In this podcast episode, we discuss how a person can create fraudulent financial statements. Key points made are noted below.

Sales Falsifications

The falsification that most people think about is sales inflation. How do you make sales look higher than they really are? The classic method is to keep the books open past the end of the month, so that sales for the next month are recorded in the preceding month. This one is especially common at the end of the fiscal year, when management wants to fluff up the full-year numbers a bit more. A more subtle option is to delay the recordation of sales returns and sales discounts. Just push them into the next period, so they appear as subtractions from gross sales in the following month.

What if the company sells a mix of products and services? If so, it overstates the price of the products, since those can be recognized at once. Otherwise, more of the sale would be associated with the service, which might not be completed for months.

Another option is to sell an asset and classify the sale as revenue – even though it isn’t. Or, set up a separate warehouse that’s under the control of the company, ship goods to it, and count them as sales. Then the warehouse holds onto the goods for a short time and then forwards them to a customer. This one essentially allows a company to record sales early.

And then we get into some major ethical breaches. You could enter into an undocumented side agreement with a customer to sell it goods, where the side agreement states that the customer can return the goods at any time – that’s not a sale, but the auditors won’t know that, since the side agreement is kept secret. Another possibility is round tripping. This is when the company sells goods to a customer and agrees in advance to buy the goods back at a later date. It doesn’t do anything to increase profits, but it does boost revenues. This one can be really hard to spot if the customer shifts the goods to a third party, and the company buys the goods back from the third party.

And if you really want to get sneaky, sell a business unit at an artificially low price, but require the buyer to keep buying goods from the company for a certain period of time. This means the sale price of the subsidiary has been split into the actual sale price and additional revenues.

Or, if you don’t have time for all of this deviousness, just create a journal entry that credits sales and debits accounts receivable. Presto, instant sales! This is called a topside entry.

Expense Falsifications

That’s not even close to all of the ways to falsify revenues, but let’s move on to how we can falsify expenses. One of the classics is to lower the capitalization limit, so that even minor expenses are recorded as fixed assets. This is actually considered legitimate, as long as the board of directors authorizes the change. I’ve seen this once or twice, and don’t find that it’s overly effective. For example, lowering the cap limit from $1,000 to $100 doesn’t really defer all that much expense.

You can also extend the useful life of assets, which reduces the depreciation expense in each period. Or, increase the assumed salvage value for fixed assets, which also reduces the depreciation expense.

And then we have the deliberate withholding of supplier invoices from the accounting records. Management could just sit on these and not show them to the accounting staff until the reporting period has already closed, so the expense is recorded in the following period. Or, one could not accrue an expense for various items at the end of the period. For example, if the company owes employees wages, just don’t accrue the expense, thereby shifting the expense into the next period.

Another possibility is to incorrectly keep prepaid expenses in an asset account for too long, after the assets have already been consumed. This is a common one during the fiscal year, and then someone miraculously catches up the account at year-end. In effect, this means that the reported profit in the monthly financials is always overstated.

Balance Sheet Falsification

Let’s talk about falsifying the balance sheet, and start with accounts receivable. When someone has faked a sale, that means the related account receivable will never be collected. This will eventually appear on the receivables aging report as an old invoice, which will attract the attention of auditors. The accounting staff gets around this by issuing a credit to eliminate each old invoice, and replacing it with another invoice – which has a current date, and so appears as a current invoice on the aging report.

Or, the company could sell the old receivables to a related entity, probably at full price, in exchange for a promissory note. By shifting the arrangement to a promissory note, the receivables are magically shifted to the loans receivable line item, which is not scrutinized as much.

Or, why bother to involve a third party? Just forge some documents stating that these fake customers have converted the receivables they owe into promissory notes. Same outcome, the invoices are removed from the receivables account, and re-appear in the notes receivable account – as new loans, not old receivables.

And how about loss reserves? A company might be experiencing really great profits, but knows that profits are going to start declining. No problem. Management manufactures some sort of crisis, and sets aside a nice fat reserve against future losses related to the crisis. Doing so evens out the reported profit level, so the current profits are not too high, and the reserve is used to prop up poor results in future periods.

Now, one of the prime areas for falsification is inventory. Here are a few good ones. First, double count inventory. Just record some expensive inventory twice. It doesn’t have to be for long, maybe just at month-end. Doing so increases ending inventory, which reduces the cost of goods sold, and therefore increases profits.

Or, you can delay the recording of supplier invoices for raw materials. Just record them in the next month, so that the profit in the current period is too high. Another possibility is to not record any charges for obsolete inventory – even though there may be a lot of obsolete inventory.

Let’s get a bit more devious. Expand the size of the factory overhead cost pool by adding costs that aren’t really related to the factory, and then allocate these costs to inventory. Or just artificially increase the size of the cost pool, and allocate the inflated costs to inventory. That pushes the expense recognition further out into the future. Or – increase the standard costs of inventory items, so the inventory has a higher ending balance.

Someone who is massively devious can repackage returned products as though they’re ready to ship out, and then count them as actual finished goods. Realistically, those items are probably damaged or in need of rework, and so should have a lower valuation.

Statement of Cash Flows Falsification

And let’s not forget about the statement of cash flows. The main goal of fraudulent reporting here is to increase the amount of cash flows that appear to be coming from operations. That means reclassifying cash outflows as either cash flows from investing or financing activities. It can also mean reclassifying cash inflows into cash flows from operations, even though they should be listed in cash flows from investing or financing activities. So how can someone do this? First, capitalize lots of operating expenses. By doing so, a cash outflow that should involve operating activities is now classified as an investing cash outflow. Or, acquire goods and services in exchange for a promissory note. That means the related cash outflow is considered to be the repayment of a loan, which classifies it as a financing activity.

Another possibility is to sell receivables, rather than waiting for them to be collected at the normal speed. This isn’t really fraudulent reporting, but it will increase the cash inflows from receivables.

And here’s a clever one. When you want to sell a subsidiary, don’t sell its accounts receivable along with the rest of the subsidiary. Instead, recognize the cash inflows related to the receivables as an operating activity. If you had instead just sold the whole subsidiary along with the receivables, then the incoming cash would instead have been classified as an investing activity.