With the release of AFP’s 2011 Payments Fraud Survey, it seems fitting that this month’s accounting commentary should focus on another form of fraud that can cripple a corporation: accounting fraud.
Accounting fraud, or financial statement fraud, is usually committed by corporate officials in an attempt to realize a projected earnings goal. According to the 2010 Report to the Nations on Occupational Fraud and Abuse, while financial statement fraud cases comprised less than 5 percent of the frauds in the study, these frauds caused a median occurrence loss of more than $4 million—by far the most costly of all fraud category (asset misappropriation schemes the most reported, but medium occurrence loss was only $135,000).
Accounting fraud usually occurs when a company overstates its assets or revenue, or understates its liabilities and expenses. Companies feel the pressure to commit such acts because the market reaction can be harsh for companies if their revenue projections do not match actual earnings. In addition, senior corporate officials’ compensation packages may be directly tied to hitting targeted earnings. Thus, this creates an insatiable need to ensure that the corporate earnings projections are precisely hit.
Jan. 13, 2011 — The Securities and Exchange Commission (SEC) charged NutraCea, three former executives, and two former accounting personnel for engaging in a fraudulent accounting scheme to inflate sales revenues at the Arizona-based company, which manufactures and sells health food products.
Fully 42 percent of corporate fraud occurs in private companies, as opposed to 32.1 percent in public companies and the remaining 25.8 percent divided between government and nonprofits. The lower percentage of occurrences in public companies may be attributed to the more strict governance and oversight imposed by the SEC, particularly after the Enron accounting scandal in 2001. This scandal brought to the forefront the issue of systemically risky corporations—with the massive losses that were sustained by many of the pension funds that were heavily invested in this company. The establishment of the Sarbanes-Oxley requirements and the formation of the Public Company Accounting Oversight Board were a result of this massive accounting fraud that crippled America from the Enron accounting scandal.
We also see the government taking an even greater stand to predict systemic shock as a reaction to the recent financial crisis. There also tends to be greater incentive for senior officials to commit accounting fraud when their compensation is tied directly to the company’s financial performance. Thus, under the provisions of the Dodd-Frank Act, the SEC has recently imposed rules that heavily scrutinize companies that offer executive compensation packages that are linked to the financial performance. Companies that enter into such compensation arrangements are now required to disclose the nature of such arrangements in their financial statements and regulatory filings.
Dell admitted that between 2003 and 2006, its accounting department was fudging quarterly numbers to meet Wall Street analysts’ financial forecasts. The company was forced to restate its earnings during that time period, which lowered its total earnings by $50 million to $150 million. With the restatement, Dell’s first quarter 2011 earnings now look like this: net income of $341 million (17 cents per share) instead of the initially reported $441 million (22 cents per share).
Since private companies do not fall under the provisions of Sarbanes-Oxley, or under the standards of the PCAOB, these companies should really take a hard look at their internal controls over financial reporting to minimize the weaknesses within the organization that would allow for an individual(s) to perpetrate a financial statement fraud. As with public companies, private companies that tie compensation to financial projections, or place extreme pressure on individuals to meet targeted financial goals, significantly increase the likelihood of accounting fraud within their organization.
Aug 4, 2009 – The SEC filed civil fraud and other charges against General Electric (GE) alleging that it used improper accounting methods to increase its reported earnings or revenues and avoid reporting negative financial results. As a result, GE agreed to pay a $50 million penalty to the SEC to settle the charges.
Companies can substantially mitigate the risk of accounting fraud occurring within their organization by doing the following:
Set the tone at the top. Management should send a clear message that fraud for whatever reason is unacceptable by establishing strict controls over financial reporting. Management must also do their part by eliminating obstacles and constraints that could pressure the accounting personnel into committing a fraudulent act, such as setting unachievable goals. In no way is it suggested that no targeted goals should ever be set by senior management for their employees to achieve. However, when the projected goals are viewed as unequivocal the tendencies to go outside the box to meet such mandates increase the vulnerability within the organization.
Training. Management should ensure that its staff is trained in all corporate policies and procedures and that these policies are adhered to at all times. Employees should also receive ethics training so that if ever a gray situation arise that may inadvertently lend itself to questionable acts, they hopefully will handle the matter appropriately.
Enforcement. Finally, even with management setting the tone at the top and providing all of the necessary training, violations may still occur. When they do, the actions of the company can also serve as a deterrent for future violations. The organization must clearly communicate the consequences for operating outside of corporate policy. Any violations must be investigated and corrective action must be given immediately.
Salome Tinkeris AFP's director of accountingand financial reporting. Contact email@example.com or 301.907.2862.