How unethical management fraudulently misstates financial statement? The majority of cases of fraudulent financial reporting involve making a company’s financial health appear better than it really is. There are a number of methods by which this can be accomplished: (1) Overstating revenues; (2) Understating expenses; (3) Understating liabilities; (4) Overstating assets; (5) Improper disclosures. Often, a combination of methods is used. For example, a company may “hold the books open” and record revenue this year when the revenue should be recorded in the following year (overstating revenues). At the same time, the company may delay the recognition of some expenses and record them in the following year when the proper recognition of the expenses should have occurred this year (understating expenses).
This post describes and illustrates how unethical management fraudulently misstates financial statement. It does not mean to encourage you to do so, but to avoid these practices at all.
Method#1. Overstating Revenues
Because net income equals revenue minus expenses, any time revenues are overstated, net income also will be overstated.
Revenue can be overstated by doing the following:
- Recording fictitious revenue
- Recognizing revenue prematurely
- Understating sales returns
Fictitious revenue can be created by recording sales to customers who do not exist (ghost customers) or by recording inflated sales to actual customers. If the latter method is chosen, management will need to take care not to over-bill the actual customers, and so although fake documentation will be required, careful records must be kept. The lengths to which some managers go to perpetrate this kind of fraud can be amazing.
Example of Fraudulent Financial Reporting with Fictitious
In the mid-1980s, ZZZZ Best Co., Inc., perpetrated a massive financial statement fraud that fooled the auditors of one of the then largest international public accounting firms, along with ZZZZ Best’s investors, who lost a reported $100 million. The company was a carpet cleaning business started by Barry Minkow out of his parent’s garage when he was 13 years old. Most of the fraud involved recording fictitious revenues and accounts receivable and was perpetrated to inflate the stock price when the company went public five years after its inception.
The company claimed to earn most of its revenues through lucrative insurance restoration jobs which involved cleaning and repairing buildings damaged by floods, fires, and other major catastrophes. However, the insurance restoration side of the business was entirely bogus, and only the carpet cleaning side of the company was legitimate (it represented approximately 2 percent of the company’s total revenue according to its fraudulent financial statements).
When the auditors insisted on physically inspecting one multi-million-dollar insurance restoration site, ZZZZ Best management found a large building under construction and was able to persuade the construction foreman to provide them with keys to the building for a weekend on the pretext that they were with a property management firm and were going to provide a tour to a prospective tenant. Before the auditor’s visit, they placed signs throughout the building indicating that ZZZZ Best was the contractor for the building’s restoration. This building had not been damaged—instead, it was under construction—but the plan went off without a hitch: The auditors were fooled.
On another occasion, when the auditors insisted on visiting another multi-million-dollar restoration site, ZZZZ Best had to lease some floors of a new building quickly. For the floors that weren’t completed, ZZZZ Best spent approximately $1 million to make the space look realistic, hiring subcontractors to make the floors look restored. All this for a tour with the auditors that lasted perhaps 20 minutes.
Recognizing revenue early—a timing difference—means recording revenue before GAAP allows it to be recorded. Revenue recognition principle states that revenue generally is considered earned and reported in the income statement in the period in which the business provided the service or sold the goods even though the customer may not pay for the services or goods until a later time.
It would not affect a company’s financial statements to record revenue on July 13 that was earned on July 25, when the fiscal year end is December 31. Thus, this type of fraud occurs around the end of the fiscal year. Companies may record their revenue prematurely at that time if it appears that they may not reach their desired earnings target. Of course, this is like robbing Peter to pay Paul because the revenue cannot be recorded in the subsequent year when it truly is earned since in that case it would be double-counted.
Understating sales returns is another technique that can be used to overstate revenues. A sales returns are deducted from gross sales to arrive at net sales revenue. Thus, if the amount of sales returns is understated, net sales revenue and net income will be overstated.
Example of Fraudulent Financial Reporting with Understated Sales Returns
In the mid–1980s, management changed at Regina Company, Inc., a manufacturer of vacuum cleaners. New products were introduced which were less expensive to manufacture, but those vacuums had plastic parts that apparently often melted when the product was used for a period of time, rendering the vacuum cleaner useless.
Consequently, the sales returns were increasing greatly, running as much as 16 percent of gross sales revenues.
The new CEO had a controlling interest in the company, and it had been his idea to meddle with Regina’s 100-year-old sterling reputation as a manufacturer of hardy, dependable vacuum cleaners. He had purchased his interest in the company by taking on a large amount of personal debt, and he needed Regina to be profi table so that he could make his debt payments. With the auditors coming soon and the warehouse fi lling up with returned merchandise, he decided to cook the books with the assistance of other members of management. He rented a warehouse elsewhere to store the useless returned vacuums and altered all the documentation indicating that the sales had been returned.
The sales returns were not reflected on the financial statements, and the auditors were fooled. However, this kind of fraud, with the underlying cause of an ineffective product, cannot continue indefinitely. Before long, word of the defective design began to spread among consumers, and sales began to drop. Eventually, the CEO realized he couldn’t continue to juggle the numbers and deceive the auditors. Like a house of cards, the company collapsed, and investors and creditors lost a reported $40 million.
Method#2. Understating Expenses
Understating expenses is a fraudulent technique that has the same effect on net income as overstating revenues. Because net income equals revenue minus expenses, any time expenses are understated, net income will be overstated.
Expenses can be understated by:
- Postponing expense recognition
- Capitalizing expenses (i.e., recording an expense as an asset)
Recognizing expenses in a subsequent accounting period violates the matching principle. Matching principle requires that costs incurred by the business generally be recorded as expenses on the income statement in the period in which the related revenue is produced. In other words, revenues are matched with the costs and efforts associated with producing those revenues, resulting in the net income or loss during the specified period. If the expenses are recorded in an accounting period later than the one in which the related revenues were generated, net income will be overstated.
Capitalizing expenses—improperly recording a cost as an asset that will appear on the balance sheet rather than as an expense of the period that will appear on the income statement—is a variation of recognizing expenses later. Costs that provide benefits to a company over a number of accounting periods, such as the purchase of a company vehicle or manufacturing equipment, should not be expensed immediately in the period of purchase. That action would violate the matching principle since those assets will help the company generate revenues over future periods. Instead, these costs are capitalized—recorded as an asset—and gradually expensed over time as the assets are used. This expense is called depreciation expense and represents nothing more than the allocation of the asset’s cost over the periods benefited by the use of the asset (depreciation in accounting terminology has nothing to do with writing an asset down to market value).
If a company is engaged in fraudulent financial reporting, it may decide to capitalize expenses improperly to overstate income.
Say a company had purchased a piece of equipment and properly capitalized it and depreciated it over its seven-year useful life.
But what if a big sum outlay had been for employee’s wages and the company decided to capitalize that expense? Sound improbable?
Capitalizing operating expenses was a technique used by WorldCom to misstate its financial statements by a reported $3.8 billion. The proper accounting technique would be to expense any amount in one period for expenditire with no future benefit; on the previous example, the employees worked that year and helped generate revenues that year.
However, if the company instead decided to record the the payment as the purchase of computer equipment, the effect on the financial statements would be to report much less expense (only through gradual depreciation) and would affect net income that year.
Thus, the effect of improperly capitalizing expenses is to do the following:
- Overstate assets (which makes the balance sheet look better)
- Understate expenses (which makes net income and the income statement look better)
- Overstate stockholders’ equity (net income increases year-end equity and so assets and equity are both overstated, and, the more equity, the better)
Method#3. Understating Liabilities
The fewer liabilities—or the less debt—a company has, the healthier and less risky it appears. Because the balance sheet must remain in balance, it will appear that more of the company is owned than owed.
This effect occurs because if a liability is understated, there is usually an expense that is not recorded (giving rise to the debt). As was explained in the previous section, if expenses are understated, net income is overstated, which in turn overstates equity. Note that these fraudulent financial reporting schemes are not necessarily mutually exclusive.
Liabilities can be understated by:
- Completely omitting some of them from the financial statements; or
- Recording them at an amount lower than what is proper
Any liability can be understated if the company decides to do so. For example, a company may decide to omit recording contingent liabilities: liabilities that become debts contingent on a future event occurring.
GAAP states that contingent liabilities must be booked if they are “probable” and the amount can be “reasonably estimated”. For example, a company must estimate and record a liability for future warranty obligations if it sells products with a warranty. It is probable that some products will fail or be defective in some manner during the warranty period and will be returned. Further, the amount can be estimated reasonably on the basis of past experience.
Another type of liability that a company may omit is unearned revenues. Recall that when a company receives cash from a customer in advance of performing a service or providing goods, the revenue has not been earned. Instead, the cash is recorded as received (an asset has increased) and a liability is also recorded (unearned revenue). The company must either provide the customer goods or services or return the money back to the customer if for some reason it does not provide the service or the goods. Warranty service contracts, sales of gift cards, and frequent flier and other awards programs fall into this category of unearned revenues.
Depending on how bold the company is in its fraudulent financial reporting scheme, it may decide to stash unpaid bills in desk drawers or filing cabinets until it can pay them and fail to include these amounts as liabilities. It is more difficult for auditors to detect an unrecorded item that should be included than to detect an error of an item that has been recorded but using the wrong amount. If an item has been recorded, it can end up being selected to appear in the auditors’ sample of items to test. In contrast, if an item has not been recorded, it is not possible for the auditors to select that item for testing from the population of recorded items.
Method#4. Overstating Assets
Overstating assets will achieve the same objectives as understating liabilities. The more assets a company has, the healthier it appears. Because the balance sheet must remain in balance, it will appear that more of the company is owned than owed.
This effect occurs because if an asset is overstated, the company is not going to record a corresponding nonexistent or overstated debt for the nonexistent or overstated asset. Rather, there is usually a revenue that also was recorded. As was explained earlier in this chapter, if revenues are overstated, net income is overstated, which in turn overstates equity. Again notice how these fraudulent financial reporting schemes are not necessarily mutually exclusive.
Any asset can be overstated, but commonly the following assets are targeted:
- Accounts receivable
- Fixed assets (property, plant, and equipment)
For a manufacturing or retail business, inventory usually constitutes a large proportion of total assets. Auditors are required under professional auditing standards to observe a client’s inventory count physically at the end of the fiscal year if inventory is material to the financial statements. This requirement is from one of the first auditing standards issued, which resulted from a major inventory fraud that occurred in 1938 at McKesson & Robbins. Despite this requirement, the auditors still can be fooled if management is intent on doing that.
Example of Fraudulent Financial Reporting—Overstated Assets
In the late 1980s and early 1990s, Phar-Mor, Inc.—a deep discount retail chain store—began to manipulate its reported inventory. The number of stores and the states in which the stores were located grew at a phenomenal rate during that time. The COO (chief operating officer) who was also the president and founder of Phar-Mor claimed that profits and growth were due to the company’s ability to successfully engage in “power buying”, a term the COO used to describe his approach of buying large quantities of products when the vendors were offering their lowest prices. He also employed a strategy of offering low prices to Phar-Mor customers in order to compete with competitors such as Wal-Mart. However, the prices were so low on so many products that Phar-Mor stopped earning a legitimate profit in 1988.
The losses suffered by the company never were reflected in the financial statements since the COO and several top executives began to engage in fraudulent financial reporting. Inventory was one of their prime targets, and the company began to overstate inventory by inflating the amount of reported inventory for each individual store. But how could this go undetected by the auditors when they were required to observe the client’s inventory counts at year end? Auditors cannot observe all stores’ inventory counts when there are many stores and they are geographically dispersed, but in this case, the auditors chose to observe the counts annually at only 4 or 5 stores out of over 300.
Furthermore, it was reported that the auditors told Phar-Mor executives ahead of time which stores they would be observing. That slip made it a simple matter for the company to ensure that the records and counts would be accurate at those few stores.
Accounts receivable also may be overstated. Recall that when a receivable is recorded, so is the related revenue. Thus, not only are assets overstated, so are revenues (and net income and therefore equity).
Auditors nearly always will confirm a sample of receivables, however. When auditors confirm information, they are requesting that an independent third party, such as a customer, directly verify to the auditors, usually in writing, that some specific information is correct (e.g., the amount the customer owes the client as of the end of the fiscal year). However, the auditors can be fooled if management is so inclined. In the ZZZZ Best case management persuasively talked the auditors out of confirming its fictitious receivables by pressuring them not to “harass” its customers. Instead, management was able to persuade the auditors to accept internal documentation relating to its receivables, which of course had been manufactured by management.
Fixed assets also may be overstated, but, in a method that is unique to them, management may intentionally understate the depreciation expense each year, such as by using an unrealistic service life. The smaller expense translates into a larger net income, which increases equity. The accumulated depreciation contra asset account that appears on the balance sheet also is understated so that the net plant and equipment added on the asset side of the balance sheet is overstated. Thus, the balance sheet still balances.
Method#5. Improver Disclosures
Recall that GAAP requires that detailed and extensive footnotes accompany financial statements. Thus, there are probably limitless ways in which management can mislead financial statement readers via the footnotes. Damaging information known to management may not be mentioned, or facts can be misstated. Those actions certainly do not conform to the full disclosure principle, but any method of misstating financial statements fraudulently does not conform to any concept of financial reporting.
The Enron case is a classic example of improper disclosure. Enron developed special purpose entities (SPEs) to finance growth and report profits without reporting the related debt on its balance sheet. According to the accounting rules in place at the time, as long as at least 3 percent of an SPE’s financing was provided by outside investors, the SPE’s financial statements did not have to be combined (consolidated) with Enron’s financial statements. Thus, Enron could use the capital raised by the SPE without having to report the related debt on its balance sheet. This debt avoidance was significant since the SPEs were structured to meet the minimum 3 percent rule, meaning that the remaining 97 percent of the capital typically was contributed by loans from banks.
Later, investigators discovered that even the minimal 3 percent rule wasn’t always followed by Enron. For example, the outside investors providing the 3 percent capital sometimes were individuals within Enron (e.g., Andrew Fastow, Enron’s chief financial officer, who was involved in the creation and operation of several of these entities and named some of them after his children). Fastow reportedly received $30 million in profits on his investments in the Enron SPE investments that he oversaw.
Enron used the these entities for other purposes as well. It sold some of its assets at grossly overstated amounts to its SPEs, enabling it to report substantial paper gains on its income statement. Further, the SPE loans often were collateralized with Enron common stock. Thus, those SPEs essentially were a convoluted business relationship by which Enron could look financially better off than it was in reality, and Enron’s management made sure that the related financial statement footnotes did not portray the true nature of Enron’s relationship with the these entities. Wall Street analysts who had years of experience reading financial statements and footnote disclosures found the Enron footnotes pertaining to the SPEs confusing.
If those experts could not understand the information provided in the footnotes, how could the average financial statement reader understand it?
Finding the Red Flags
How can an investor or a potential investor detect possible fraudulent financial reporting in a company’s financial statements?
First, keep in mind that fraudulent financial reporting is the exception, not the rule. In the five surveys conducted by the Association of Certified Fraud Examiners, fraudulent financial reporting represented only 5.0 to 10.6 percent of the fraud cases reported by the respondents. This statistic does not mean that fraudulent financial reporting happens up to 10 percent of the time, since these results were not derived from all financial statements produced in any one year, only from fraud cases investigated by the respondents for the most recent year.
Unfortunately, there is no single foolproof method of determining whether financial statements are fraudulently misstated; if there were, all auditors would be aware of that method and use it regularly. However, sometimes a careful look at ratios and their trend over time can be useful, especially when the ratios are compared with industry averages.
It bears repeating that fraudulent financial reporting is the exception, not the rule. Although numerous corporate accounting reporting scandals have been publicized widely in the last several years those companies account for only a fraction of 1 percent of all published financial statements.