What is Third Party Fraud?
This is a fraud committed by people outside an employee employer relationship. They can be committed against individuals, businesses, companies, the government or any other entity. Third party frauds are not as common as occupational frauds, but on average each fraud is for a larger amount.
Some third party frauds are not meant to remain hidden forever. Some only remain hidden long enough for the fraudster to make their get-away. The fraudster may not care if the fraud is eventually discovered as they do not have a continuing relationship with the victim and they cannot be found.
What is Financial Statement Fraud?
Financial statement fraud is the manipulation of the information used to prepare the financial statements released to the public and financial institutions. Manipulating these statements allows the business to portray a better but false financial picture, or to hide a disbursement of money, liabilities or assets.
Major Headings
Description of Financial Statement Fraud
1. Manipulating Timing
(i) Early Recognition of Revenues
(ii) Postponing Expenses2. Falsifying Entries
(i) Fictitious revenues
(ii) Manipulating liabilities and expenses
(iii) Valuing assetsLessons to be Learned
Description of Financial Statement Fraud
These frauds involve the manipulation of the information used to prepare the financial statements released to the public or other interested parties. The frauds are generally done to show that some financial target, sales or budget projections have been fulfilled. The intended result is usually either to increase share prices of publicly listed companies, or obtain finance on more favorable conditions that would have otherwise been available. Alternatively, the results may be manipulated to show a lower taxable income in order to reduce a tax liability.
Many investors and advisors rely on quarterly or monthly results produced by a company, particularly public companies. Company officers know that special attention is paid to these results and some of them may do everything they can to achieve the desired results. Sometimes those actions are fraudulent.
These frauds have a number of forms and can be companywide or limited to an area or person within the business. Generally they fall into either sales and expense manipulation (profit and loss figures), or asset valuation and hiding liabilities (balance sheet items). These frauds focus on one of two main objectives:
1. to make the performance look better than reality (to entice investment or to ‘make the figures’); or
2. to make the performance look worse (to lower the company’s tax liability).
The victims of these frauds are usually investors, shareholders or financiers. They lose the value of their investments especially when share prices fall after the frauds are discovered. The offender is not the company itself, but some of the people within the company, whether top company officers or other managers in divisions of the business.
The majority of these frauds fall into two major categories:
1. Manipulating Timing
2. Falsifying Entries
1. Manipulating Timing
The matching principle in accounting provides guidelines for when transactions should be recognized and recorded. In its most basic form, revenues and expenses should be recorded in the period in which the transaction occurred or the period in which the benefit is obtained and, where possible, the expenses associated with a revenue item should be recorded in the same period.
There are two ways of manipulating timing. Both methods make the current period look good, but will cause problems in the next period.
(i) The early recognition of revenues – bringing revenues from a later period into the current period, increasing revenues for the current period.
(ii) Postponing expenses – delaying booking expenses to the next period, decreasing the expenses and raising profits for the current period.
The alternative is to reverse these methods to make the current period look worse and the next period look better.
(i) Early Recognition of Revenues
Businesses will have a policy stating when revenue (sales) should be recorded. The early recognition of revenues is achieved by manipulating these policies to either record sales that were made in the early part of the next period in the current period, or record transactions that should not yet be recognized as sales.
Sales may be recorded when stock is shipped to customers, so some schemes involve shipping stock to customers when that stock has not been ordered and knowing that it will be returned. The sale is recorded when the stock is shipped, and reversed when the stock is returned early in the next quarter, but the earlier period has been closed and the results reported. If you cannot ship the stock directly to the customer – for fear or raising suspicion – you may ship it to a third party warehouse to ‘hold’ for the customer. It can stay there almost indefinitely.
A sale may be recorded when the invoice is issued. To be able record a sale early, an invoice is issued early, even when there is no sale and no transfer of stock. Sending the invoice to the wrong address, so that it will be returned to you some days later, or holding it in a bottom draw, will save sending the invoice to the customer. This is commonly used when the stock is to be delivered in a later period, but someone wants the sale recorded in this period.
A sales may be recorded when an order is received even if the order is not to be filled, and the actual sale will occur, until a later period.
If the recording policy cannot be manipulated, the fraudster may simply record a sale based on some other action. The more common approaches are:
(a) recording a sale when there are still items or services to be provided;
(b) recording a sale before the sale contract has been finalized and before shipment to customers:
(c) recording a sale when items are sent on consignment, on approval, or with a right of return;
(d) recording a sale to associated parties; or
(e) recording a sale when an order is received
(f) issuing invoices for non-existent sales and recording the transaction.
(ii) Postponing Expenses
Recording expenses in a later period is just as simple. Accounting standards state that expenses should be recognized in the period in which the related benefit is recognized. Expenses and their associated liabilities should be recorded when a legally binding obligation has been created. Most businesses will also have policies about when expenses should be recorded and paid.
The fraud involves postponing the recording of expenses until the next period. The business may only record expenses after the invoice arrives from the supplier. To postpone the expenses, the receipt of the invoice is not recognized. It may be held in an Inbox until the start of the new period.
Expenses may be recorded when the expense is finally paid, in which case the expense is not paid until the next period and recorded at that time. Large expenses may be improperly capitalized and written off over a period instead of being expensed in the current period, or capitalized expenses may be written off (depreciated or amortized) over a longer period than appropriate. This lessens the amount recorded as expenses in the current period and puts some of the expense is later periods.
These actions raise the profits in the current period. Doing the scheme in reverse (delaying recording sales and recording expenses early) lowers a profit in order to reduce a tax liability.
2. Falsifying Entries
Schemes that manipulate the timing of recording transactions affect real transactions. The schemes detailed in this section involve and produce false entries on either real or fictitious assets or liabilities. They commonly fall into the following areas:
(i) Fictitious revenues
(ii) Manipulating liabilities and expenses
(iii) Valuing assets
(i) Fictitious revenues
Fictitious revenues can be created by:
(a) inventing sales transactions; or
(b) classifying other incomes or gains as sales.
A business may enter into transactions that on paper appear to be sales, but when the whole transaction is considered, they either lack any substance or do not create any gain. The method used may depend of the trigger used to record sales. If that trigger is the shipment of stock, you ship stock to someone and record a sale, albeit that the stock was never ordered and will be returned. The account receivable associated with that sale will be reversed at some later stage. Recording the return of the stock as an expense and not against sales will maintain the high sales level.
If sales are recorded when orders are placed by suppliers, fictitious orders may be created. Stock may be sent on consignment, but booked as a sale. Issuing fictitious invoices for sales that never happened can create recordable sales in the current period. They can be reversed in a future period.
Entire transactions may be invented that give the illusion of a transaction that creates revenue. Small nonpublic companies do not have the regulatory bodies look at their records. A entry into Sales (Cr) and Debtors (Dr) as an end of period adjustment makes the company look healthier. This is usually done when the company needs to send information to a financier to support loan applications. This is easier in a service industry company, as there is no movement of stock in any transaction.
Other non-revenue gains may also be recorded as sales. Investment income, capital gains on the sale of assets and other onetime gains may be recorded as sales revenue to make the core business appear healthy. Items like discounts and rebates from suppliers and other non-revenue injections of money from loans etc. may also be recorded as sales.
(ii) Manipulating liabilities and expenses
Manipulating or falsifying liabilities and expenses is done for the same two reasons as the other schemes:
1. to make the company look better to increase share prices or for investment purposes; or
2. to reduce the tax liability.
This can be done in a variety of ways.
- Moving a short term liability to long term liability improves the working capital figures on the balance sheet. It is also used to indicate solvency when that may not be the fact.
- Capitalizing expenses and writing them off slowly creates an asset that does not exist and reduces the expenses in the current period. These capitalized expenses can then be written off over an extended period spreading the expense.
- Not writing off assets when appropriate – usually debtors that become uncollectible, or investments, stock or other assets that will depreciate or fluctuate in value – keeps an ‘asset’ in the balance sheet when it has no or little worth. These assets should be expensed when their value decreases.
- Moving reserves from the balance sheet reduces expense accounts on the profit and loss account.
Understating provisions for contingent expenses makes a balance sheet appear healthier. A business must either calculate various provisions (for bad debts, sales returns, employee entitlements, tax etc.) and make allowance for them in the balance sheet; or allow for known provisions that will cover more than one accounting period (e.g. rectification work on a capital project, ongoing Court actions etc.).
These schemes may be used in reverse if the aim is to reduce a tax liability.
(iii) Valuing assets
There are many ways of inflating the values of or creating assets. The ones mentioned below are just a few of them.
Inventory
Inventory can be the major asset owned by a business and can be one of the easiest to manipulate. There are a few ways of doing this.
1. Value the inventory at a higher price than appropriate (at an inflated selling or cost price) and count the correct amount.
2. Value the inventory at the correct amount and inflate the number of items.
3. Do both.
There may be some limitations on placing very high values on physical items of inventory. Generic items would have a recognizable value. Valuing work in progress has less limitations.
Gaining extra inventory for stock takes is done by either counting empty boxes stacked high on shelves, moving inventory between warehouses so that it is counted multiple times, obtaining inventory from a supplier on consignment or under some right of return, or borrowing inventory from a friendly supplier.
Assets or expenses may be manufactured to hide money that has been misappropriated, or ‘investments’ in other entities may disguise loans to various parties. This is not done to manipulate the financial position of the company, but to hide the real nature of certain transactions.
Accounts Receivable
Accounts receivable are amounts that are due to the business, and that are expected to be paid. This makes it a flexible concept as the expectation of payment is subjective. Some businesses have debtors that have been with them for years. In fact, the debts have never been written off as uncollectible. This practice improves the balance sheet as the asset stays on the balance sheet and the bad debt expenses is not recorded.
Creating debtors and sales is a simple credit sales / debit debtors entry. This has the same effect. Small businesses that do not have their accounts audited may be able to get away with is when seeking finance. Creating false sales will usually have the effect of increasing debtors.
Alternatively, writing off good debtors at the end of a period creates an expense and lowers profits. You can simply write them back on when collected.
Lessons to be Learned
The role of auditing was created so that an independent person could look behind the financial statements and discover whether they were accurate. This is not an exact science and the cost of an audit can be large. As costs constraints make test sample sizes smaller, the chances that misstatements will slip through the examination increases.
Financial statement frauds are committed within the business, not on the business. The best way of preventing or detecting these frauds is a strong internal and independent audit function. Internal and independent can seem contradictory, but it is an idea that must become a reality.
Some of these frauds have originated from the pressure to get short term results. If the consequences of not getting the results are too great, improper or illegal behavior will increase. Corporate ideals have a large role to play in deterring these activities, by making them unnecessary.