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Financial Statement fraud - what are the signs?

Forensic Focus - June 2009

Bernard Madoff’s $US50 billion ponzi scheme in the United States and the $1 billion Satyam fraud in India are two high profile examples of financial statement fraud. It seems likely New Zealand has not been immune from this, with many finance companies reporting high levels of profit and strong balance sheets, only to be placed into receivership months later.

Investors, lenders, creditors, shareholders and insurers are all vulnerable to financial loss caused by financial statement fraud.

There are often signs that financial statement fraud is occurring, if the fraud is significant. Harry Markopolos, a US based Certified Fraud Examiner, had a hunch that Mr Madoff was running a ponzi scheme because he found it difficult to believe that Madoff could generate such consistent returns for investors over a long period of time. He modelled Madoff’s investments and determined that the returns were mathematically impossible to achieve. Mr Markopolos first took his concerns to the Securities and Exchange Committee (“SEC”) in 2000. He resubmitted evidence to the SEC in 2001, 2005, 2007 and 2008, but the authorities took no action (Source: Fraud Magazine, May/June 2009, pages 37 and 38).

Although some financial statement frauds occur where unscrupulous executives actively create assets that never existed (e.g. reporting non-existent bank balances), many financial statement frauds are considerably more subtle, often occurring as a result of inactivity. Profits and the financial position of companies can be easily manipulated by managers failing to:

  • Write-off or provision for uncollectable accounts receivable and loans;
  • Write-off inventory that has reduced in value;
  • Accrue for expenses incurred but not paid.

There is often considerable incentive for managers of companies to misstate the financial performance and position of companies to:

  • Meet performance targets;
  • Maintain employment, salary and status;
  • Achieve bonuses;
  • Prevent banking covenants from being breached.

As a lender, creditor, insurer, investor and shareholder there are a number of triggers that could allude to statement fraud and you should be asking questions around this possibility when you identify one or more of the following:

  • The company is reporting profits, but has tight cash flows;
  • Gross profit levels remain at high levels, even though the company is facing pricing pressure in the market;
  • Accounts receivable, accounts payable and stock levels are increasing, when sales are flat or declining;
  • The company is close to breaching banking covenants;
  • There is a significant level of “year-end” adjustments;
  • There are significant bonuses available to senior management; and perhaps most importantly
    It doesn’t “feel right”.

For information on this subject and what to do if you suspect statement fraud please contact Jason Weir.

Jason Weir
Associate Director, Forensics
+64 9 303 0966
jasweir@deloitte.co.nz

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