Warning Signs of Financial Statement Fraud with Examples

The three primary categories of occupational fraud are asset misappropriation, corruption, and financial statement fraud. According to the Association of Certified Fraud Examiners’ (“ACFE”) 2024 Report to the Nations, in which real cases of occupational fraud were analyzed between January 2022 and September 2023, financial statement fraud, which occurs when a perpetrator intentionally caused a misstatement or misrepresentation in the organization’s financial statements, was the least common occupational fraud to occur but caused the greatest median loss. There are a number of reasons why financial statements may be manipulated, including attempts to secure financing, beating earnings targets to inflate stock prices, or to hide losses. Based on results of 2024 Report to the Nations, financial statement fraud represented only 5% of perpetrated fraud schemes, but results in median losses of $766,000 per case.

Financial statement fraud can be represented by net worth or net income overstatements or understatements, and can be carried out by reporting fictitious revenues, improper valuations, improper disclosures, incorrectly reported liabilities and expenses, and timing differences. Some of the most well-known frauds have been financial statement frauds, including the Enron, WorldCom, and Wirecard frauds.

Some examples of different types of financial statement fraud include the following:

• Fictitious revenues: In 2000, Lucent Technologies admitted to improperly recognizing revenue, by overstating revenue by approximately $700 million by recognizing revenue on certain transactions that in which products had not yet been sold or accepted by the customer.
• Improper valuations: In 2015, Toshiba was found to have delayed recognition of the impairment of certain nuclear power assets, thus reflecting overstated assets on the company’s balance sheet, thus improperly presenting the overall health of the company.
• Incorrectly reporting liabilities: In 2001, Enron was found to have used special purpose entities to hide massive debts and liabilities, which artificially inflated equity and understated liabilities. This scandal lead to the collapse of Arthur Andersen, at the time one of the five largest accounting firms, and the creation of the Sarbanes-Oxley Act.
• Improper disclosures: Valeant Pharmaceuticals concealed a key business relationship, and failed to disclose to investors that a captive pharmacy network was used to drive sales. The Securities and Exchange Commission found that Valeant failed to disclose the material impact of revenue it received from drug wholesalers, and that executives chose to present GAAP and non-GAAP financial measures to misrepresent revenues.
• Timing differences: In 2004, Bristol-Myers Squibb agreed to pay a $150 million settlement to the SEC for inflate earnings prior to reporting to meet earnings expectations. Bristol-Myers Squibb booked future sales as current period revenue to boost sales, thus prematurely recognizing revenue.

Financial statement fraud can often be difficult to detect because it is carried out by those at higher levels within an organization. In certain instances, financial statement fraud is covered up by collusion and the override of internal controls; these situations often can only be created by those at the management or executive level. However, patterns of unusual activity can point to deeper issues that may be obscured via financial statement manipulation.

• Aggressive revenue recognition policies: Examples include recognizing revenue before the delivery of goods and services, as described above in the Lucent Technologies fraud scheme. Aggressive revenue recognition can also include misrepresenting the progress on a contract to recognize revenue sooner than actually earned.
• Management override of internal controls: Bypassing of internal controls by management or company executives is a red flag, and this behavior creates additional risk for a company. Maintaining a strong control environment can help prevent fraud, but overriding internal controls weakens the overall control environment of an organization.
• Turnover in accounting roles: If a company experiences high turnover in key accounting roles, this may suggest turmoil within the accounting department of the organization. High turnover could result in weakened internal controls, which creates an environment in which financial statement fraud can occur.
• Exceeding targets in a down market: If a company is consistently beating earnings targets in a down or volatile market, this could suggest that the finances of the company are being manipulated.
• Excessive related-party transactions: Related-party transactions can be used to conceal financial results, especially if these transactions are disclosed improperly or outside of the normal course of business.

According to the ACFE Report to the Nations, 43% of occupational fraud cases were uncovered by a tip from a whistleblower. The next most common method of detecting occupational fraud is through internal audits, which only identified fraud in 14% of the cases analyzed. Of those who have reported occupational frauds, more than half of the whistleblower tips came from employees. Creating an anti-fraud culture is a cost-effective way for companies to prevent fraud, and it signals to employees, vendors, and investors that the organization does not tolerate fraud and has open communication channels to prevent fraud. Although financial statement fraud can be difficult to detect, establishing a strong ethical culture and being aware of common red flags can aid in its prevention.