Accounting fraud

Accounting fraud is the intentional manipulation, misrepresentation or omission of financial information to deceive stakeholders about an organization's true financial position and performance ^[1]. Unlike accounting errors which result from unintentional mistakes, fraud involves deliberate action by individuals who seek to derive personal benefit or to conceal damaging information from investors, creditors, regulators or other parties. Accounting fraud can take many forms ranging from minor misstatements to massive schemes that destroy entire companies and cause billions of dollars in losses.

Historical development

Accounting fraud has existed as long as businesses have maintained financial records, but the modern understanding of the problem developed primarily in response to major corporate scandals. The early twentieth century saw various manipulations of financial statements as companies sought to attract investment during economic booms ^[2]. The stock market crash of 1929 and subsequent investigations revealed widespread misrepresentation of corporate finances which contributed to the creation of the Securities and Exchange Commission in 1934 and the establishment of requirements for audited financial statements.

The period from 1970 to 1990 witnessed numerous fraud cases that prompted calls for stronger oversight. The failure of savings and loan institutions in the 1980s involved extensive accounting manipulation and highlighted weaknesses in auditing and regulatory supervision. Professional bodies responded by developing new auditing standards and guidance on fraud detection though these measures proved insufficient to prevent larger scandals.

The most significant wave of accounting fraud occurred between 2000 and 2002 when multiple major corporations were discovered to have materially misstated their financial results ^[3]. The collapse of Enron Corporation in December 2001 revealed that executives had used special purpose entities, mark-to-market accounting abuses and other techniques to hide billions of dollars in debt from shareholders. Enron's bankruptcy with sixty-three billion dollars in assets was the largest in American history at that time and resulted in the dissolution of Arthur Andersen, one of the world's largest accounting firms.

The WorldCom scandal emerged in June 2002 when internal auditors discovered that the telecommunications company had overstated assets by more than eleven billion dollars primarily by improperly capitalizing operating expenses ^[4]. The subsequent bankruptcy exceeded Enron's record and chief executive Bernard Ebbers was sentenced to twenty-five years in prison. Other major frauds discovered during this period included those at Tyco International, HealthSouth Corporation and Adelphia Communications.

These scandals prompted the United States Congress to enact the Sarbanes-Oxley Act of 2002 which established new requirements for corporate governance, internal controls over financial reporting and auditor independence ^[5]. The law made chief executive officers and chief financial officers personally responsible for the accuracy of financial statements and created the Public Company Accounting Oversight Board to supervise auditors of public companies.

More recent scandals have demonstrated that fraud continues despite regulatory reforms. The Wirecard scandal discovered in 2020 revealed that the German financial technology company had fabricated nearly two billion euros in revenue making it the largest accounting fraud in German history ^[6]. Investigations continue to uncover fraud schemes at companies worldwide.

The fraud triangle

Researchers have identified three factors that typically must be present for fraud to occur, known as the fraud triangle ^[7].

Incentive or pressure

Perpetrators of fraud typically face some pressure that motivates them to manipulate financial records. For corporate executives this might include pressure to meet earnings forecasts that affect stock prices, debt covenant requirements that could trigger default if violated, personal bonuses tied to financial metrics, or a desire to conceal deteriorating business conditions. Individual employees may commit fraud due to personal financial difficulties, gambling debts, substance abuse or simple greed.

Opportunity

Fraud requires the opportunity to commit and conceal the manipulation. Opportunities arise from weak internal controls, inadequate supervision, lack of segregation of duties, complex accounting that obscures transactions, and failures in audit procedures. Industries involving significant estimates and judgments provide greater opportunity for manipulation because subjective assessments are difficult to verify. High turnover in accounting personnel can create opportunities when institutional knowledge is lost and controls weaken.

Rationalization

Fraudsters typically rationalize their behavior to justify their actions to themselves. Common rationalizations include beliefs that the manipulation is temporary and will be corrected when business improves, that the fraudster deserves additional compensation, that everyone else is doing similar things, or that the harm to victims is minimal. A corporate culture that emphasizes results over ethics can make rationalization easier by implicitly encouraging whatever actions are necessary to achieve financial targets.

Types of accounting fraud

Accounting fraud schemes generally aim either to inflate apparent revenue and assets or to conceal expenses and liabilities ^[8].

Revenue recognition fraud

Revenue recognition fraud involves recording revenue before it is earned, recording fictitious revenue or manipulating the timing of legitimate revenue. Schemes include recognizing revenue from goods shipped before the sale is complete, recording revenue from transactions where the customer has a right of return without appropriate reserves, creating fictitious sales with fake customers or related parties, and channel stuffing where customers are encouraged to purchase excess inventory under agreements allowing later return.

Expense manipulation

Expense manipulation understates costs to inflate reported income. The most common technique is improper capitalization where expenditures that should be expensed immediately are instead recorded as assets and depreciated over time. The WorldCom fraud primarily involved capitalizing ordinary network access costs. Other schemes include failing to record expenses that have been incurred, understating reserves for bad debts or warranty claims, and manipulating the timing of expense recognition to shift costs between periods.

Asset overstatement

Asset overstatement inflates the value of assets on the balance sheet. This can involve recording fictitious assets, failing to write down impaired assets, overstating inventory quantities or values, improperly valuing investments or intangible assets, and capitalizing costs that should be expensed. Asset overstatement affects both the balance sheet and income statement because assets that should be written off remain on the books rather than reducing income.

Liability concealment

Concealing liabilities understates obligations to make the organization appear more financially stable. Schemes include failing to record known liabilities, using off-balance-sheet entities to hide debt as Enron did, understating reserves for litigation or environmental remediation, and failing to disclose guarantees or contingent obligations. Hidden liabilities can result in sudden large losses when the obligations eventually must be recognized.

Improper disclosure

Even when the numbers in financial statements are accurate, fraud can occur through misleading or incomplete disclosure. This includes omitting material information from footnotes, describing transactions in ways that obscure their true nature, failing to disclose related party transactions, and using complex language to hide unfavorable information. Disclosure fraud allows management to technically comply with standards while preventing stakeholders from understanding the true situation.

Detection of accounting fraud

Detecting fraud requires vigilance and the application of multiple techniques ^[9].

Red flags and warning signs

Research on fraud cases has identified numerous warning signs that may indicate manipulation. Financial indicators include revenue growth significantly higher than competitors, unusual fluctuations in earnings or revenues, growth in sales without corresponding growth in receivables or inventory, significant transactions with related parties, and earnings that consistently meet or barely exceed analyst forecasts. Organizational indicators include a domineering chief executive with little board oversight, high turnover in financial personnel, frequent changes of auditors, and a corporate culture that emphasizes results over ethical conduct.

Analytical procedures

Analytical procedures compare account balances and ratios to expectations based on prior periods, industry benchmarks or budget projections. Unusual patterns may indicate manipulation. Shifts in key ratios such as days sales outstanding, inventory turnover, gross margin or operating margin can signal problems. Analysis should consider whether changes have plausible business explanations or whether they might reflect manipulation.

Audit procedures

Both internal and external audits employ procedures designed to detect fraud including direct confirmation of balances with third parties, examination of supporting documentation for large or unusual transactions, testing of management estimates and assumptions, and interviews with personnel at various levels. Auditing standards require auditors to consider the risk of material misstatement due to fraud and to design procedures that address identified risks.

Whistleblower reports

Tips from employees and others are the most common way fraud is detected according to research by the Association of Certified Fraud Examiners ^[10]. Effective whistleblower programs provide confidential channels for reporting concerns, protect reporters from retaliation, and ensure that reports are investigated and acted upon. Many frauds are known to multiple employees who do not report them due to fear of consequences or belief that reports will be ignored.

Prevention of accounting fraud

Prevention requires a comprehensive approach addressing all three elements of the fraud triangle ^[11].

Internal controls

Strong internal controls reduce opportunities for fraud by ensuring that no single individual can authorize, execute, record and reconcile transactions without independent verification. Key controls include segregation of duties, authorization requirements for significant transactions, regular account reconciliations, physical controls over assets, and independent review of journal entries. Controls should be documented, communicated to employees and tested regularly to verify their effectiveness.

Corporate governance

Effective corporate governance establishes accountability and oversight at the highest levels. The board of directors should include independent members with financial expertise who actively oversee management. Audit committees should meet regularly with internal and external auditors and review significant accounting policies and estimates. Executive compensation should be structured to avoid creating excessive pressure to meet short-term financial targets.

Ethical culture

Organizations should establish and communicate ethical standards through codes of conduct, training programs and management behavior. Employees at all levels should understand that ethical conduct is expected and that violations will result in consequences regardless of financial results achieved. Management sets the tone at the top and inconsistency between stated values and actual behavior undermines ethical culture.

External auditing

Independent external audits provide a check on management's financial reporting. Auditors should be truly independent with no financial or personal relationships that could compromise their objectivity. Audit committees should evaluate auditor performance and consider rotating audit firms periodically. Recent regulations have enhanced auditor independence by prohibiting certain non-audit services and requiring partner rotation.

Legal consequences

Perpetrators of accounting fraud face severe legal consequences ^[12].

Criminal prosecution

Intentional manipulation of financial statements can result in criminal charges for securities fraud, mail fraud, wire fraud and other offenses. Convictions carry substantial prison sentences as demonstrated by the twenty-five year sentence imposed on WorldCom's Bernard Ebbers. Individual employees who participate in fraud schemes may also face prosecution even if they acted at management's direction.

Civil liability

Companies and individuals may face civil lawsuits from investors who purchased securities based on false financial statements. Class action lawsuits by shareholders have resulted in settlements of billions of dollars. Officers and directors may be held personally liable if they knew or should have known about the fraud. Insurance may not cover losses resulting from intentional misconduct.

Regulatory sanctions

Regulatory bodies such as the Securities and Exchange Commission can impose civil penalties, bar individuals from serving as officers or directors of public companies, and require disgorgement of ill-gotten gains. Professional bodies can revoke the licenses of accountants and auditors involved in fraud. These sanctions can end careers even without criminal conviction.

Consequences for stakeholders

Accounting fraud causes widespread harm beyond the perpetrators ^[13]:

• Shareholders lose value when fraud is discovered and stock prices collapse
• Employees lose jobs and retirement savings invested in company stock
• Creditors may not recover amounts owed when fraudulent companies fail
• Customers and suppliers face disruption when business relationships are severed
• Public confidence in financial markets and corporate reporting is damaged
• Honest companies in the same industry suffer from guilt by association

Accounting fraud — recommended articles

Corporate governance — Internal audit — External audit — Risk management — Management — Quality control — Standard — Documentation — Stakeholder

References

• Association of Certified Fraud Examiners (2024), Occupational Fraud 2024: A Report to the Nations, ACFE.
• Wells J.T. (2017), Corporate Fraud Handbook: Prevention and Detection, John Wiley & Sons, 5th edition.
• Albrecht W.S., Albrecht C.O., Albrecht C.C., Zimbelman M.F. (2018), Fraud Examination, Cengage Learning, 6th edition.
• Schilit H.M., Perler J. (2018), Financial Shenanigans: How to Detect Accounting Gimmicks and Fraud, McGraw-Hill Education, 4th edition.
• Sarbanes-Oxley Act of 2002, Public Law 107-204.

Footnotes

1. Wells J.T. (2017), p. 3
2. Albrecht W.S. et al. (2018), pp. 15-25
3. Schilit H.M., Perler J. (2018), pp. 1-10
4. Albrecht W.S. et al. (2018), pp. 30-35
5. Sarbanes-Oxley Act of 2002, Sections 302 and 404
6. Schilit H.M., Perler J. (2018), pp. 12-15
7. Wells J.T. (2017), pp. 8-12
8. Schilit H.M., Perler J. (2018), pp. 45-180
9. ACFE (2024), pp. 18-25
10. ACFE (2024), p. 18
11. Wells J.T. (2017), pp. 385-420
12. Albrecht W.S. et al. (2018), pp. 485-510
13. Wells J.T. (2017), pp. 425-430

Author: Sławomir Wawak