Fraud, Reasoning and Consequences Found in Financial Statements

Overview of Financial Fraud:

As technology increases and the world becomes more reliant on financial data for global interaction then there is a greater risk for financial fraud to be present. The 21st century has seen the collapse of many large companies such as Enron, and World Com, due to errors in financial reporting and committing overt acts of financial fraud. In 2002, the Sarbanes-Oxley Act was enacted as a direct response to financial fraud. The Sarbanes- Oxley act is also known as the SOX act or the Public Company Accounting Reform and Investor Protection Act. This bill is a direct response to the accounting scandals of the publicly traded companies Enron and WorldCom which were facilitated by the once prestigious accounting firm known as Arthur Anderson. This article is meant to explain causes of fraud, the methods used to commit fraud as well as the consequences that come with committing financial statement fraud.

Learning Objectives

  • You should be understand the elements that it takes for a fraud to be committed.
  • You should be understand and distinguish the different methods for creating fraudulent financial statements.
  • You should be to understand the three necessary components that allow the perpetrator(s) the opportunity and reasoning to commit financial fraud.
  • You should be familiar with the classifications of fraud and the different roles that business owners, employees, investors, and auditors play in each type of fraud.

Fraud can encompass various different types of acts but is generally defined as the intentional misleading of a person or deception of a person in order to cause someone to lose property, money, or some other right. This therefore implies that fraud must be intentional. So theoretically someone can commit an error on the financial statements without it being considered fraud or rather without trying to deceive anyone for personal financial gain.

To Identify Fraud you must have a number of items that are identified first. These items are listed below:

1.) There must be a victim.

2.) There must be a detailed account of the deceptive or fraudulent act.

3.) There must be able a mechanism to identify and quantify the victim's loss.

4.) There must be a person suspected of committing the crime.

5.) There must be evidence that the suspect acted with the intent to commit the crime.

6.) There must be evidence that the suspect profited in some way by the act(s) that were committed.

It is important to note that the indicators and the symptoms of fraud can be separated and differentiated from any errors that might occur as a result of account mistakes by the use of fraud indicators. These fraud indicators help serve as specific clues or "red flags" that could merit further investigation by an auditor into a specific area of the business or a specific activity that the business. These fraud indicators can be classified into three main categories, which are listed below.


1.) Personal Mistakes or Shortcomings:

  • A situation where a person lives too far beyond their means
  • There is a high turnover of employees or personnel
  • There is a situational pattern of uncharacteristic behavior from employees.

2.) Financial Downfalls and Shortcomings:

  • There are unexplained changes or entries of financial records
  • There has been an extremely unusual or high amount of cash transactions
  • There is evidence of altered, missing, or stolen financial documents.
  • The transactions that have taken place don't have the proper transaction numbers or serial numbers.

3.) The Operational Downfalls and Shortcomings:

  • A lack of internal accounting and process controls exists within a business
  • There is one person in the business that is in control and there are no separations of duties that exist in that structure.
  • The financial records and the inventory for a business are not reconciled.
  • There are one or more unauthorized transactions that exist.

Classifications of Fraud:

Generally the term fraud is meant as a generic overview and can encompass many different types of fraud that are deliberate acts meant to deceive or mislead someone that can result in personal, physical, or financial harm. This act of fraud or intentional deception can be separated and differentiated in a number of different ways depending on the nature of the act and who committed the act. Take for example when fraud is committed by an individual in the form of embezzlement or theft, this type of fraud has a different classification than the type of fraud that is committed by the management team of a company where the management team falsifies or knowingly and inaccurately reports incorrect information on the financial statements of the company. The first example is known as employee fraud and the second example is known as management fraud. There are multiple types of fraud that are segmented by the people who commit the fraud, the type of fraud, and the victims or people who are negatively affected by the fraud that has been committed.

Types of Fraud:

Type of Fraud


Victim or Victims

Explanation of Fraud

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Employee Embezzlement Fraud



The employee either directly or indirectly steals money or other items of value from the business that the work for.

Customer Fraud

The Customers

Businesses or organizations that buy goods or services

Customers will try to scam sellers into giving the customers something they should not have or scamming the business into not charging the customer

Management Fraud

The management team for a company

People who rely on financial statement information such as investors, banks, and other lenders.

The management team of a business allows for misrepresentation, of the financial information

Vendor or Supplier Fraud

Organizations or individuals who sell goods and services directly to other businesses

Businesses or other organizations that purchase goods and services on a B2B channel.

Organizations will over change the business that the sell to or not even ship the good even though payment has already been made.

Investment Scam Fraud

Usually individuals

Individual Investors

People trick other investors in giving them money for an investment that is either not financially sound or does not exist at all.

Financial Statement Fraud:

Generally when the business owners or managers of a company report false financial data it is referred to as financial statement fraud. For the most part financial statement fraud is generally committed with the goal that if there is an audit of the financial statements then no misappropriations or material misrepresentations will be caught by the auditor or auditing team. As technology increases and financial transactions take place in greater volume and at a more frequent rate it can be difficult to accurately and thoroughly monitor against financial statement fraud. As stated earlier in the article financial statement fraud can be defined as the intentional or deliberate wrongful act committed by a person or persons inside the company through the use of false or misleading information in the financial statements which result in a form of harm or injury to creditors, investors, and potentially employees. These acts are usually committed by the financial management team and are considered to be well-masked schemes that are not immediately discernable as financial statement fraud. Listed below are four common fraudulent schemes that companies have used before.

Fraudulent Schemes That Are Often Used by the Management Team of a Company

  • The falsification, manipulation, or the alteration of material financial statement documents or records and the manipulation of supporting documentation or transactions that occurred.
  • Manipulation of the GAAP accounting practices and standards that have been established by the FASB and other governing boards.
  • The usage of aggressive accounting techniques through the illegal or illegitimate financial earnings of the management.
  • The material omission, misstatements, or the misrepresentation of events, financial accounts for the company, or other significant sources from which the financial statements are derived.

The Methods for Creating Fraudulent Financial Statements:

1.) The Overstatement of the Assets- The assets of a business can be overstated by not logging the accounts receivables or by not reporting the assets with any depreciated or impaired values, or the items in the inventory that are considered to be obsolete of no value.

2.) The Understatement of Liabilities- The liabilities of a business can be understated by improperly recording the liabilities as equity or it can be done by moving the liabilities between short-term and long-term classifications.

3.) The Overstatement of Revenue- The revenues for a business can easily be overstated by the use of inflated sales. This is generally accomplished by entering in fake sales that never happened or it can be done in a more deceptive fashion by entering in a sale into the financial records before the revenue from the sale is actually earned.

4.) The Understatement of Expenses- Expenses can be understated by holding the expenses the business incurred in one period over to the next accounting period. This can easily happen by improperly capitalizing an expense over multiple accounting periods rather than correctly expensing it immediately.

5.) One Time Expense Mischaracterization- The management team of a company may remove one-time expenses from the accounting records, which thereby gives investors and other people the false impression regarding the results from operations for the business to the participants in the capital markets.

6.) The Misrepresentation of Information- The management team or individuals inside the company can either omit or misrepresent certain types of financial information to present a healthier overall appearance for the business. Often times many people who are trying to commit financial fraud will just omit certain items from their reports.

7.) The Improper Use of Reserve Accounts- There are reserve accounts that hold reserves for things such as the accounts receivables, obsolete inventory accounts, returned sales accounts, and warranties. These accounts can be notoriously difficult to discern because a substantial amount of judgment and knowledge of the business is required in order to determine the proper balances at the end of the accounting period.

8.) The Misapplication of the GAAP Rules- There are many businesses that employee clever accountants and members of the management team that have familiarized themselves with all of the rules and regulations for the FASB and GAAP. Just like every system there are still loopholes, which can be exploited for those people who are looking to intentionally commit financial statement fraud.

Reasons for Fraud and the Triangle of Fraud:

Financial statement fraud is considered to be a deliberate and wrongful act where the perpetrator has the intent to deceive. With this intent there is generally some sort of basis for rational or justification for their actions, along with the right conditions present inside of the business that would allow the fraud to be committed. This is where the triangle of fraud comes into use. When analyzing the nature of fraud there are generally three characteristics that universally apply. These characteristics are: Opportunity, Rationalization, and Motive.

  • Opportunity- Opportunity is considered to be the set of situational circumstances that provide the perpetrator a chance or opportunity to perform the material misstatement of the financial recodes. These opportunities that might lead to fraud can be things such as a weak or non-existent internal accounting control system, absence of an auditor or auditing committees, and the negligent or improper oversights by the board of directors for the company.

  • Rationalization- When the term rationalization is used we are referring to the ability for a person to commit certain action based on a self-perceived set or ethical values or a moral code. Many times people that commit fraud have found a way to justify their actions to themselves, often citing a utilitarian principle of "helping the greater good". An example of this would be when a business owner over states his assets on the balance sheet when presenting his financial records to the bank in order to receive a loan to help the business stay afloat and thereby keeping the people that work for him employed. He thinks that by defrauding the bank he is only hurting the bank while at the same time providing help to multiple employees, therefore providing benefit to the maximum amount of people in the situation.

  • Motive- The motive for committing fraud can be thought of as a type of pressure. This pressure can be thought of as either internal pressure or external pressure. This means that the person committing the fraud either feels the need internally to do it or there is an outside influence such as a person or a business that is pressuring him to commit the fraud. Motivation or pressure can also be classified as "psyche", "egocentric", "ideological", or "economic". The psyche classification relates to things that are habitual in nature. The egocentric classification is related to image, personal prestige, or the way that people view the perpetrator. The ideological classification relates very closely to the utilitarian principle that was discussed in the previous section over rationalization. This utilitarian concept or ideology relates to someone committing an action because they believe that they have the moral justification to do so. The economic classification relates to the need for money that an individual or a business may experience.

Auditing and Types of Audits:

Types of Audits: in order to counteract financial fraud and limit the likelihood of a business to engage in fraudulent financial reporting an accounting process known as auditing is used by many companies and in the case of publicly traded companies auditing is required. An audit is defined as an examination of the financial accounts and the reporting of financial activities for business entity that is performed by an individual or company that is independent of the business entity that is being audited. The types of financial reports that our audited include the balance sheet, income statement, statement of stockholders equity, statement of cash flows, and any financial information or notes that summarize or explain the accounting procedures and techniques that are used by a business.

The purpose and goal of an audit is to formulate an opinion based on empirical evidence of whether or not the financial information that a business has presented is accurate. Auditors must follow auditing standards that have been set forth by the FASB, the United States Securities and Exchange Commission, and any other auditing boards that are instrumental in the development of these standards. After an order has examined the financial information of a company and their work is complete they write an audit report explaining what exactly they have done, the techniques they have used, the information that they have evaluated, and then summarize all of this by giving an opinion of whether or not financial statements for business are accurate based upon their findings. It is important to understand that there are multiple types of audits, which an auditor may perform. These types of audits are listed below.


  • Investigative Audit: An investigative audit generally will take place as the result of a business being reported for unusual or suspicious activity by an individual or an entire department within a business. Investigative audits tend to be focused on specific functions and aspects the deal with the scope of work for an individual or department within the business.
  • Departmental Review: A departmental review is an analysis based in the current time period of the administrative functions for business. This type of evaluation seeks to measure and review the adequacy of controls, how efficiently resources are being used, the safety or safeguarding of assets, and in compliance with any relative regulations, enterprise policies, or laws that have been set as standards for the business to follow.
  • Financial Standards Audit: A financial audit is an independent evaluation that is historically based and has the purpose of confirming the accuracy, fairness, and reliability of financial data that has been reported via business. A certified public accounting firm usually performs the financial audit. These accounting firms are usually larger accounting firms such as Deloitte, Pricewaterhouse Coopers (PWC), Ernst and Young (EY), or KPMG.
  • Business Information Systems Audit: There are three basic types of Information Systems Audits they can be performed. These three types of audits or for general controls review, system development review, and applications control review. These types of audits are designed to guarantee that the controls are in place in the information systems function in order to protect the operation as well as the security of the information systems, which ensure the safeguarding of financial data for business.
  • Business Operations Audit: An operational audit has a future based scope that is systematic and employs an independent evaluation of the organizational activities of a business. While financial data of the business may be used it is not considered to be one of the primary sources of evidence. The primary sources used for operational audit are the operational policies and the achievements that are related to the organizational objectives for business. In this type of audit internal controls and efficiencies are the most likely to be evaluated and reviewed.


  • Fraud is generally defined as the intentional misleading of a person or deception of a person in order to cause someone to lose property, money, or some other right.
  • The fraud triangle consists of three elements: Opportunity, Rationalization, and Motive
  • Investigative audits tend to be focused on specific functions and aspects the deal with the scope of work for an individual or department within the business.
  • The three categories of fraud indicators are: Personal Mistakes or Shortcomings, Financial Downfalls, and Operational Downfalls.
  • A financial audit is an independent evaluation that is historically based and has the purpose of confirming the accuracy, fairness, and reliability of financial data that has been reported via business.