Understanding Accounting Fraud with Key Concepts and Examples
What is Accounting Fraud?
Companies use accounting fraud to alter their financial data and tax records to report favourable financial health. Organizations generally use three possible fraudulent accounting techniques:
- Overstatement of sales
- Understating or misrepresenting the expenses as well as liabilities
- Falsifying records to report inflated assets
Organizations carry out this practice to attract additional investors or to improve their brand’s financial profile or in many cases it is done by staff members or accountants for personal gains on behalf of the company. The act of number manipulation counts as a criminal offense leading to possible legal penalties for those committing it.
Are Creative Accountancy and Accountancy Fraud Synonymous?
No, not really. Business entities deploy creative accounting strategies with methods, that are not strictly illegal but against international accounting standards, to present improved financial outcomes. They adopt these methods to make their profits seem stable by, lets say, modifying asset depreciation calculations and reporting income selectively. Accounting professionals should avoid such practices because they lack ethical standards in professional accounting. On the other hand, accounting fraud is conducted by manipulating financial numbers to deceive investors and lenders along with other stakeholders. Accounting fraud mainly consists of creating fictitious sales reports, concealing debts, recording nonexistent and distorted financial transactions.
What Kind of Behaviours Constitute Accounting Fraud?
Altering Real Revenue
A company that presents false revenue numbers engages in accounting fraud. A company underperforming in net profits can execute accounting fraud by creating false sales records in order to show higher profits to stakeholders. However, showing inflated profits by altering sales records does not necessarily mean that the company is performing well. May be the management did not use available resources efficiently to improve actual profits, and perhaps that inefficiency led them to alter sales records. Using existing resources efficiently and effectively to generate genuine profit is what defines profitability. Read our article on key differences between profit and profitability to understand this concept in detail.
The following signs indicate potential revenue manipulation in an organization:
- The bookkeeping continues beyond the reporting period for the purpose of entering additional sales transactions.
- Goods have not been sold or the services have not been delivered yet, but the accountant has already recorded the sales transaction.
- The goods or services are delivered before the customer actually purchase them.
- A company moves merchandise to a warehouse at a separate location and then records the products as sales.
- Invoices are not finalized within the reporting period.
Not Recording Expenses
An expense fraud occurs when companies hide their expense entries from the financial statements and demonstrate a completely wrong financial image by showing lower spending and higher income. A manipulative view of net income is created even though the company may be facing financial loss in reality.
Forging Assets and Liabilities
Sometimes organizations get involved in accounting fraud by providing wrong reports about the assets they actually own and how much debt they owe. Organizations manipulate people by showing that they own a lot of worthy assets while keeping a lower amount of outstanding bills. This presentation suggests that the organization possesses a great deal of cash during the immediate period.
Now imagine an organization owns assets worth $1 million, and they have total remaining debts of $5 million. The company’s information becomes doubtful when, for example, they claim that they own $5 million in assets but only show $500k in debts. Due to these fraudulent figures, stakeholders start believing that the company’s financial state is better but in reality it’s not.
Manipulating Inventory
A proper and complete record of inventory is crucial as income is generated from selling these inventories. A lot of companies alter the stock numbers to show better financial results. For example, a company may increase the ending inventory which will reduce the cost of goods sold figure, hence increasing the net income figure.
Boosting the Balance Sheet
By changing the financial records in a wrong way, it’ll increase the company’s share price, loan chances, and the rewards for top managers. This manipulation happens only to benefit the people involved in the plan. This manipulative method is used to maintain the company’s reputation and position of income.
A couple of important signs of accounting fraud that can be identified through certain irregular activities:
- If they claim that their fixed assets are worth more than their real market price.
- Trying to increase sales numbers while neglecting to record doubtful debts.
Indications of Fake Accounting Practices in the Financial Statements
If a company reports high profits but lacks cash transactions to support it, consider it an active case of financial fraud.
- The organization’s sales keep increasing even when the graph of market and competitors is going down.
- The company shows a suspicious performance surge when the financial reports are generated.
- The financial reports consist many unexplained items and missing valid records and invoices.
- The company’s inventory doesn’t grow when sales go up, there’s no proper connection between sales and inventory.
The Following Strategies Can Help Prevent Accounting Fraud
Strong Internal Controls: The company should make strong rules for accounting that separate duties and use security like password protection and access tracking to avoid fraud attempts. Periodical reconciliation helps organizations maintain allignment with external financial documents like bank statements.
Periodic Financial Audits: The organization should perform regular checks on its financial statements in order to monitor the controls and also to identify weaknesses. External audits make sure the employees remain accountable, and it reduces their tendency to act dishonestly.
Ethical Leadership: The highest leaders in the company should maintain a workplace environment depending on ethics and honest behavior. They have to show moral values and also train the staff about fraud and the consequences they will face if they break any ethical rules.
Accounting Software: Try using specialized accounting software to monitor policy violations and automate accounting procedures. It makes sure that the duties are separated and approvals are set up to help prevent any illegal transactions.
Reporting Hotline: Set up a reporting system with a hotline that ensures the data remains confidential. It’ll encourage employees to report fraud-related concerns. Numerous studies demonstrate that using these systems boost the rate of fraud detection accuracy.
Balanced Compensation: Organizations must avoid connecting complete management compensation packages to short-term targets because this practice encourages unethical workplace behavior. Organizations should base their focus on creating long-term value because this approach prevents fraudulent conduct.
Trust Your Instincts: Check the financial statements for any irregular activities and make sure to get clear answers from the accounting team, because unclear answers might be a signal of financial wrongdoing.
