What Is Fraudulent Financial Reporting? A Look at a Vital Accounting Issue

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Two accountants, one of them standing and pointing and one seated, look at auditing data on a tablet.

Fraudulent financial reporting occurs when companies or individuals purposely manipulate financial reports for their own gain. They can do this through revenue overstatement, asset inflation, volatility manipulation or statement fabrication. These false statements could lead outside investors to invest in a failing business that is not likely to provide a profitable return.

Fraudulent financial reporting is, bluntly, stealing. Unfortunately, it is all too common in modern business. Companies such a Theranos and, most famously, Enron, have all been accused of fraudulent financial reporting, and they have not only lost millions but have tarnished their reputations as well.

Companies and organization leaders intent on embezzling millions of dollars through fraudulent accounting can be deterred by forensic accountants. Typically hired by governmental, law and insurance organizations, forensic accountants analyze complex financial and business matters to identify fraud.

Aspiring forensic accountants must be strategic in addition to being heavily datacentric. This article will explore past cases of fraudulent financial reporting, relay the benefits of forensic accounting and illuminate a path toward a career in forensic accounting.

A Look at Fraudulent Financial Reporting

A common financial crime is misreporting a company’s financial performance to mislead those with a financial stake in the organization. Financial criminals purposely misrepresent their company’s performance to boost investments either from previous investors or potential investors. Pressure to commit financial crimes could come from business leaders or executives asking accountants to falsify reporting to mislead investors and stakeholders.

While a company could experience brief benefits from financial crimes, the long-term effect of getting caught is devastating. For one thing, the public immediately loses faith in the organization. This drives away potential investors and customers, drying up the organization’s income.

Internally, employee morale suffers. This could lead to increased turnover rates and potentially a complete loss in staffing. Low morale could cause an organization to self-destruct rapidly.

Lastly, financial fraud leads to a significant monetary loss for the organization. For every dollar taken away from the organization, funding that could have been used for hiring, talent retention, building updates and so on diminishes. Guilty verdicts in financial crimes also force organizations to pay millions, or even billions, of dollars (depending on the company’s size) to settle lawsuits.

Fraudulent Financial Reporting Examples

There are many types of fraudulent financial reporting that could occur within an organization, such as:

  • Revenue overstatement: Revenue overstatement occurs when a company misrepresents its revenue in its statements by including prospective or projected sales in revenue.
  • Asset inflation: Asset inflation occurs when a company knowingly fails to apply a depreciation schedule to its assets.
  • Volatility manipulation: Volatility manipulation occurs when an organization understates revenues from one period to reserve them for later periods, misrepresenting the company’s year-round volatility.
  • Statement fabrication: Statement fabrication is the most common form of fraudulent financial reporting. The act of falsifying areas of performance statements, statement fabrication allows company leaders to immediately reap the rewards, as their compensation and bonuses are usually tied to company performance.

World-renowned companies have been found guilty of these financial crimes, including the following:

Theranos

In 2018, blood-testing organization Theranos and its founders and chief executive officer were charged by the Securities and Exchange Commission with massive fraud. The company had raised over $700 million in funding over the previous decade based on false performance statements. The two founders were later charged by a federal grand jury with nine counts of wire fraud and two counts of conspiracy to commit wire fraud.

Enron

Enron was famously found guilty of massive fraud in 2011 after fooling regulators with fake holdings and accounting practices. They hid massive amounts of debt and toxic assets — assets that are difficult or impossible to sell due to limited demand — from investors through special purpose vehicles (SPVs) and special purpose entities (SPEs). The company paid its creditors more than $21.7 billion between 2004 and 2011 with its final payout in 2011.

The Importance of Forensic Accounting

Forensic accountants play a pivotal role in identifying and stopping fraudulent financial reporting. They use their strong analytical skills to conduct vertical and comparative ratio analysis to identify red flags in a business’s behavior. Forensic accountants must also be highly detail oriented and research driven to spot trends in data and identify outliers.

Forensic accountants commonly look for the following red flags when conducting research into fraudulent financial reporting:

  • Accounting anomalies: Growth in one area (revenue) without a correlating effect in another (cash flow)
  • Competitive anomalies: Outlier growth in the same field in which competitors are failing
  • End-of-year/quarter growth: Significant growth found prior to the reporting period

Aside from data skills, forensic accountants must be expert communicators to relay their findings and present their cases. Additional characteristics, including persistence, help forensic accountants seek out, detect and prosecute financial criminals. Through these traits, forensic accountants can leverage their data purposefully and achieve their goal of halting fraud.

Learn the Skills Required to Become a Forensic Accountant

Learn the data, research and communication skills required to become a forensic accountant through Rider University’s online Master of Accountancy program with a Forensic Accounting concentration. Students can expect to expand their skills and develop in key areas with courses such as Auditing: Practice and Problems, Fraud Detection and Deterrence, and Fraud and Forensic Accounting. Discover what it takes to become a driving force in identifying and stopping fraudulent financial reporting.

Recommended Readings

Forensic Accounting: Explore Careers in this Rewarding Field

Investigating Truth in Numbers: What Is Forensic Accounting?

Public vs. Private Accounting: An Overview of the Types of Accounting Careers

Sources:

Forbes, “CFOs Less Likely to Report Fraud Amid Pressure to Meet Financial Targets”

Houston Chronicle, “How Fraud Hurts You & Your Organization”

International Compliance Association, “What Is Financial Crime?”

Investopedia, “Detecting Financial Statement Fraud”

Investopedia, “Enron Scandal: The Fall of a Wall Street Darling”

MarketWatch, “The Last Days of Theranos — the Financials Were as Overhyped as the Blood Tests”

U.S. Securities and Exchange Commission, Spotlight on Financial Reporting and Audit (FRAud) Group