The signs and pitfalls of financial statement fraud

May 2007

IN THIS ISSUE

— Taming the Corporate Wild West: Fighting Financial Statement Fraud
— Warning Signs of Financial Fraud
— In the next issue

GREETINGS!

Welcome to our May newsletter. In this issue, we’ll examine the matter of financial statement fraud, from the difficulties in detecting it to the proactive steps your company can take to prevent it from happening.

TAMING THE CORPORATE WILD WEST: FIGHTING FINANCIAL STATEMENT FRAUD

At the dawn of the 21st century, a rash of corporate scandals made big headlines and generated even bigger shareholder losses. From Enron and Worldcom to Tyco, Adelphia, and dozens of others, these scandals had at least one thing in common: at the heart of each were fraudulent financial statements.

Some, like Enron and Tyco, kept many of their misdeeds off the books entirely, affecting shareholder value without any disclosure whatsoever. Enron maintained questionable partnerships with science fiction names like “Raptor” and “Jedi” to artificially inflate its position, while onetime Tyco CEO L. Dennis Kozlowski hid $170 million in loans which the company made to him, essentially at his direction, away from prying eyes.

WARNING SIGNS OF FINANCIAL FRAUD

While some corporate frauds were simply kept off the books, only to be discovered after close examination (when it was often too late to remedy), some financial statement frauds involve, appropriately enough, altering of financial statements. Former WorldCom chief Bernard Ebbers and his cohorts, for instance, mischaracterized millions of dollars in expenses as assets, making a company that was drowning in accrued debt, such as lease obligations, seem far more profitable than it actually was.

Some key signs to look out for when reviewing a company’s financial statements from one period to the next:

• Significant fluctuations in profits, losses, or other key indicators like accounts receivable. Every business can have good or bad periods, but wide deviance from industry norms warrants scrutiny.
• A long list of “related party transactions” between officers and directors and the company itself. For public companies, these details can be found most often in a company’s proxy statement or annual report.
• Disclosures made in an auditor’s notes. If an auditor disagrees with a client’s method of accounting or other decision making, they are required to note this disagreement, even if they still issue an opinion, either qualified or unqualified.
By being aware of these and other red flags, you may be able to avoid scandal and maintain your company’s good name.

Maintaining a truly independent board of directors with a strong audit committee will help to create a culture where management at all levels know that financial statement fraud will not be tolerated.

IN THE NEXT ISSUE

In the June issue, we’ll look at steps your clients can take to protect themselves from fraud when considering acquiring a privately-held company.