Small Business Financial Statement Fraud

by | Small Business Consulting

It’s much easier to get into trouble than it is to get out of it.

That sounds like something you might tell your teenager, but it’s also pretty solid business advice. If you’re not careful, there are dozens of ways you can steer your company into a bad situation that can be tough to escape from.

Financial statement fraud, for instance, is generally associated with large, publicly traded companies. But unfortunately, smaller, growing companies can run into problems with financial statement fraud, too.

Types of Fraud

Several kinds of fraud can harm a small company. Employee theft, which generally involves taking or misappropriating cash or other assets, is the most common, and costs small companies about $150,000 on average. These schemes tend to continue for about 18 months before they are detected.

A second type of fraud involves the illegal or unethical activities of corrupt employees. Accepting bribes, kick-backs or other unauthorized payments in exchange for business favors can easily rise to the level of criminal activity.

If you suspect that your company is the victim of, or engaged in, either type of fraud contact your attorney immediately.

Financial statement fraud is potentially more serious, and definitely more complicated than other forms of business fraud. Have you ever heard the term, cooking the books? It refers to financial statement fraud.

This type of fraud involves the deliberate falsification or manipulation of financial reports for the purpose of misleading the users of these reports.

The fraud can involve the portrayal of phony or inaccurate transactions (revenues to the company and/or payments out) or the exclusion of relevant non-financial information.

Simply stated, this type of fraud is usually the result of someone with a vested interest trying to make a company appear that it is performing better than it actually is.

Examples of What NOT to Do

But what exactly might a less than honest company – or more specifically, its managers – do that might be considered fraudulent pertaining to its financial statements?

Unfortunately, there are dozens, if not hundreds, of ways to leave faulty impressions, and more are being devised all the time. But most manipulations of financial statements tend to fall in one of these categories:

  • False revenues. Fictitious sales, payments from customer accounts, or other revenue streams are contrived to give the impression of revenue higher than it actually is.
  • Inflated asset valuations. This type of fraud is perpetrated on a company’s balance sheet. Unrealistic or blatantly false values are assigned to company property, inventory, or even investment securities to dress up the business’s value and offset large liabilities.
  • Hidden liabilities and expenses. This is where some of the company’s debts are concealed, potentially leading to a stronger balance sheet, or where expenses aren’t included on an income statement, usually to present a misleading state regarding the company’s cash flow or profitability.
  •  Misleading or incomplete disclosure. This is where non-financial information that can significantly harm a company’s financial position is not revealed to potentially affected parties. An adverse judgment in a lawsuit is a typical example.

Preventing Fraud

Financial statement fraud can be disastrous for your growing company. The downside of fraud can include penalties and fines, legal fees, a loss of credibility with lenders and investors, and long-term and potentially irreparable harm to your reputation.

It turns out that smaller companies, those with fewer than 100 employees, are less likely than larger businesses to implement policies and controls that can help with prevention of fraud.

For example, according to information published in the Journal of Accountancy, just 56% of small companies subjected their statements to external, independent audits, versus 91% of larger businesses.

Fortunately, anti-fraud policies and controls aren’t necessarily expensive. An experienced accountant with a background in small business accounts can help you implement a plan. Here are a few ideas:

  • Job rotation. When employees developing and monitoring financial statements are regularly required to switch duties and responsibilities, mistakes or unethical behavior can often be detected and reported.
  • Mandatory vacation policies. When an employee is out long enough for a co-worker to take over his or her duties, there’s often enough time to spot any inconsistencies or errors in reporting.
  • Employee training. Your workers can’t be expected to spot and report fraud if they don’t know what it is. Anti-fraud training, either on-site or in a remote setting, can alert your employees to the potential signs of financial statement fraud, while also sending the message that you won’t tolerate it in any form.
  • Code of Conduct. Having new and established employees adhere to a code of conduct that outlines expectations and specifically addresses penalties for falsifying accounting entries or fabricating financial information can be highly effective in preventing fraudulent activity.

As your company grows, more detailed methods of fraud prevention might be in order. Internal and external audits, fraud risk assessments, and formal anti-fraud training for upper management are options you should discuss with your legal and financial advisers.

Image courtesy Federal Bureau of Investigation

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