Financial reporting fraud, commonly referred to as financial statement fraud, is the intentional act to misrepresent the financial condition of an organization through the intentional misstatement or omission of amounts and/or disclosures in the financial statements to deceive financial statement users.
An individual’s reason for committing financial reporting fraud can vary. The Fraud Triangle, developed by Donald Cressley and actively discussed in his work Other People’s Money: A Study in the social Psychology of Embezzlement, shares three components that most likely lead an individual to commit fraud. The components are pressure, opportunity, and rationalization.
Pressure can arise from inside and outside parties, and it can force an individual to feel obligated to meet expectations. Opportunity can emerge when an organization lacks the proper controls or oversight. Rationalization is the justification for an individual to commit the fraud scheme.
The Fraud Triangle sets a baseline for understanding how and why fraud in the workplace might occur. When considering financial reporting fraud, the parties involved are often c-suite executives. The financial performance of an organization is highly leveraged by c-suite executives for a multitude of reasons, including but not limited to expectations, compensation, and power. Fraud committed by owners/executives were more than 7x greater than those carried out by employees.
Financial reporting fraud comprises less than 5% of total frauds according to the Association of Certified Fraud Examiner’s (ACFE’s) Occupational Fraud 2024: A Report to the Nations, but the average loss is among the highest at $766,000. While the instances of financial reporting fraud are rare, their ramifications are substantial.
Several organizational issues and factors that contribute to these financial schemes include:
- A poor tone at the top
- A high-pressure environment
- Weaknesses in an organization’s internal control system
- Misleading or inaccurate financial statement disclosures
- Personnel with a lack of sufficient accounting experience or training
The five classifications of financial reporting fraud schemes are:
- Fictitious revenues
- Timing differences
- Improper asset valuations
- Concealed liabilities and expenses
- Improper disclosures
The Fraud Triangle, in conjunction with the aforementioned issues, factors and classifications shed more light on how financial reporting fraud schemes occur. A fraud can include one or more of these factors or schemes at the same time. For example, from 2002 to 2016, Wells Fargo employees created falsified checking and savings accounts for clients, without their consent, to meet sales targets. It can be inferred there was a poor tone at the top and a high-pressure environment at Wells Fargo, which led to fictitious revenues and likely improper asset valuations and disclosures.
There are tried-and-true methods to prevent such instances of financial reporting fraud schemes. Each preventative control put in place adds an additional dimension to an organization’s control system that can hinder the occurrence of fraudulent activity. To prevent and detect financial reporting fraud, here are ten tips to consider for your organization:
1. Define success
- Create policies and procedures
- Write policies and procedures for the organization and its key financial reporting positions including duties and expectations. Consider writing narratives for positions in the event of turnover and create a “checklist” of steps to follow.
- Train and communicate
- Provide robust training to personnel at hire date and on a frequent basis through the year. Be available for your team and consistently communicate necessary information.
2. Establish boundaries
- Segregate duties
- Limit access to financial reporting software from unauthorized users and segregate duties to prevent users from performing tasks unchecked. Consider requiring individuals in essential positions to take time off.
- Implement controls
- Implement physical (lock and key, badge ID, etc.) and/or electronic (multi-factor authentication, electronic signoffs, etc.) to prevent unauthorized user access and to create an audit trail for financial reporting changes.
3. Implement oversight
- Implement an audit committee
- Make sure the organization and its executives are held accountable and there is proper management oversight.
- Set a tone at the top
- Develop a strong example for personnel to follow and an environment that is conducive for ethical work.
4. Stay organized
- Upgrade systems
- Use software that can detect changes, trends, errors, or requirements rather than leaving reporting to chance and easily manipulable programs.
- Maintain files
- Save files in a secure and organized location from inception to the end of the retainer period. Organization of reports and corresponding support will reinforce a clear audit trail for financial reporting changes.
5. Be practical
- Create a forecast
- Utilize a forecast to have an expectation of financial performance at reporting time. This can identify possible anomalies.
- Hire trusted individuals
- Hire individuals who have experience, a clean background, have obtained the proper credentials and have glowing recommendations.
6. Avoid questionable business practices
- Beware conflicts of interest
- Limit questionable journal entries or line items that might raise eyebrows of financial statement users.
- Incorporate correct standards
- Ensure the organization is implementing the correct accounting standards and not it is not using questionable accounting methods.
7. Protect the Financial Statements
- Require prompt recording
- Don’t let accounting entries linger. Enter in financial occurrences when appropriate and update any accruals or deferrals.
- Consistently monitor accounts
- Consistently monitor the accounts and business activity. Be aware of all that occurs and how each transaction can impact any of the financial statements.
8. Perform “Due Diligence”
- Perform regular audits
- Conduct regular internal audits over financial reporting functions using both preventative and detective testing to ensure procedures are properly adhered to.
- Review the review process
- Implement a thorough review of the financial reporting final review stages and document any changes that occur.
9. Be proactive
- Set up a fraud hotline
- Launch an anonymous whistleblower hotline for personnel to flag financial reporting malpractice for outside review.
- Establish investigative procedures
- Create a response plan and set action steps in the event of financial reporting malpractice.
10. Reach out
- Hire an external auditor
- Use an external auditor to review financial statements for regulatory requirements and to instill peace of mind.
- Hire an internal auditor or consultant
- Use an internal auditor to review or develop internal audit procedures. Hire a consultant to perform forensic accounting services, write key personnel narratives, and perform other value-added operational reviews.
These steps can reduce the opportunity for fraud to occur in the workplace and set an organization up for success. Consider implementing these ten tips if they are not in your organization already.
Stay Tuned
This is article is a part of our “Leader’s Guide to Fraud Prevention” series, designed to provide ongoing guidance on simple, effective actions leadership can take to prevent fraud, waste, and abuse. Future articles will explore everything from emerging fraud trends to critical risk areas like cybersecurity, as well as entity-wide recommendations for strengthening controls. By making a few strategic improvements to your fraud prevention environment, your organization can build a stronger foundation for long-term financial success.
Missed the other articles of the series? Check them out here:
- Risk Mitigation Starts with You | The Bonadio Group
- Fraud Facts & Misconceptions | The Bonadio Group
- How to Protect Your Business from Cash Fraud | The Bonadio Group
- Payroll Fraud: Understanding the Schemes Involved | The Bonadio Group
- Cash Disbursement Fraud Schemes and How to Prevent | The Bonadio Group
- Expense Reimbursement Fraud: Understanding the Risks | The Bonadio Group
Legal Line: This material has been prepared for general, informational purposes only and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. Should you require any such advice, please contact us directly. The information contained herein does not create, and your review or use of the information does not constitute, an accountant-client relationship.
