Nicole Wrigley, a partner with Winston & Strawn, and Eileen Felson, a director with Navigant, explore the nature of financial statement fraud. Such frauds may be committed not for obvious personal gain but for other incentives, such as continued employment, fear of delivering bad news to investors or an intimidating supervisor, or a desire to increase the value of performance-related bonuses. Most frauds start small and grow. Fraudsters believe the fraud will be short lived or can be reversed when “things turn around.” Yet, in most cases, neither the fraudsters’ personal motivations nor the company’s financial results “turn around.” Often, future earnings expectations increase as a result of the false positive or inflated performance. To avoid exposure, fraudsters are then forced to continue and likely escalate the fraud.
Hiding Earnings Fraud on the Balance Sheet The primary goal of a financial statement fraud is to make the company’s earnings appear better than reality. Earnings fraud necessarily has an impact on the balance sheet, and the fraudster’s fundamental challenge is where on the balance sheet to hide the fraud. At some point, earnings fraud must be reversed. Fake assets (or liabilities) cannot live forever. Recording a fake asset today means booking expenses such as depreciation, amortization, impairment charges, or write-offs tomorrow. When inevitably “things don’t turn around,” the fraud must remain hidden on the balance sheet in order to avoid detection or risk reporting even lower earnings in a later period. As a result, fraudsters often need to recruit accomplices to assist with their schemes.
The Role of Collusion
Collusion can and does occur at even the most respected companies. In theory, a lone fraudster will eventually be discovered by a properly designed system of internal control. However, in a collusive fraud, fraudsters can work together to manipulate and even “launder the fraud” through the balance sheet. Ringleaders of fraud are usually those:
- With financial and accounting backgrounds;
- In positions of authority, including those who have responsibility for components of financial reporting;
- Knowledgeable about the company’s actual results; and
- In a position to circumvent internal controls and auditor inquiries.
As a fraud escalates, even collusive fraud schemes may become increasingly unpredictable and complex.
How a Fraud Scheme Can Escalate
The authors investigated a matter where fake assets were recorded on the books to offset fake revenue. While the primary fraud scheme involved the inflation of earnings, the fraudsters’ ancillary schemes were counterintuitive, unpredictable and involved escalating levels of collusion. For example, the fraudsters not only depreciated the fake fixed assets but also paid property taxes on them. Both of these concealment schemes actually increased expenses. Further, the ringleaders eventually recruited employees in the fixed asset department to:
- enter false fixed assets into the books and records;
- prepare false invoices to support the false fixed assets when vouched by the auditors;
- use special codes and names when referring to the fake assets;
- create a software program to exclude the fake assets when printing reports; and
- lie to others who were not part of the scheme.
Burying the impact of the income statement fraud in fixed assets and the later follow-on schemes —had nothing to do with the primary fraud scheme used to inflate earnings. Investigators cannot assume that if fraud is found in one place or if a whistleblower raises one issue that the whole fraud scheme has been revealed.
Whether the board chooses to perform an investigation internally or to involve outside counsel and advisors, the investigation should focus not only on the predictable accounts and primary alleged fraud scheme, but also on seemingly unrelated accounts that may have been impacted by other concealment schemes.