Success in business is about reaching financial goals. Wherever you want to be, you need to be transparent on where you currently are. Without accurate data, you’re guaranteed to make mistakes.
Even if you’re brilliant at making financial decisions.
Costly mistakes you can avoid by preventing accounting fraud.
You can only improve the results that you measure.
- What Is Accounting Fraud
- Types Of Frauds In Accounting
- Accounting Fraud Examples And Cases
- How To Detect Accounting Fraud
- How To Prevent Accounting Fraud
- Signs of Accounting Fraud
- The Bottom Line
What Is Accounting Fraud
The purpose of accounting is communication. It’s about reporting the essential variables so that we can make better decisions. Therefore, accounting fraud is about data distortion. People make up financial results, which complicates decision-making. These accounting flaws happen in many forms: asset valuation, inaccurate tracking, inconsistent revenue, or hidden information.
The Basics Of The Scheme
Don’t be mistaken. It rarely has anything to do with a lack of accounting skills. It’s a scheme used to meet personal interests. If there is an incentive but no preventive measures, it may happen to you.
As a result, a company creates a false image for the public. This temporary illusion may be useful in many ways:
- Investors keep financing the firm with confidence.
- The company’s reputation is higher based on this performance data.
- The fraudsters can profit from hidden information and unrecorded expenses.
However, the price may be steep. As soon as others find the truth, the company may lose its credibility. Once the problems are revealed, the business starts to contract.
Those who use these practices may be limiting their long-term success.
How Does It Happen?
Dishonest people in large businesses can find numerous ways to misrepresent the financial condition of a company, including accounting for stock options, pension plans, derivatives and more. Just because small companies don’t face these technical accounting challenges doesn’t mean there’s no potential for accounting fraud.
People are very social creatures. We don’t like to expose our flaws. When we show our failures, especially if there are many, people may lose confidence.
It’s all about expectations. If a CEO values what stakeholders expect, he will ensure to meet those standards. Even when the reality is different. That’s when delusion replaces honesty. The firm presents the way people want it to be, not how it actually is.
What if they are underperforming? The board members can exaggerate revenue and hide expenses. The company finances will look healthier than they are.
Dangers Of The Accounting Scam
Accounting fraud is not a new threat. Those who don’t prepare for it expose to the most risk. If you don’t stop it quickly, it could mean bankruptcy in worst case scenario.
Accounting scams could be the devil in sheeps clothing for a company. Not only ‘does the business lose money. The firm may also lose its credibility, and the decisions based on wrong number are flawed.
When this happens in large corporations, it can have implications so large to even help sink the global economy, as was the case in 2008.
Types Of Frauds In Accounting
The four types we will review have one thing in common: optimistic representation. All try to make the company look better than it is and profit from that image.
Each case is different. A person taking money away without recording the expense. Loans disguising as sales. A member stealing from revenue round-offs. Any case falls into some of these categories.
The accountant manipulates the numbers to meet expectations. They achieve it by inflating revenue and reducing expenses.
Exaggeration is a powerful tool to mislead people. The company could take a loan but show it to the public as sales revenue. It could also exclude costs to make the profit look substantial.
Marginal gains and losses can also be taken advantage of. If a company gets 30.58% ROI from a product, they may register it as 30% and steal the 0.58%, for example.
Inaccurate registers can add up and create big losses. Unless the whole process is optimized and monitored, it may be hard to detect.
When an organization has no data to show, they can make up the numbers completely.
When giving bad news, the truth is uncomfortable. But if we don’t want to lie, what do we do?
Hidden information is the art of lying without lying. You’re not faking the reports, but you aren’t showing the truth. Instead, you only show people what they want to see.
In finance, a firm can hide debt and other expenses from the equation. It may seem they doing well while they’re actually down in the red.
Misinterpretors can reveal this information whenever it’s more convenient. If a global event happens, they may use it as an excuse for their “performance decrease.” In reality, they’re disguising their scheme.
Speculation is mostly based on market noise. Here, scammers send others information to influence their choices and expectations. If they want others to believe in a market rise, they will gather all information that can prove that.
Of course, it means hiding the contrary news. If you make others believe you are worth more, they will invest in your firm. This delusion can give the company the capital needed to stay in business.
It’s difficult to recognize unless you work inside the company or do your research.
This practice is an extra more than a fraud type. Inadequate disclosures create false evidence and strengthen the scheme.
The fraudster may fake documents such as income reports and expense registers. An investor that relies on this kind of proof would be instantly at risk of losing his money.
The company may be going out of business next year. But investors won’t know it due to misinformation. They think it’s a smart investment when it’s a money pit.
The authorities consider these frauds very threatening. For the involved members, it could either mean years in prison or great business limitations.
Accounting Fraud Examples And Cases
Example of under-recording liabilities: The Enron case
Enron has cost billions of dollars for its stakeholders. How would you have expected it? For six-years straight, it’s been the “America’s Most Innovative Company” in Fortune Magazine.
Enron was an energy company led by Jeff Skilling and the former CEO, Kenneth Lay.
It was in 2001 when investors started to suspect. Jeff and Ken had been working on multiple projects that failed. They decided to hide the huge debts created and ignore the issue.
Back to the Enron event, there weren’t the accounting regulations we have today. The company price dropped by 99% in less than six months, from $90.75 to under $1.
The stakeholders began an investigation and found the plan. Enron had been under-recording expenses the whole time.
Example of inflated asset valuation: The HealthSouth case
You may have thought of this expression. Overcommit and overdeliver. It’s better to exceed expectations than coming up short.
It’s easy to overdeliver when not committing in the first place. At HealthSouth, the directors were making up numbers to meet stakeholders’ expectations.
They inflated their revenue by $1.4 billion. In 2003, CEO Richard Scrushy sold $75 million in stocks. Coincidentally, HealthSouth faces a huge financial loss right the next day.
The U.S. Securities And Exchange Commission (SEC) used this clue to detect the scam. Scrushy had falsified the HealthSouth revenue since 1996.
Example of overstating revenue: The Lehman Brothers case
The Lehman case was a critical event leading to the 2008 recession. This corporation offered financial services globally. Like Enron, Lehman Brothers earned prestige in the Fortune Magazine, one year before the collapse.
In middle 2017, the economy had started to crumble. Lehman needed extra funds to finance the deals, and the future was uncertain. What seemed to be a $50 billion deal was a loan with the Cayman Island banks.
Although it created a temporal illusion of success, Lehman went bankrupt permanently. This inconsistency raised the SEC suspicions, revealing the plot.
How To Detect Accounting Fraud
We can choose to take control. What can we do to protect ourselves? Most people detect scams when it’s too late. Here are three ways to recognize them.
Understand the financial relationships
In business, cause and effect is an absolute rule. Entrepreneurs can learn about the effects of decisions. Here are a few examples:
- If you reduce costs, you may expect profits to go up. However if profits are very dependant on these costs (like advertising costs), this may not be true.
- If the liabilities increase, the asset value is lower.
- Cash-flow models barely have any expenses but limited revenues.
- Some variable costs can change the break-even point of a product.
Nothing just happens. Finance follows predictable patterns based on the data you register. If it’s inconsistent, you can suspect of an accounting scheme.
Analyze Performance Spikes
Are you suspicious about accounting fraud in your company? Look at the company history. See if you can find inconsistent results. What could have caused it?
Make a list of the variables you want to revise. Study the results while changing one variable at a time. If you use more, you won’t recognize the financial relationship. It could be profits, interest rates, debt, working capital, or any variable responsible for your company results.
Once you understand what caused the past spikes, you can detect them in the future. If you haven’t had any, you can study other companies to learn how they did it. Here, you will find the links to the three cases we’ve reviewed.
Contrast Business Predictions
Accounting scams are all about expectations. If the news is always good, it may feel like researching isn’t needed.
Most people never do their own analysis. They follow the popular predictions, and scammers use it to their advantage. Take time to make predictions and be as transparent as possible.
When you receive the official reports, compare. Is it what you expected? Are they overly optimistic? Until you start questioning your registers, there’s no way to detect accounting scams.
Don’t get it wrong. Trust your team, but verify the facts. You aren’t being responsible, not doubting.
If your company has years of history, you can expect consistent results. Use the proof to your advantage.
How To Prevent Accounting Fraud
People are quite creative when it comes to making up reality. If the reward is big enough, people will find a way to deceive. And it’s not easy to detect these deceiveing practices.
You’d be amazed at the many ways you can prevent it. Structure your company the right way, and you maybe never have to deal with these problems.
Outsource Without Giving Up Control
Delegating activities is a smart decision. Giving control is a delicate choice.
Remember the importance of personal research? As an entrepreneur, you must build a team for the right reasons. When you hire an accountant, you only do it to save time and focus on the business. Not because you don’t understand accounting.
You need some basic knowledge to evaluate how your workers are performing. If you don’t understand what they do, you lack control over the business.
The last thing we want is to let others decide our future. It’s better to be wrong than letting others sink the ship. Hence the importance of financial education.
Check Accounting Systems
You can protect your business from both innocent typos and intentional accounting fraud by documenting fundamental pay outs and revenue procedures and identifying the number of people that could be involved. Check how your accounting system works, and identify what controls are in place and who has responsibility to exercise those controls. Inventory and cash must be counted. Liabilities need to be confirmed. Any increase or decrease in the equity since the last check is profit or loss. A system check does not protect you against accounting fraud or innocent mistakes, it just simply tells you the company’s financial condition after the fraud or innocent error has occurred. Many small business use this method because the company does not have systems controls in place, and because it is inexpensive. People do make mistakes that can cost an organization substantial amounts if the errors aren’t caught and that is what makes the systems approach essential.
Document Spending Habits
Quantity, description, price and authorization for expenditure should all be documented In larger companies, the person preparing the purchase order and the person authorizing it are different people. It is advised that the owner alone should authorize all expenditures to prevent spending company money for personal use. The levels of approval required are determined by how much impact the decision could have on the company’s profitability. The more money at risk, the more care should be taken that the right decision is being made. Payback analysis and discounted cash flow analysis, measure how fast the business will recover the investment in the form of profits earned from the assets being acquired.
Keep The Paperwork
Save all bills and documents for at least two years, but recommended is too keep them forever. Documenting disbursement and revenue procedures protect against unintended loss. To be sure a company is profitable, the revenue and cost of every transaction must be measured. Some costs are incurred solely for the purpose of earning revenue, and are therefore easy to measure and document. Overhead, or period charges, such as rent, power, insurance and even salaries are more difficult to work with.
Prevent The Fraud Triangle
When accounting fraud happens, avoid the blame game. It will not do you any good. It’s all about risk and reward. People will look for the fastest way to meet their goals.
People do what they do because they find a big reward at low risk, short-term speaking. Later, they rationalize their actions based on this relationship. It’s opportunity followed by pressure and rationalization.
When CEOs set poor accounting standards, others will take advantage of it. Apply everything you’ve learned here, and you ensure maximum protection.
These detection measures increase the risk of getting caught. That’s how you block the fraud triangle.
Signs of Accounting Fraud
- Someone insists that he or she handle activities for which other departments are normally responsible. Including picking up the daily mail, acting as the sole responsible person with the company’s financial contacts and working with police if items or money are found missing.
- Someone continually works after hours, comes in frequently on weekends or insists on taking work home. Fraudulent activities are easier to accomplish when work is unobserved and unsupervised.
- Someone refuses to follow recently established accounting guidelines. Owners should demand that guidelines be strictly followed and investigate financial and payroll records for up to several years in the past.Someone works without direct supervision on all company’s financial operations. When one trusted bookkeeper is responsible for records, payroll, receivables, deposits, payments and so on and you notice that at the end of the month or year the numbers don’t match, this is the first place you should look at.
- Someone refuses to take a vacation. This individual may be thought of as a highly dedicated and hard-working employee, but it could be that he or she simply doesn’t want anyone to discover any fishy documents.
Owners should always carefully monitor income and deposits, comparing sales receipts against actual amounts put into the bank. There are no sure-fire tips for accounting fraud. But by being on the lookout a small business can avert a potentially disastrous and embarrassing financial loss.
The Bottom Line
Accounting frauds can be some of the most expensive mistakes in business. When they happen, you require high awareness to detect them.
Protecting your business from fraud is time-consuming and requires in-depth thought about the way your operation is structured. However, as more revelations of accounting fraud practices come to light, it’s obvious that the time it takes to put even the most basic safeguards in place is time well spent.
Remember, the first step is awareness. You protect against future frauds by learning and preparing today.