Spotting Fraudulent Financial Statements


Evaluating a company’s financial statements can help credit professionals determine the creditworthiness of current or potential customers. However, sometimes fraud is committed within the highest company levels to deliberately alter these financial statements. That is why credit professionals need to be better educated at spotting distorted financial information on a company’s financial statement. This was the purpose of an NACM teleconference presented Feb. 7 by Bruce Dubinsky, MST, CPA, CVA, CFE.

Dubinsky said credit professionals should ask one simple question when reviewing financial statements: "Does it make sense?" Dubinsky pointed out that certain information on a financial statement could send out a red flag that something is wrong. If that happens, a closer inspection of what went into the reporting of that information would be prudent. He said, "paper talks in different ways," and offered tips on how to identify those things that should "jump out at you." While some personnel may make some honest mistakes in preparing their company’s financial statements, Dubinsky noted that some company officials deliberately provide false information. When this occurs, it is fraud, which he defined as "one or more deliberate acts designed to deceive other persons and cause them financial loss."

There are a number of ways people commit fraud. Some include the encouragement of investment through the sale of stock; demonstrating increased earnings per share or partnership profits interest thus allowing increased dividend/distribution payouts; covering the inability to generate cash flow; obtaining financing, or more favorable terms on existing financing; dispelling negative market perceptions; receiving higher purchase prices for acquisitions; demonstrating compliance with financing covenants; meeting company goals and objectives and receiving performance-related bonuses.

Financial statement fraud typically occurs through the overstatement of company assets and income and the understatement of liabilities and expenses, Dubinksy noted. Conversely, bankruptcy financial statement fraud typically occurs through the understatement of income and assets and the overstatement of company liabilities and expenses. For bankruptcy, the motive for committing fraud is to understate what the company is worth to its creditors. Therefore, it is important to determine the motives behind the presentation of a financial statement in order to figure out what type of fraud may exist on the statement. For example, overstating assets and income and understating liabilities and expenses could be designed to entice investors, to get bank loans, to obtain vendor credit and to get an inflated price in the sale of the business. The understating of assets and income and the overstating of liabilities and expenses could be motivated by a bankruptcy, divorce or, in shareholder disputes, as a way of reducing financial exposures. "Most times, fraudulent financial statements are used to deceive people to gain credit," Dubinsky added. "Learning to understand the motive of why financial statements are submitted to you will give you a heads up of detecting fraud."

Audited financial statements are no guarantee that the numbers haven’t been fraudulently manipulated. Dubinsky pointed to famous corporate financial fraud cases such as Worldcom and Enron that had audited financials. Audited financial statements are not designed to detect fraud, only verify that the numbers on the given financial statements add up correctly. He offered several examples of financial statements that could provide very different results by altering certain elements on the statements that are hard to verify without further investigation, such as the value of inventory or accounts receivables. For accounts receivables, Dubinsky recommended getting aging schedules for the end of the month for the last 12 months to determine any trends. If there is a sharp drop in accounts receivables, for example, he said this could be an indication of fraud. In order to provide protection from relying upon a possible fraudulent financial statement, he advised asking for a security interest in a particular asset that has appreciated, such as land. Another tip he offered was to pick out businesses listed on a financial statement and do a Google search on them to see if they really exist, to guard against fictitious companies providing fictitious receivables.

Other advice Dubinsky offered was to read audit qualifications carefully to learn more information about possible financial downturns of the company. He also recommended asking for the management letter of an audit. "There may be things in there to make you look at the financial statements differently. I would highly encourage you, if you’re granting a credit request for a high dollar amount to conduct a site visit," he added. "When you’re doing a face-to-face meeting with someone, you’ll be surprised what they’ll tell you." As a general piece of advice when evaluating financial statements Dubinsky said, "Put your level of professional skepticism as high as it can be without hindering the performance of your job."
Sources: Tom Diana, NACM Staff Writer and Bruce Dubinsky, MST, CPA, CVA, CFE

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