Financial reporting fraud is the deliberate misstatement or omission of amounts or disclosures in a company’s financial statements. It involves intentionally misrepresenting the financial position or financial results of the company in order to alter the company’s actual profits and losses.

Financial reporting fraud can be carried out for many reasons, and can involve the manipulation or falsification of:

  • Assets
  • Liabilities
  • Revenue
  • Expenses
  • Disclosures
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Overview

Overview

Financial reporting fraud can take many forms and can be carried out for many reasons.

At its most egregious, financial reporting fraud can involve the outright falsification, fabrication and alteration of records, transactions or amounts. However, financial reporting fraud can also involve more subtle misrepresentations or manipulations, aggressive accounting policies and complex transactions.

In most large-scale cases of financial reporting fraud, the company’s upper-management is usually aware of the fraud, and may have knowledge regarding who is perpetrating the fraud. However, depending on the circumstances, financial reporting fraud can be undertaken by:

  • Accounting or finance staff (who are responsible for posting accounting entries)
  • Management or executives (who are responsible for reviewing and approving accounting entries and the company’s financial statements)
  • Salespeople or other employees who receive commissions or other compensation based on the company’s financials
  • Employees who oversee any business function which reports the financial results to the accounting or finance group. For instance, a warehouse or inventory manager could manipulate inventory amounts which would result in inventory being misstated on the company’s balance sheet

Motivations

Motivations

Those who commit financial reporting fraud often want to give the impression that their company is in a stronger financial position than it actually is, in order to:

  • Achieve certain targets and benchmarks, particularly if they are evaluated or compensated based on these targets being met (for example, bonuses might be based on the company achieving certain profitability targets)
  • Increase the company’s stock price for their own financial benefit (if the person owns or expects to receive company stock)
  • Have the company appear as though it is returning a sizeable profit, particularly if the company is struggling to meet expectations, or if it is preparing for a debt or equity offering
  • Keep the company from violating debt covenants that require the company to maintain certain financial results or ratios
  • Keep the company in a viable position to continue operations if it is struggling
  • Deceive other into believing that they are a successful manager, or to give the impression that the company is yielding greater returns than it actually is. Thus, the motivation for the fraudster may be related to the his or her ego, personal greed or career aspirations
  • Sustain or conceal another fraud that he or she is committing, such as an asset misappropriation scheme

Financial reporting fraud can also be used with the intention of showing financial results that are worse than they actually are, in order to:

  • Show stronger results in the future (sometimes referred to as taking a ‘big bath’)
  • Decrease the company’s stock price for their own financial benefit (for example, if the fraudster plans to purchase a company’s stock in the near future, or holds a short position with respect to the company’s stock)
  • Reduce or defer taxes
  • Assume a stronger position regarding a matrimonial dispute, shareholder dispute, or bankruptcy

Others

Financial Reporting Fraud – Assets

Financial reporting fraud involving assets can include:

  • Recording fictitious assets, such as indicating that a company holds and maintains equipment that it does not
  • Overstating and overvaluing holdings by reporting that a company’s intangible assets are worth more than they are actually worth
  • Misclassifying assets such as falsely reporting ‘held-to-maturity’ investments as ‘available-for-sale’ investments, or vice versa

Financial Reporting Fraud – Liabilities

Financial reporting fraud involving liabilities can include:

  • Omitting liabilities, such as not reporting all outstanding accounts payable
  • Understating or undervaluing liabilities. For example, under reporting the company’s pension liability
  • Misclassifying liabilities, such as presenting short-term debt as long-term debt)

Financial Reporting Fraud – Revenue

Financial reporting fraud involving revenue can include:

  • Fictitious revenue, characterized by booking sales that never occurred
  • Inflating the revenue by reporting sales as being higher than they actually were
  • Premature revenue recognition by recording the revenue before they were earned

Financial Reporting Fraud – Expenses

Financial reporting fraud involving expenses can include:

  • Omitting expenses, such as not recognizing all of the expenses that were incurred
  • Under reporting expenses as being lower than they actually were
  • Delaying expense recognition by reporting expenses in the future even though they were incurred during an earlier period

Disclosures

Financial reporting fraud involving disclosures, such as those contained within the notes to financial statements or in management discussion sections of annual or quarterly reports, can include:

  • Omitting disclosures such as failing to divulge certain negative pieces of information
  • Misleading disclosures by misrepresenting certain events or assumptions

Financial Reporting Fraud Case Study

In July 2017, Mr. Bailey purchased a controlling interest in VendPot, a company that specializes in the legal dispensing of marijuana products through proprietary vending machines. The VendPot machines scan a patient’s medical marijuana card to confirm identity. Once confirmed, it uses biometric authentication in order to ensure that the patient is the person that they are representing themselves to be.

In August 2017, Mr. Bailey set up a shell company called Bail-Vend Investments, which was registered under his wife’s name. Mrs. Bailey would assume the positions of CEO, corporate secretary and sole officer and director.

In December 2018, Mr. Bailey transferred his VendPot shares to Bail-Vend Investments, without registering the purchase. Mr. Bailey created fraudulent documentation stating that Bail-Vend Investments had paid $3,000,000 for the shares of VendPot, when in reality nothing was paid.

Throughout the first two quarters of 2019, Bail-Vend Investments illegally sold VendPot shares as restricted securities in several private transactions. As a result, they received tens of millions of dollars in proceeds.

In order to transfer the illicit proceeds from Bail-Vend Investments back to VendPot, Mr. Bailey had to fabricate the financial records of VendPot that were related to purported revenue transactions. This would, he believed, give the appearance that VendPot was in a much stronger financial position than it actually was.

In September 2019, VendPot’s accounting and finance department requested documentary support from Mr. Bailey that would indicate the financial ability to acquire the shares from Bail-Vend Investments. Mr. Bailey provided fabricated financial statements to both the auditors and the accounting and finance department with the sole purpose of misleading them.

In October 2019, Mr. Bailey was arrested. The OSC claimed that they had investigated the transactions between VendPot and Bail-Vend Investments, and that over 95% of VendPot’s revenue figures were completely fictitious.

Relevant Evidence:

  • Contracts and Agreements
  • Financial Records
  • Banking Records
  • Corporate Profiles and other Company Registered Documents

To determine whether your organization may be susceptible to financial reporting fraud, take the following brief survey: