Masking financial statements: financial fraud and financial statements – part 1

The COVID-19 pandemic has us accustomed to wearing facial coverings and only seeing half faces. Once the pandemic is finally behind us, we might see financial statements “masked” to hide certain aspects of the finances of companies adversely affected by COVID. Feeling pressure to reassure their stakeholders, they might be tempted to manipulate their reporting. With all eyes on the economic recovery, are you up to speed on financial statement fraud and falsification? And more importantly, do you know how to ask the right questions to protect your financial health?

Financial statement fraud

The Association of Certified Fraud Examiners (ACFE) defines financial statement fraud as “the deliberate misrepresentation of the financial condition of an enterprise accomplished through the intentional misstatement or omission of amounts or disclosures in the financial statements to deceive financial statement users.” The key message here is that financial statement fraud is not just about presenting inaccurate information, but can also consist of non-existent information. Both cases aim to achieve a specific goal, such as to secure new funding, maintain special status, award bonuses based on financial performance, prevent a loan from being recalled, influence stock prices, or conceal an embezzlement.

There are many infamous examples of financial statement fraud, the most notorious being Enron, after which new regulations were introduced. Nevertheless, new scandals have continued to emerge, proving that we need to stay vigilant. A recent example is Theranos, a Silicon Valley start-up that promised comprehensive blood testing with a single drop of blood. One of the issues was that the tests never worked. The company’s founder, Elizabeth Holmes, still managed to bring her company’s valuation to billions of dollars based on false financial data provided to a pool of potential investors, including several attorneys.

This is not such an unusual story. Advisors, business partners and investors base their decisions on the financial information produced by companies. However, they should keep in mind the following statistics on financial statement fraud compiled by the ACFE in 2020, which encourage them to exercise vigilance about the financial information they receive:

• Financial statement fraud is the type of fraud that causes the most financial damage on average per occurrence (over US$950,000 median loss). These losses affect investors, of course, but also the clients and suppliers of these companies.
• 30% of financial statement frauds are committed by executives and senior managers. Senior executives are more likely to have motive and pressure that would push them to carry out this type of fraud, in addition to having access and opportunity. In addition, they have the most to gain from a positive bottom line and a healthy balance sheet. A long-term relationship does not guarantee reliable information.
• Only 4% of fraud detections are made by external auditors. The fact that financial statements are audited by an external auditor is not a guarantee that they are free of fraud, since fraud detection is not part of the auditors' mandate.

How financial statements are manipulated

There are a few factors that can enable the manipulation of financial statements. Here are a few:

• Inadequate monitoring and weak internal controls: As previously mentioned, external audits detect very few frauds. The key lies instead in the strength of the company's internal mechanisms, including the code of conduct, appropriate board and audit committee oversight, and robust and effective specific anti-fraud controls.
• Accounting standards: Financial statements are normally prepared by management in conformity with an established basis of accounting. In some cases, however, these accounting standards allow for the “choice” of one accounting method over another and also provide for the use of accounting estimates. These “choices” can have a strong impact on what will be reflected in the financial statements. The determination of estimates, provisions and reserves can materially affect the appearance of the balance sheet and income statement.

Financial literacy of users: To decipher financial statements, you need a basic knowledge of accounting and an attention to detail. Potential fraudsters can take advantage of the fact that users of financial statements are not all accounting experts, do not necessarily have access to all the details supporting the numbers, and generally have limited time to thoroughly review them. In recent years, especially with the pandemic, we've noticed a shift in financial statement fraud, whereby it's no longer used just to hide another fraud, but becomes the fraud itself, serving to meet certain goals as listed above. It is unfortunately not always easy to identify a single fraudulent process. Fraudsters are ever more creative and inventive, and may make use of more than one process at a time. But we can categorize the different ways of manipulating financial statements in three major types:

1. Overstating the company's net worth and profits
2. Understating the company's net worth and profits
3. Inappropriate disclosure (including intentional omission) of information

From this list, is the second category the one that surprises you the most? Who would want to report a lower corporate value or smaller profits? This is an interesting case, especially in the context of a pandemic. Consider the example of an executive of a company that performed well in 2019 before the pandemic. In order to qualify for a bonus, might he have been tempted to delay the recognition of certain revenues to show that his company performed better during the pandemic?

We will revisit the different manipulations in the next chapters of our series on financial statement fraud.

Impact of the COVID-19 pandemic

The COVID-19 pandemic has created an environment conducive to a rise in financial statement fraud. This is primarily the case because certain sectors suffered a sudden drop in revenue or market share. Like in our previous example, a manager, a representative, or any other employee may want to mask the decrease in revenue by recording fictitious revenue or recognizing revenue sooner to post better performance.

Massive losses related to the pandemic may present a good opportunity for fraudsters to write off “everything but the kitchen sink” in order to conceal new frauds or correct old ones. Everything on the balance sheet may be at high risk of being written off, including inventory and debt.

On another note, anticipated changes resulting from the pandemic may cause some assets to lose value. For some companies, a business unit may even become obsolete. Some will have difficulty determining the value of these assets, either at fair value or realizable value, and they might be tempted to not recognize the losses.

Above we spoke about the absence of information as a potential financial statement fraud. This will be especially meaningful in the aftermath of the pandemic. Certain corporate players will want to minimize information and communications that could bring bad news to their stakeholders. We will cover this topic in the next installment of our series on financial statement fraud.

Questions to ask and next steps

The following is a non-exhaustive list of possible questions:

• Why is this company profitable when others in the same industry are struggling? Does it show a profit and loss trend comparable to its peers?
• Why are revenues increasing but cash flows are not?
• What accounting policies and estimates are used? Are they appropriate? Have they changed recently?
• Why does the company have so many related party transactions? Or so few?
• How has the pandemic impacted this company and how is it reflected in its financial statements?

If you have doubts or suspicions about the financial statements that have been submitted to you, it is critical to reach out to a qualified and experienced team that includes a forensic accountant.