Financial statement fraud involves the intentional publishing of false information in any portion of a financial statement. It usually occurs when a company overstates assets or revenue, or when it understates liabilities and expenses. Oftentimes stockholders, employees and investors are kept completely in the dark about the value of corporate assets and the existence of liabilities when such a fraud is taking place.

Most of the 2002 fraud-related scandals that resulted in the Sarbanes-Oxley Act - including Enron and WorldCom - were financial statement frauds. Their scams ranged in level of intricacy, but the end results were similar enough: massive stockholder losses and debts to creditors, not to mention trauma to employees who lost their jobs and retirement funds.

In the 2008 Report to the Nation on Occupational Fraud and Abuse published by the Association of Certified Fraud Examiners, U.S. companies suffered a median loss of $2 million to fraudulent statement schemes. The report notes that this form of fraud differs greatly from other types of occupational fraud because "the typical goal of a fraudulent statement scheme is not to directly enrich the perpetrator, but rather to mislead third parties (investors, owners, regulators, etc.) as to the profitability or viability of an organization."

In other words, it is typically perpetrated by company managers who are seeking to enhance the economic appearance of the company by covering enormous debts or other lost assets. Members of management may benefit directly from the fraud by selling stock, receiving performance bonuses, or by using the false report to conceal other illegal acts. Management benefits indirectly from financial statement fraud when the tactic is used to obtain financing on a company’s behalf, or to inflate the selling price of a company.

Preventing Financial Statement Fraud

According to Dr. Donald R. Cressey’s Fraud Triangle, people commit fraud when they are under financial or social pressure, have an opportunity to gain funds undetected, and can rationalize their actions. Any attempt to prevent financial statement fraud should focus on these three factors:

1. Reduce the Situational Pressures that Encourage Statement Fraud

• Avoid setting unachievable financial goals.
• Eliminate external pressures that might tempt accounting personnel to prepare fraudulent financial statements.
• Remove operational obstacles blocking effective financial performance such as working capital restraints, excess production volume, or inventory restraints.
• Establish clear and uniform accounting procedures with no exception clauses.

• Maintain accurate and complete internal accounting records.
• Carefully monitor the business transactions and interpersonal relationships of suppliers, buyers, purchasing agents, sales representatives, and others who interface in the transactions between financial units.
• Establish a physical security system to secure company assets, including finished goods, cash, capital equipment, tools, and other valuable items.
• Divide important functions between employees, separating total control of one area.
• Maintain accurate personnel records including background checks on new employees.
• Encourage strong supervisory and leadership relationships within groups to ensure enforcement of accounting procedures.

• Managers must promote honesty by example. Dishonest acts by management, even if they are directed at targets outside the organization, create a dishonest environment that can be used to rationalize other illicit business activities by employees or externals.
• Honest and dishonest behavior should be defined in company policies. Organizational accounting policies should address any questionable or controversial areas in accounting procedures.
• Consequences for violating rules and provisions for punishment of violators should be written and prominently communicated.