Financial Statement Fraud (#215)
/In this podcast episode, we discuss the reasons why people engage in financial statement fraud. Key points made are noted below.
Reasons for Financial Statement Fraud
Financial statement fraud is when the managers of a company falsely alter the financial statements. There are several reasons for doing so. One is pressure from senior management to reach hard budget numbers. This is pretty common when the president is really aggressive, and wants to grow the company as fast as possible.
Another reason for financial statement fraud is when management can earn some major bonuses if they meet aggressive stretch goals, usually either to increase sales or profits.
Another reason for fraud is to keep from breaching loan covenants. When lending to businesses, a lot of lenders will insert covenants into the loan document, such as maintaining a reasonable current ratio. If the covenant is breached, then the lender can call the loan. If a business is heavily in debt, there’s a good chance that calling the loan will drive the company into bankruptcy, so management keeps really close track of the covenants before it releases financial statements each month, and then tweaks the numbers to make sure that the covenants aren’t breached.
A slight variation on the concept of breaching loan covenants is when someone on the management team has personally guaranteed the loans, and so could lose a lot of money if the company can’t pay up. This is usually the president. When that’s the case, you can bet that the guarantor will want to preview the financials before they’re released, and will put pressure on the controller to modify the financials if the results aren’t good enough.
Yet another reason for fraud is when a business is publicly-held, and managers own a lot of shares or stock options in the company. They have a large interest in keeping the stock price as high as possible, so that they can sell their shares or exercise their options at a good price. When the company is being followed by an analyst, the analyst may publish an expected earnings per share figure that he thinks the company will achieve. If the company reports a number even a fraction below this expected earnings per share figure, then the stock price will probably drop – by a lot. So this arrangement means that management has a strong incentive to meet a specific target earnings number, quarter after quarter after quarter. This is a particular problem when a company has just gone public, since the shares held by managers are usually restricted for the first half-year. In this case, managers will really want to keep the reported earnings level high until their shares can be sold.
We also have a reverse situation in privately-held companies that are owned by a small number of people. If the business normally earns a lot of money, the owners have an incentive to reduce the reported amount of earnings, in order to shrink the income tax liability of the business.
And finally, we come to the most pernicious reason of all for altering the financial statements, which is getting into the habit of making minor adjustments to the financials to smooth out earnings, and then getting caught up in the process. The situation is common enough. As an example, the president promises investors that earnings will be at least $100,000. At the end of the period, the controller finds that the actual profit number is $99,000, so he makes some minor “adjustments” to increase the figure to $100,000. Over time, management gets into the habit of doing this to make sure that the business always meets its numbers. In essence, managers get used to the idea that the financials can be altered.
But then there’s a month when sales or profits are substantially less than expected; so the controller makes some really serious “adjustments” to still make the numbers. This means that the management team is now becoming accustomed to some major fraud, where the new normal is to falsify a large part of the income statement. After a while, managers spend more time figuring out ways to maintain the fraud than they do running the business, so the disparity between the actual and reported results gets bigger and bigger. In essence, the fraud has taken over the business.
This situation is especially common when a growing business becomes more mature, so that its rate of sales growth declines and then levels out. When managers have been promising investors that sales will continue to growth, they get caught by this maturation in sales, and end up fabricating sales to show the old rate of sales growth – which completely falsifies the actual situation.