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How to Prevent and Detect Financial
Statement Fraud
Anthony M. Lendez and James J. Korevec
Fraudulent financial reporting has been a long-standing problem, but
there are important lessons to learn from some recent cases. The authors
explain how you can uncover bogus financial statements—or prevent
dishonest reporting in the first place. © 1999 John Wiley & Sons, Inc.
F
Anthony M. Lendez, CPA is a
director in the Litigation Services
Practice of BDO Seidman, LLP. He
is a former member of the National
Accounting and Auditing Department of BDO Seidman. Before
joining BDO Seidman, Mr. Lendez
was a technical manager in the SEC
Practice Section of the American
Institute of Certified Public
Accountants, where he was responsible for investigating alleged audit
failures. James J. Korevec, CPA,
CFE, is a director in the Litigation
Services Practice of BDO Seidman,
LLP. Before joining BDO Seidman,
Mr. Korevec was a Special Agent of
the Federal Bureau of Investigation,
where he was responsible for
investigating a wide variety of white
collar crimes.
raudulent financial reporting has been more than just a thorn in the side of
the financial community since at least the late 1930s when the irregular
accounting practices of McKesson-Robbins became the subject of front page
news. Even though a reputable accounting firm audited the company’s financial
statements, McKesson-Robbins managed to improperly inflate its total assets
by more than 20 percent. That a division of McKesson should again 60 years
later be accused of accounting irregularities is rather ironic. In fact, during these
past 60 years, the unsuspecting public, officers, directors, and accounting firms
have fallen victim to a number of highly publicized financial statement frauds—
Equity Funding, ESM Government Securities, ZZZZ Best, Crazy Eddie,
MiniScribe Corporation, and Phar-Mor, just to name a few. Regulators, the
accounting profession, and other groups recognize the problem and have made
countless attempts to correct it. Despite their efforts, however, fraudulent
financial reporting continues to be a major problem for the financial community.
This article discusses important lessons learned from two widely
publicized financial fraud cases. It provides information on ways to detect
financial statement fraud and describes some of the schemes often used to
perpetrate such fraud. It also provides suggestions on how to prevent
fraudulent financial reporting.
DEFINITION OF FRAUDULENT FINANCIAL REPORTING
To fully understand the rationale for the fraud detection and prevention
techniques discussed in this article, a basic understanding of the characteristics
of financial statement fraud is necessary. In Statement on Auditing Standards
(SAS) 82, Consideration of Fraud in a Financial Statement Audit, the American
Institute of Certified Public Accountants (AICPA) defines fraudulent financial
CCC 1044-8136/99/1101047-08
© 1999 John Wiley & Sons, Inc.
47
Anthony M. Lendez and James J. Korevec
reporting as “intentional misstatements or omissions of amounts or disclosures
in financial statements to deceive financial statement users.” This can involve:
•
•
•
The manipulation, falsification, or alteration of accounting records or
supporting documents used to prepare financial statements
Misrepresentations or intentional omissions of significant events or
transactions from the financial statements
The intentional misapplication of accounting rules
Individuals who perpetrate financial statement fraud typically seek to
enhance the company’s (1) earnings by overstating revenues and/or understating
expenses or (2) financial position by overstating assets and/or understating
liabilities. Surprisingly, greed is not always the motivating factor. Often it is
senior management’s overwhelming desire to report financial results that meet
or exceed Wall Street’s expectations. Regardless of the reason, the end result is
the same—false financial reports.
MANAGEMENT CHARACTERISTICS
The new CEO had an
overbearing, autocratic
management style. He
immediately established
overly aggressive sales
quotas for divisional
managers and began
placing tremendous
pressure on them to
achieve their goals.
48
The characteristics of management have a strong influence over the financial
reporting philosophy of an organization. When management demonstrates
integrity and high ethical values, it sends a clear message to employees that
improper accounting practices will not be tolerated. On the other hand, if
management disregards rules and condones achieving company goals at any
cost, then employees are more likely to engage in illegal or unethical behavior
on behalf of the company—as well as against it. The MiniScribe Corporation
(“MiniScribe”) fraud is a good example of how senior management influenced
the fraudulent behavior of its employees.
In the mid-1980s, MiniScribe was a struggling manufacturer of computer
disk drives. The company had recently lost several large customers, including
International Business Machines, and the personal computer industry was in a
decline. In 1985, a new chief executive officer (CEO) was hired to help turn the
company around. The new CEO had an overbearing, autocratic management
style. He immediately established overly aggressive sales quotas for divisional
managers and began placing tremendous pressure on them to achieve their
goals. As a result, MiniScribe increased sales from $114 million to $603 million
in just three years. However, no one outside the company knew the numbers had
been fabricated.
In May 1989, the company announced that its financial statements for 1986,
1987, and for the first three quarters of 1988 could not be relied upon. This
prompted an internal investigation. The investigators concluded that
“MiniScribe’s management environment created and maintained an exceptional
amount of pressure on company managers to achieve pre-established quarterly
profitability goals. . . . For division managers, the most important task was,
invariably, to ‘make the numbers.’” Since the industry was in a downturn, the
only way divisional managers could achieve the aggressive targets imposed by
the CEO was to manipulate the results through irregular practices. Such
irregularities included, among other things, concealing inventory shortages;
shipping bricks to distributors as disk drives and, when the shipments were
returned, including them in inventory; and shipping obsolete parts to overseas
The Journal of Corporate Accounting and Finance/Autumn 1999
How to Prevent and Detect Financial Statement Fraud
The most obvious red flag
was the company’s ability
to increase sales by over
400 percent from 1985 to
1988, a period during
which the entire personal
computer industry was in
a downturn.
locations, combining them with scrap and other parts, repackaging them as
active parts, and including them in inventory.
The most obvious red flag was the company’s ability to increase sales by
over 400 percent from 1985 to 1988, a period during which the entire
personal computer industry was in a downturn. This should have been a
telltale sign that something was clearly wrong. If a company experiences
unusually rapid growth or profitability with no justifiable reason, especially
when compared to other companies in the same industry, it is probably too
good to be true. Another noteworthy red flag was the structure of the
management bonus plan. Bonuses represented a large portion of the
managers’ compensation package and were contingent upon MiniScribe
achieving the targets established by the CEO. While there is absolutely
nothing sinister about motivating employees with cash incentives, tying a
significant portion of their compensation to unrealistic goals may motivate
some employees to commit acts they otherwise would not commit.
The MiniScribe matter clearly demonstrates how an improper tone at the
top can influence the behavior of subordinates. If top management projects an
ends-justify-the-means mentality, then employees are likely to develop a similar
attitude. Financial statement fraud has been the subject of many studies. Over
and over again, these studies have emphasized the importance of establishing an
appropriate tone at the top (or control environment) as a way of improving the
financial reporting process. For example, the Report of the National Commission
on Fraudulent Financial Reporting identified the control environment as an
element “of overriding importance in preventing fraudulent financial reporting.”
In fact, the control environment is so important to the financial reporting
process that the recently issued auditing standard on fraud requires auditors to
consider it when assessing the risk of misstatement arising from fraudulent
financial reporting.
Some other management characteristics that might be helpful in reducing
the risk of financial statement fraud include:
•
•
•
•
•
Closely supervising the activities of the company, for example, by
adequately monitoring employees and remote locations
Ensuring that significant accounting controls are employed, for example,
by insisting that bank and other reconciliations be performed
periodically and on a timely basis
Correcting known reportable conditions, for example, by addressing
on a timely basis internal control weaknesses and other concerns
identified by internal and/or external auditors
Demonstrating appropriate respect for regulatory authorities and
regulations, for example, by taking regulatory inquiries seriously and
responding in a timely fashion
Employing effective accounting, information technology, and internal
audit personnel
COMPANY OPERATING CHARACTERISTICS
The operating characteristics of a company can sometimes create an
environment that facilitates the perpetration of fraudulent financial reporting.
These characteristics essentially relate to the nature and complexity of the
The Journal of Corporate Accounting and Finance/Autumn 1999
49
Anthony M. Lendez and James J. Korevec
company and its transactions. For example, if company assets are based on
significant estimates involving subjective judgments, it is much easier to
manipulate the financial results than when such estimates are based on objective
criteria. Examples of other operating characteristics that can provide
opportunities to commit financial statement fraud can include:
•
•
•
Related-party transactions
can be designed to
obscure the true financial
picture of a company,
especially if the
transactions involve
unconsolidated or
unaudited entities.
50
Related-party transactions with unconsolidated affiliates or with related
entities that are not audited
Complex transactions
Complex organizational structures
Take, for example, complex transactions with related parties. There are
various reasons why the complexity of a transaction can provide ample
opportunity for accounting fraud. First of all, complex transactions tend to be
more prone to error and manipulation simply because there are relatively few
individuals who fully understand their substance and can challenge their
propriety. Also, many such transactions often involve subjective judgments that
cannot be made without the requisite practical experience. In a similar way,
related-party transactions can create a greater risk of fraud because the substance
of these transactions can sometimes be significantly different from their form.
Related-party transactions can be designed to obscure the true financial picture
of a company, especially if the transactions involve unconsolidated or unaudited
entities. For instance, a company experiencing operating losses can engage in
transactions with an unconsolidated affiliate to reduce or eliminate those losses
(e.g., by recording fictitious revenues or by transferring the losses to the
affiliate). The ESM fraud demonstrates the risky nature of complex, relatedparty transactions.
ESM was comprised of two significant entities: ESM Financial and ESM
Group. ESM Group was the parent of two operating companies: ESM Government
Securities and another, inactive, company. ESM Government Securities was an
unregistered broker-dealer that traded mainly in repurchase and reverse repurchase
agreements involving government securities. In a repurchase agreement, securities
are sold under an agreement to repurchase them later at a stated price. Under a
reverse repurchase agreement, securities are purchased under an agreement to
resell them later at a stated price. From an accounting perspective, these agreements
are treated as collateralized borrowings and lendings. The difference between the
repurchase price and the original sales price represents interest income to the
buyer-lender and interest expense to the seller-borrower. Generally, the sellerborrower hopes to earn a profit by investing the proceeds in a venture that
produces a profit greater than the interest paid to the buyer-lender.
ESM Government Securities was losing money on these transactions and on
some of its other investing activities. To conceal its poor financial condition,
ESM Government Securities engaged in a series of intercompany transactions
with ESM Group, whereby losses and liabilities related to the repurchase and
reverse repurchase agreements were removed from the books of ESM
Government Securities and transferred to ESM Group. Through a series of
fraudulent intercompany transactions, ESM Group transferred those losses and
liabilities to ESM Financial, an affiliate that was not consolidated with ESM
Group. The ESM Group entities had been insolvent for many years; however,
The Journal of Corporate Accounting and Finance/Autumn 1999
How to Prevent and Detect Financial Statement Fraud
If members of top
management have
difficulty understanding
such matters, they should
seek the advice of
experienced professionals.
they were able to conceal their deteriorating financial condition by transferring
their losses and liabilities to ESM Financial. Although the related party
transactions were disclosed in a footnote to the financial statements, no one ever
questioned the transactions or the footnote, quite possibly because no one fully
understood the nature of the transactions. The entire scheme ultimately fell
apart in March 1985 when a customer questioned the footnote. By then,
however, losses on the repurchase and reverse repurchase agreements had
grown to over $300 million.
To effectively reduce the likelihood of fraudulent financial reporting, top
management needs to fully understand the company’s relationships with its
subsidiaries and affiliates as well as with its customers and vendors. It also
should fully understand the substance of complex transactions entered into by
the company. If members of top management have difficulty understanding
such matters, they should seek the advice of experienced professionals. Only
then can management assess whether the transactions reflect economic reality
and whether the related fraudulent financial reporting risks have been properly
considered. This understanding also will facilitate top management’s discussions
with the outside auditor in assessing whether the accounting for such transactions
is appropriate under the circumstances.
DETECTING FINANCIAL STATEMENT FRAUD
Fraudulent financial reporting can be difficult to detect—but not impossible.
While it is generally more cost-effective to prevent fraud, companies should also
consider employing proactive measures to help them detect fraud. Internal
auditors or other personnel with similar responsibilities can carry out these
measures.
Procedures that might help management detect possible financial statement
fraud include:
•
•
•
•
Periodic reviews of ledgers and records for transactions that do not
appear to make sense, such as erroneously recorded transactions,
transactions recorded late, partially recorded transactions, unsupported
or unauthorized transactions, and numerous adjusting journal entries
Investigations of suspicious activity, such as large, unexplained, or stale
items on reconciliations, unusual personal relationships between key
personnel and customers or vendors, and seemingly unbelievable
explanations from personnel regarding certain transactions
Periodic application of analytical procedures to search for unusual
financial trends, such as unexpected increases or decreases in expenses,
cost of sales, receivables, and inventories or for changes in key ratios,
such as inventory turnover and sales returns as a percent of total sales.
Performance of fraud assessment questioning in which employees are
asked whether they are aware of any accounting practices that might be
considered improper.
Knowing how to detect possible accounting irregularities only solves part
of the problem—management should also be aware of the schemes used to
perpetrate fraudulent financial reporting. Following are examples of some of
the more commonly used schemes to manipulate financial statements.
The Journal of Corporate Accounting and Finance/Autumn 1999
51
Anthony M. Lendez and James J. Korevec
•
•
•
•
Most fraud experts agree
that in the long run it is
more cost-effective to
prevent financial
statement fraud rather
than try to detect it.
•
Improper Revenue Recognition—The most common scheme is simply
recording sales to nonexisting customers. Another common scheme is
the recognition of sales when the customer’s obligation to pay is
contingent upon some future event.
Improper Capitalization of Costs—These schemes have included the overcapitalization of costs related to internally developed assets, the
capitalization of assets that fail to provide a future benefit, the capitalization
of research and development costs or administrative costs, the
capitalization of preopening costs and the capitalization of advertising
costs in a manner inconsistent with the provisions of AICPA Statement
of Position (SOP) 93-7, Reporting on Advertising Costs.
Overstatement of Assets—These schemes typically involve failing to
establish reserves for obsolete inventory and/or failing to provide
adequate allowances for uncollectible receivables. Other common
schemes include recording nonexistent inventory as an asset or failing
to write down impaired long-lived assets.
Unrecorded Liabilities—These schemes usually involve failing to properly
accrue for expenses incurred within the period or failing to record
liabilities for infrequently occurring items such as environmental
matters.
Inadequate Disclosures—These schemes include failing to disclose going
concern problems, guarantees of indebtedness of others, guarantees to
repurchase receivables sold, and pending or threatening litigation.
Most fraud experts agree that in the long run it is more cost-effective to
prevent financial statement fraud rather than try to detect it. With this in mind,
we will now discuss some fraud prevention techniques.
PREVENTING FINANCIAL STATEMENT FRAUD
To help prevent financial statement fraud, top management needs to create
a positive control environment. It also needs to hire honest people, provide all
employees with fraud awareness training, and develop an understandable code
of ethics.
Creating a Positive Control Environment
Studies have shown that organizations with positive control environments
tend to be less vulnerable to fraudulent financial reporting. To foster such an
environment, members of the board of directors and audit committee need to
display and communicate a proper attitude toward internal control and the
financial reporting process, including demonstrating high integrity and positive
ethical values. This also requires active participation in the day-to-day operations
of the company and frequent meetings to discuss ongoing company activities
and performance. An effective system of internal control should include a
reliable accounting system, adequate control policies and procedures, and
policies to ensure the proper safeguarding of company assets. It also requires
clearly defined accounting and financial reporting policies.
The audit committee should fully understand the company’s operations
and its accounting policies. It should actively participate in audits conducted by
the internal audit department and in the annual audit performed by the outside
52
The Journal of Corporate Accounting and Finance/Autumn 1999
How to Prevent and Detect Financial Statement Fraud
auditors. For more information on the qualities of an effective audit committee,
readers should review the report and recommendations recently issued by the
Blue Ribbon Committee appointed by the New York Stock Exchange and
National Association of Securities Dealers. The Committee was formed in
response to SEC Chairman Arthur Levitt’s concerns about the quality of
financial reporting.
Hiring Honest People
For highly sensitive
positions, consider using
a private investigator to
conduct a full
background check.
New hires should be effectively screened through proper background checks.
This can include searching publicly available databases, such as IRSC or KnowX.
Sometimes a review of an applicant’s credit history can reveal undesirable
characteristics that might not be suitable for the position being filled. For sensitive
positions (e.g., divisional managers, controllers), consider using an outside
agency to help you obtain information on the applicant’s employment history,
educational data, professional licensing, references, criminal record, military
record, and driving record. For highly sensitive positions, consider using a private
investigator to conduct a full background check. The personnel responsible for
interviewing applicants should be properly trained. Not only should they know
which questions can and cannot be asked, they should also have the skills to detect
evasive and deceptive responses. Companies should always verify past employers
and references. Because of the risk of potential litigation, past employers will not
reveal adverse information about former employees. They may, however,
voluntarily express a positive view of the applicant, which can be more comforting
than just providing dates of employment.
Providing Fraud Awareness Training
Personnel should be made aware of what is considered acceptable and
unacceptable behavior, preferably through fraud awareness training. They
should know what to do if they see someone engaging in behavior that is
inconsistent with company policy and should be familiar with the company’s
code of ethics, if any. Fraud training can be done as part of employee orientation
and on an ongoing basis through lectures, training films, and workshops. At a
minimum, the training should provide information on:
•
•
•
The acts or omissions prohibited by company policy and by the laws
and regulations applicable to the company
How employees and the company are adversely affected by fraud (e.g.,
negative publicity, lawsuits, decreased employee morale)
How to avoid potentially compromising situations
Fraud training should advise employees on what actions should be taken in
the event possible fraud is suspected. In this regard, organizations may want to
consider establishing an employee “hotline” or other reporting mechanism that
provides for the anonymous reporting of possible fraud.
Larger companies may want to develop a written fraud policy that provides
specific information on who will be responsible for investigating allegations of
fraud, how such investigations will be coordinated internally, what actions will
be taken against perpetrators, and who will have the authority to approve such
actions. A high-level person should be appointed to follow up on any suspicions
The Journal of Corporate Accounting and Finance/Autumn 1999
53
Anthony M. Lendez and James J. Korevec
of fraud. In addition, the policy should specify the circumstances under which
outside counsel and investigative assistance will be retained.
Developing an Understandable Code of Ethics
All companies should consider adopting a code of ethics. It is one of the best
ways to officially notify employees of what is considered acceptable and
unacceptable behavior. The code should be distributed on a periodic basis, and
employees should be asked annually to acknowledge that they have read and
understand the code.
Ample evidence suggests
that the risk of financial
statement fraud can be
reduced to a relatively low
level if appropriate
safeguards are employed.
54
ADOPTING SAFEGUARDS
When allegations of financial statement fraud surface, costly litigation
usually follows. Oftentimes, the professional reputation of innocent officers and
directors is forever tainted. Ample evidence suggests that the risk of financial
statement fraud can be reduced to a relatively low level if appropriate safeguards
are employed. Since the benefits of adopting measures to reduce the likelihood
of fraudulent financial reporting far outweigh the costs, there is really no
rationale for not adopting such safeguards. ♦
The Journal of Corporate Accounting and Finance/Autumn 1999
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