Investigation of Financial Statement Fraud


In this chapter:

  • Revenue Overstatement
  • Channel Stuffing
  • Round-Tripping
  • Asset Overstatement
  • Liability and Expense Understatement
  • Reserve Manipulation
  • Misrepresentation or Omission of Information
  • Improper Recording of Mergers and Acquisitions
  • Off-Balance-Sheet Items
  • Accounting Involves Judgment and Estimates
  • Earnings Management

The manipulation of financial statements through revenue overstatement is a fraud concern at every single company. From the book:

The first and most common way that financial statement fraud is carried out is through revenue overstatement. The easiest way to improve the apparent financial condition of a company is by fraudulently inflating revenue. Companies can do this by:

  • Booking fictitious sales
  • Holding the books open at the end of a period
  • Recognizing legitimate sales early
  • Shipping items not ordered by customers and booking the sales
  • Booking revenue before it has been earned on projects in progress
  • Recording sales for items produced but not yet shipped, or only partially shipped
  • Booking sales but delaying shipment to customers (bill-and-hold schemes)
  • Not properly recording allowances for returned goods

Revenue overstatement is detected by examining revenue patterns and looking for irregularities. Unusual changes in cost of goods sold might signal a problem, as companies that book fictitious revenue do not always book corresponding expenses. Revenue overstatement may also be suspected when a company has consistent cash flow problems, even in light of apparently increasing sales and profits.

One irregularity that may not often be considered as such is a suspiciously constant increase in sales or profits from period to period. Remember that especially for public companies, there is a high expectation that revenues will grow by a certain percentage, and that profits will increase accordingly. Executives know the “acceptable” parameters for their numbers. Anything outside those ranges will raise questions. So it is not a stretch to believe that revenue and expenses could be manipulated to conform with those expectations.

For example, I examined the financial statements and related notes for a public company that sells a specific type of clothing. The financial statements showed extremely stable gross profits as a percentage of revenue. Yet the notes to the financial statements indicated that the business was suffering because of significant increases in the cost of materials. Therefore, it would make sense that the gross profit percentage might be negatively affected, unless the company could raise the retail pricing enough to cover the cost increases. Independent evidence suggested that retail prices were not up, bringing into question the accuracy of the profit-and-loss statement and raising the possibility that the numbers were manipulated.

This situation illustrates a common occurrence in cases of financial statement fraud: The face of the financial statements appears reasonable. The fraud is discovered only once facts are cross-checked with the numbers and outside evidence is compared with management’s assertions.

Other indicators of fraudulent manipulation of revenue include: existence of unusual ratios related to inventory or accounts receivable, rebooking receivables so unpaid amounts related to phony sales do not look so old, or recording large write-offs shortly after the close of a period. An internal report (a tip from an employee) of revenue manipulation may be necessary in order for auditors or other professionals to become aware of the fraud, as schemes to manipulate revenue are often carefully crafted and covered up.

If a revenue overstatement is suspected, the following procedures can be used to investigate:

  • Examine the books for adjusting entries, especially toward the end of an accounting period, that increase revenue.
  • Look for “on-top” accounting entries that were booked after the close of the accounting period and changed the financial statement numbers.
  • Examine documentation to determine whether sales toward the end of an accounting period were legitimate. This is often referred to as cut-off testing by auditors.
  • Search for transactions toward the end of an accounting period that cause the company’s results to barely meet or exceed budgets, projections, or Wall Street’s expectations.
  • Compare purchase orders to invoices to see whether a customer issued a purchase order after a sale was booked. The purchase order could be proof that a sale was booked before the items were even ordered by the customer.
  • Analyze write-offs and returns in later accounting periods to see whether earlier sales may have been improperly recorded.
  • Look for altered documentation that may indicate backdating of sales documents.
  • Check post-closing shipping documentation to determine when goods were actually delivered to customers.
  • Use date-stamped and time-stamped evidence like e-mails, faxes, and accounting system entries to try to determine when agreements were made, contracts were signed, and sales were actually made.
  • Compare commissions paid to sales booked. Management is not eager to pay commission on fictitious revenue.
  • Examine payments of invoices to determine whether payment lags on sales booked toward the end of an accounting period. Delayed payment may suggest the sale was not really made until later.
  • Independently confirm sales dates and amounts with customers.
  • Independently confirm accounts receivable balances with customers.
  • Examine what appear to be partial payments on accounts, which could suggest inflated invoices used to manipulate revenues. The customer clearly would pay only what is legitimately owed, making it appear as if there has been only partial payment.