Financial statements are central to understanding any business. A public company’s balance sheet, income statement and cash flow statement enable investors, lenders, the media and other stakeholders to value the company, forecast short- and long-term performance, and determine potential credit risk, among other purposes. To ensure analysis of a company is accurate and insightful, financial statements must be reliable.

For this reason, financial statement fraud — the exaggeration or outright fabrication of numbers by insiders, such as owners and executives — is extremely dangerous. It can lead to criminal charges, lawsuits, large financial losses and even the company’s demise. It’s critical that your business do everything possible to prevent this type of fraud.

More common than you might think

Financial statement fraud involving large public companies has received considerable press coverage in the past couple of decades. But small and mid-sized businesses aren’t immune to this type of fraud. In fact, such schemes generally are easier to perpetrate in small companies where there’s less oversight.

Regardless of size and sector, financial statement fraud is probably more prevalent than you think. A well-received 2023 study by a University of Toronto finance professor finds that 10% of publicly traded companies are committing securities fraud.

These schemes can involve everything from overstating revenue and inflating assests, to understating expenses, hiding liabilities and omitting disclosures. According to the Anti-Fraud Collaboration of the Securities and Exchange Commission, the most common enforcement actions involving financial statements feature:

• Improper revenue recognition (43%),
• Operational reserves manipulation (24%),
• Inventory misstatement (11%), and
• Loan impairment issues (11%).

6 red flags

Although each fraud scheme is as unique as the company it victimizes, financial statement scams share certain characteristics that can tip off fraud experts and eagle-eyed stakeholders. These include:

1. Implausible revenue growth. A sudden or sustained increase in revenue, especially when the company faces harsh economic conditions, can be a cause for concern and deserves further investigation.
2. Relationship between expenses and revenues. Expenses typically increase as revenue grows. If a company reports significant revenue growth, its costs should also generally rise, unless there are extenuating circumstances.
3. Inconsistencies and anomalies. Closer scrutiny may be warranted if financial statements include numbers that are out of line with industry benchmarks, report a trend reversal with no plausible explanation or merely appear inconsistent with historical performance.
4. Related-party transactions. Transactions with related parties aren’t inherently problematic. There can be good reasons to engage in such transactions. But exercise skepticism if they’re hard to understand or seem to serve no purpose.
5. Changes in accounting methods. A company may have a legitimate reason for switching accounting methods. But such changes can mask weaknesses because they make it more difficult to compare performance between accounting periods and spot suspicious numbers.
6. Frequent changes in auditors. If a company changes auditors frequently, it could be a sign of conflict or represent an effort to conceal material financial misstatements.

Reducing risk

To minimize the threat of financial statement fraud, always encourage — and model — ethical business practices. This includes communicating clear expectations to executives regarding acceptable behavior. Be sure to empower rank-and-file employees (and other stakeholders) who may witness illicit activities by providing an anonymous reporting hotline.

Include a separation of duties and multiple layers of approval and oversight in your internal control policies. And make it nearly impossible for managers to override controls. Education also plays a critical role in preventing financial statement fraud. Put the basics of financial statement fraud and potential warning signs in your company’s training materials.

Personal stake

One of the most common reasons executives commit financial statement fraud is because their compensation depends on company performance. For this reason, look for ways to evaluate and compensate managers on several fronts — including on leadership and coaching — not simply on financial performance. Also rely on outside advisors who have no personal stake in your business’s financial results.

(This is Blog Post #1400)