Publicly traded companies get a lot of press when they commit corporate fraud, but financial fraud can happen at private companies as well. Furthermore, fraud is not solely reserved for large companies – it can occur at any size company, including small locally owned businesses. While fraud can arise in any number of unique circumstances, it typically occurs to secure bonuses for management or to appear more appealing to investors.
Though private companies are not formally required to abide by SOX (Sarbanes-Oxley Act of 2002), the requirement that companies conduct an annual audit of their internal controls is always a best practice. A business’s accounting practices and financials should be reviewed regularly (either internally or by a third-party) to look for vulnerabilities and discrepancies.
While murky books or incomplete financial statements may not necessarily indicate that a company is committing fraud, it should raise a red flag that earnings manipulation or other types of fraud could be occurring. It is crucial to analyze financial reports and key financial documents to look for signs that someone might be cooking the books, in any of the following ways:
Manipulating Earnings
Earnings can be manipulated to make a reporting period look stronger than it was or to give the illusion of continuous performance over time, artificially demonstrating sustainability and resilience. Either scenario can misrepresent the company’s ongoing success to trick investors.
While income and losses can simply be faked, most financial fraud is more sophisticated than that, utilizing various means like:
Accelerating Revenue
When services are provided over an extended period (like a multi-year software subscription service) recording revenue upfront instead of amortizing can accelerate revenue to inflate the numbers in the reporting period when the sale was made. This is not as obvious to spot as fraudulently entering unearned revenue, but it is still unethical.
Channel stuffing schemes are another way to accelerate revenue that can have serious financial implications in subsequent reporting periods. When a manufacturer takes part in channel stuffing it will ship too much product to a distributor right before the end of a reporting period and then record it as sales despite the fact that the distributor is likely to return unsold products. These “sales” are then conflated with actual sales to paint a rosier picture of earned revenue for the period.
Companies that want to inflate revenue earnings in anticipation of an acquisition, merger, or major funding push with investors may also unscrupulously inflate revenue numbers with limited time offers that are unsustainable. The result is increased short-term sales that confuse the true trajectory or earnings potential of the business.
Delaying Expenses
Delaying expenses can be just as advantageous as accelerating revenue for companies looking to manipulate earnings. Moving expenses to a later reporting period or recording expenses over the wrong timeframe can smooth out costs to give the business more wiggle room when significant expenses must be recorded. Misclassifying an expense as a long-term investment and subsequently recording it over time instead of upfront is another common way that companies will delay expenses to smooth out revenue earnings.
Manipulating Cash Flow
Because cash flow is vital to the longevity of any business, manipulating cash flow can have a profound effect on how a business is perceived by partners, investors, and other key stakeholders. While cash flow can be fraudulently altered in any number of ways, corporate fraud schemes may involve one of the following tactics:
- Improperly categorizing financing, acquisitions, or PPE (property, plant, equipment) disposals to inflate inflows of operating cash
- Reducing pension plan costs and then recording gains on these benefit plans as revenue
- Improperly categorizing outflows of operating cash as investments
- Booking an inflated one-time charge for a non-recurring expense in one period and then fixing the “overestimation” in a subsequent reporting period
- Prepaying expenses before a merger to make subsequent revenue numbers look better afterwards
A forensic accountant or CFO can use their experience with cash flow statements to look for the kind of discrepancies or behavior that could indicate a company is cooking the books.
Misrepresenting the Balance Sheet
Much like cash flow manipulation, misrepresenting the balance sheet can take many different angles. The most common ways that a company could alter their balance sheet include:
- Changing the definitions for “receivables days outstanding” to make them look more recent
- Misclassifying inventory as noncurrent when it will, indeed, be used within the year
- Excluding a portion of inventory from inventory calculations (for example, inventory in warehouses or inventory in transit)
- Lumping questionable expenses in the nebulous “Other Expenses” category to hide them
- Funneling a major asset purchase (like that of land or a building) through a separate entity set up specifically for that purpose and then renting it back to the business to keep the liability off the books (which is commonly referred to as a “synthetic lease scheme”)
Each of these corporate fraud schemes can exist individually, or in conjunction with other types of fraud, but all are more difficult to spot that simply stealing money or fabricating revenue numbers. Identifying these types of fraud requires close attention to detail and the experience required to understand what kind of affect each would have on how the company is presenting itself.
Do you know where your business is most vulnerable to financial fraud? Learn more about how you can benefit from a risk assessment analysis in our guide: Financial Risk Assessments – What Are They & Why Your Company Needs One
