You Cannot Buy Honesty and Trust When It Comes to Financial Reporting
By Michael S. Brown, Director, Advisory Services
Most fraudulent financial reporting schemes fit into three general categories – i) manipulation of the accounting records or supporting documents from which financial statements are prepared; ii) misrepresentation of financial statement events, transactions or other significant information; or iii) intentional misapplication of accounting principles relating to amounts, classification, manner of presentation or disclosure. Forensic accountants like me who investigate these types of fraud are trained to delve beneath the numbers for potential indicators of fraud such as related party transactions, unsupported top side journal entries, aggressive revenue recognition and non-recurring charges, to name just a few.
Recent Financial Scandals and Fraud Schemes
We have seen a plethora of both small and large fraud schemes over the first decade of the 21st century that can really make your head spin – Lehman Brothers, Madoff, AIG, Health South, WorldCom, Tyco, Enron and Computer Associates.If we go beyond a decade, there is certainly no shortage of scandals – Waste Management (1999), Milken and Drexel (1989), Boesky (1987) and the Savings and Loan crisis in the 1980’s.Not enough? There was also the collapse of the Samuel Insull Empire in 1932, the Teapot Dome scandal in the 1920’s and Civil war profiteering in the 1860’s.
Many these scandals involved misusing or misdirecting funds, overstating revenues, understating expenses, underreporting the existence of liabilities and off balance sheet transactions. What is similar in all of these scandals is a penchant for greed.
According to Yale sociologist William Graham, “the greed and selfishness of men are perpetual.” What is both unfortunate and certain is that we will continue to see these types of scandals until the existence of man ceases.Whenever there are outside forces such as adverse economic conditions, third party pressures, financial targets to meet, covenants and personal financial obligations, coupled with opportunities like internal control deficiencies and assets susceptible to theft, you will find someone who can rationalize their actions. These people will say “I am only borrowing the money”, “nobody will get hurt”, “the company treats me unfairly” or “the money is for a good purpose” to justify their behavior.
The Independent Accountant’s Role
Accountants have taken lumps in the media as it relates to their alleged role in some of the larger financial scandals mentioned above. While some of this is warranted, much of it is not.One should understand that there are distinct differences between financial statement audits, reviews and compilations and that none create an absolute assurance that fraud or financial manipulation has not occurred.
Audited financial statements are the product of a CPA’s highest level of assurance services. However, audits have some inherent limitations. During an audit, the CPA performs verification and substantiation procedures such as physically inspecting inventory and corresponding directly with creditors and debtors to verify amounts reportedly owed on a sample of, and not all of the company’s transactions. The CPA also gains a knowledge and understanding of the entity’s system of internal control and assesses the risk of material misstatements due to fraud. These procedures enable the CPA to issue an opinion that he believes that the financial statements fairly present the company’s financial position.
A review has a substantially narrower scope than an audit because a review does not require that the CPA perform verification or substantiation procedures. A review also does not require the CPA to gain an understanding of the company’s internal controls or assess the company’s fraud risk. As a result, a review does not provide an opinion, but rather just a statement that the CPA is not aware of any material modifications that need to be made to the financial statement.
Too often, especially in small companies, owners and management believe that if the financial statements are being audited or reviewed that no other measures need to be taken to prevent fraud. Unfortunately this is not the case because collusion can circumvent controls and enable a malfeasance to go undetected. This is why companies need to be proactive and be actively involved in preventing fraud at the company. One area that management can and should focus on is employee fraud.
Employee fraud can be in the form of embezzlement, cash and check schemes, fictitious disbursements, and accounts receivable and inventory fraud.Embezzlement is the fraudulent appropriation of assets by someone to whom the assets have been entrusted i.e. stealing cash from the register, an attorney stealing funds from a client’s trust account.
Cash and check schemes can involve such mechanisms as: i) larceny – stealing cash after it has been documented on the company’s books; ii) skimming – stealing cash before it is recorded on the company’s books; iii) Kiting – building up balances in two or more accounts by floating checks drawn against other accounts then withdrawing cash from the accounts before the bank discovers that the original deposits were bogus; and iv) check tampering - which may involve an altered payee, forged endorser, or forged maker.
Fictitious disbursements can be: i) doctored sales figures – to increase a person’s commission; ii) sham payments -sometimes to a ghost employee or vendor; and iii) bid rigging – providing a vendor with an unfair advantage in an open competition for a contract.
Being proactive and implementing internal controls can prevent fraud because sometimes the mere threat of future investigation can reduce the occurrence of fraudulent behavior.For example, there should be a segregation of duties for those charged with handling cash as well as forced vacations and surprise cash audits.Additionally management should review and sign off on all disbursements. Lastly, management should compare the company’s forecasted results to its actual results and analyze variances for reasonableness.
Reliable financial reporting is a core concept in our system of capitalism because financial statements are the main source of accountability of management performance by the shareholders.Absolute assurance is just about impossible to guarantee due to the inherent limitation of audits.Individuals and business owners have a responsibility to ensure the integrity of the financial statements and need to take a proactive approach in maintaining honesty and integrity throughout.Owners should always project, and have, an active involvement in the process.While implementing internal controls can be costly, ensuring appropriate segregation of duties and proper checks and balances is imperative.Unfortunately one cannot buy honesty and trust, you either have it or you don’t. The hope is that the combination of strong internal controls, management oversight and an independent accountants audit or review of the financial statements will help deter the dishonest employee.