FINANCIAL FRAUD
A Little Journal Entry Can Bring Big Trouble
December 2011 | Glen Harloff, Grenada
Financial statement fraud, designed to deceive investors or creditors, is one of the
most common and costly of all frauds, but one that tends to get little attention.
It’s time to renew the line of credit with the bank, but the company is offside on its loan covenants. If the current period’s loan interest payment of $2 million were put on the balance sheet though, instead of the income statement, and $1 million of next year’s sales were included in this one, net income would grow by $3 million. The company would no longer be offside. It’s only a few journal entries that can be reversed in the next fiscal period. No harm, no foul, right?
The proper response, of course, is “wrong.” This is an example of financial statement fraud – the deliberate inclusion of misleading amounts or disclosures, or the omission of pertinent ones, in order to deceive financial statement users, especially investors or creditors. It is one of the most costly of all frauds in terms of size and damage created, but also one that tends to get the least attention.
A company’s financial statements may be the only window into the company’s financial affairs for the average investor and sometimes for banks and other institutional investors. At the same time, the high stakes business environment in which companies operate creates a tremendous pressure on management to portray the company in the best possible light and, as a consequence, may cause the management of some companies to create fraudulent financial statements.
The forms this fraud can take are many and various. Typically, it involves multiple journal entries, which use different types of falsehood, making the crime more difficult to detect. A common misconception is that financial statements prepared by auditors are an insurance policy against such misconduct. Detecting fraud, though, is not a primary objective of financial statement audits. Standard sampling techniques do not – and cannot – examine every transaction.
The perpetrator of financial statement fraud is not necessarily the company itself but more commonly a group of people within it, including senior executives at the very top of leadership who have the ability to override internal controls. The motivation may be the ostensible good of the company and its stakeholders, which can allow the fraudsters to rationalize their actions. For example, a fraudster could convince himself that a few “white lies” may seem essential in order to save the company and the jobs of its employees. Alternatively, those involved may simply be seeking their own private benefit by inflating the stock price before sale, securing performance bonuses or even concealing other illegal acts.
So what are some of the red flags of financial statement fraud?
- Unusual or large transactions recorded at the end of an accounting period or occurring with related parties.
- Unusually rapid growth or unusual profitability compared to other periods or peer companies.
- Restrictions placed on auditors or bankers in reviewing company accounting records.
- Unreasonable assumptions or estimates.
- Management dominated by a single person or small group.
When financial statement fraud occurs, investors, bankers, and others cannot properly assess the financial health of the company and make informed decisions. As those relying on the last financial statements of Enron and WorldCom before they went bankrupt can attest, the result can be substantial losses. Companies where executives engage in fraudulent activity also run a high risk of their own demise – something management should remember when tempted to make “just a few journal entries that won’t hurt anyone.”
The Author: Glen Harloff ( This e-mail address is being protected from spambots. You need JavaScript enabled to view it ) is a managing director in the Caribbean and Latin America, specializing in forensic accounting and complex financial investigations, litigation consulting, and financial due diligence. He heads Kroll’s Grenada office.
This article originally appeared in Kroll's 5th annual Global Fraud Report released in October 2011. Click here to download a copy .