to borrow funds from financial institutions and will manipulate assets so that they can show the company has a lower debt to asset ratio on their financial statements.
  4. Incorrect disclosures: Be aware that companies could have off balance sheet obligations that should be added to the footnotes of the financial statements. In my experience, usually related party transactions are omitted and further investigation needs to take place.
  5.  Cookie jar accounting: This is another method utilized in preparing financial statements fraud, which involves moving sales from one accounting period to another. This is also referred to as “income smoothing.” Management might be enticed into performing “cookie jar accounting” because they want to show steady sales or profit level throughout the year, so they will reserve the high sales in one month to apply them to a different month with lower sales.

These “Red Flags” provide warning signs to current or potential investors, financial institutions and owners, but they do not necessarily indicate the occurrence of financial statement fraud. They simply indicate that further in-depth analysis must be conducted.

Veronica Larriva, CPA
McHale, Caruso, Scullion & Knox, CPAs