Financial Statement Fraud

Harry Markopolos once said: “…it’s not the armed robbers or drug dealers who cause the most economic harm, it’s the white-collar criminals living in the most expensive homes who have the most impressive resumes who harm us the most. They steal our pensions, bankrupt our companies, and destroy thousands of jobs, ruining countless lives.”

What is Financial Statement Fraud?

Financial statement fraud is the deliberate misrepresentation of the financial condition of an enterprise accomplished through the intentional misstatement or omission of amounts or disclosures in the financial statements to deceive financial statement users.

Financial statement fraud almost always involves overstating assets, revenues, and profits and understating liabilities, expenses, and losses. However, sometimes the opposite result is desired. For example, understating assets or revenue might lead to a smaller tax liability for the company.

There are a number of reasons why individuals commit financial statement fraud:

  • To encourage investment through the sale of stock
  • To demonstrate compliance with financing covenants
  • To meet company goals and objectives
  • To receive performance-related bonuses
  • To demonstrate increased earnings, thus allowing increased dividends
  • To avoid negative market perceptions
  • To obtain financing, or to obtain more favorable terms on existing financing
  • To receive higher purchase prices for acquisitions

Opportunities to commit fraud most often arise gradually. Generally, these opportunities can come from a lack of adequate oversight functions within the company:

  • Absence of a board of directors or audit committee
  • Improper oversight or other neglectful behavior by the board of directors
  • Weak or nonexistent internal controls, including an ineffective internal audit staff
  • Unusual or complex transactions

Corporate accounting scandals that shook the world

ENRON

The Enron scandal, publicized in 2001, led to the bankruptcy of the Enron Corporation, and the de facto dissolution of Arthur Andersen, which was one of the Big 5 accountancy firms at the time.

The senior executives of Enron managed, through the use of accounting loopholes, special purpose entities, and poor financial reporting, to hide billions of dollars in debt from failed deals and projects. Enron’s shareholders lost $74 billion in the four years before the company’s bankruptcy.

WORLDCOM

From 1999 to 2002, senior executives at WorldCom orchestrated a scheme to inflate earnings in order to maintain WorldCom’s stock price. The fraud was uncovered in 2002 when the company’s internal audit unit discovered over $3.8 billion of fraudulent balance sheet entries.

Eventually, WorldCom was forced to admit that it had overstated its assets by over $11 billion. At the time, it was the largest accounting fraud in American history.

OLYMPUS

In 2011, it emerged that top executives of Olympus had falsified accounts to conceal losses of more than $900m in one of the biggest financial frauds in Japan’s history.

It prompted an 82% share price dive within a month, the resignation of the board members and the arrest of several Olympus officials for fraud – almost destroying the company that was started in 1919.

TESCO

News of Tesco’s accounting scandal sent shockwaves through the City in 2014 and raised serious questions over how a FTSE 100 firm could get away with “cooking the books”. Tesco overstated its profits by £326 million and the revelations wiped £2 billion off the supermarket’s share price in one day.

In 2017, Tesco reached an agreement with authorities over the scandal that saw it pay £85 million in compensation payouts to investors and £129 million in fines and costs.

TOSHIBA

A shocking news broke in 2015 when the company announced that it was investigating an accounting scandal and it might have to revise its profits for the three previous years.

Upon deeper investigation, it was revealed that Toshiba Corporation had been struggling to meet its financial targets since 2008 amid the global financial crisis that cut deeply into Toshiba’s profitability. The enduring struggles finally caused Toshiba to commit a $1.22 billion accounting fraud, claiming numbers that were up to three times the actual level.