Financial Statement Fraud

Financial statement fraud can lead to significant investor losses every year. These cases often involve orders from company executives to accountants to purposefully misstate a company’s earnings and/or hide the company’s debts and liabilities. This type of fraud artificially inflates the value of a company’s stock, and when the fraud comes to light, the stock prices typically plummet.

The Association of Certified Fraud Examiners reports that while financial statement fraud is the least common type of fraud – accounting for 5% of cases – it is also the costliest. The median loss in these types of cases is $766,000, while asset misappropriation cases have median losses of $120,000. The SEC incentivizes insiders with knowledge of financial statement frauds to make reports, as devastating losses can easily shake investors’ confidence in the market.

What is Fraud in Accounting?

A report from the Anti-Fraud Collaboration states that the following are the most common types of accounting fraud:

• Improper revenue recognition
• Reserve manipulation
• Inventory misstatement
• Loan impairment issues

Financial Statement Frauds: Examples

These recent examples of financial statement fraud demonstrate the close involvement of management in many cases of accounting fraud. Executives will go to complex lengths to hide signs of their fraud from investors.  

Improperly Recognized Revenue

The SEC announced in February 2024 that it had settled accounting fraud charges against Cloopen Group Holding Limited. Two senior managers allegedly directed their employees to improperly record revenue on numerous contracts that had either not completed work or had not started work. Allegedly, the company had strict quarterly sales targets which motivated them to make misstatements in their financial statements. Due to Cloopen’s cooperation with the investigation, the SEC decided not to impose a civil fine.

Convertible Note Fraud and Improperly Recognized Revenue

In July 2021, the SEC charged two executives of an infrastructure company with accounting fraud. The individuals were also charged in a parallel criminal action. According to the allegations, the company issued $22.7 million in convertible notes, which are a type of debt instrument that may be converted to equity (stock) in a company at a certain point. Allegedly, the fraudsters misappropriated millions in company funds to pay for unauthorized salary increases and private jet services.

The complete information concerning the notes allegedly did not appear in the company’s financial statements. In this case, the co-conspirators allegedly directed the company to “improperly recognize revenue and related accounts receivable for non-existent construction projects.”

Reserve Manipulation

Companies may manipulate their reserves to create the appearance of profits. The SEC alleged in 2003 that Nortel Networks Corporation “improperly released approximately $500 million in excess reserves and to boost its earnings and fabricate a return to profitability.” Without the use of reserves, the SEC alleges that Nortel would have had to report a loss for its first quarter. The company paid $35 million to the SEC to settle the fraud charges.

Inventory Misstatement

Accurate inventory accounting is crucial for financial statements and gross profit calculations. In 2021, the SEC alleged that the Tandy Leather Factory accounting system did not maintain historical cost information for its inventory. Allegedly, the CEO was aware of the company’s inventory tracking system’s limitations. In 2021, the company released restated financial statements for fiscal years 217 and 2019. Following SEC allegations that Tandy Leather Factor failed to maintain internal control over financial reporting, the company consented to pay a civil penalty of $200,000, and the CEO consented to a separate civil penalty of $25,000.  

Loan Impairment Issues

Impaired loans are loans that are unlikely to be repaid according to the original terms of the loan. According to SEC allegations from August 2023, Malvern Bancorp and its Chief Financial Officer produced financial statements with material misstatements concerning commercial real estate loans. They allegedly failed to account for troubled debt restructuring and loan impairments. As part of the settlement with the SEC, Malvern Bancorp paid a civil penalty of $350,000 and the Chief Financial Officer paid a settlement of $40,000.

Unsupported Adjustments

Unsupported adjustments are also common in financial statement fraud. GTT Communications allegedly failed to disclose information concerning unsupported adjustments the company made that increased its reported income by at least 15%. The SEC alleges that there was a discrepancy between the expenses reflected in invoices from vendors and reported expected expenses. The SEC did not impose a civil penalty in light of GTT’s cooperation.

Management Involvement in Accounting Fraud

The Anti-Fraud Collaboration report found that Chief Financial Officers and Chief Executive Officers were some of the most commonly charged individuals in SEC enforcement actions. The report determined that inexperienced management personnel and high-pressure environments contributed to the likelihood of management fraud.

Alleged Misappropriation of Funds by Management

Management may use accounting fraud to obscure the misappropriation of company funds.

The SEC alleged that in 2023, the CEO and CFO of HF Foods signed off on filings that contained materially false and misleading statements – statements that obscured their misuse of company funds for their own benefit. HF Foods’ managers allegedly used a fictitious line of credit to conceal repayments on $7.4 million in liabilities that the conspirators removed from the company’s books. The company then allegedly converted the line of credit into promissory notes to conceal the fraudulent conduct. HF Foods leadership also allegedly misappropriated $3.4 million from HF Foods in order to purchase luxury cars. The SEC alleges that payments for cars should have appeared on financial statements as executive compensation.

The SEC and Fraud Detection

The SEC encourages those who have insider knowledge of financial statement fraud to make a report to the Office of Whistleblower. In addition to legal protections for whistleblowers, the SEC also offers monetary awards for whistleblowers who provide “high-quality original information that leads to a Commission enforcement action in which over $1,000,000 in sanctions is ordered.” The SEC also relies on pattern recognition – in 2013, the SEC introduced “RoboCop,” also known as the Accounting Quality Model, which automatically analyzes corporate filings to look for financial patterns that indicate a higher risk for fraud.

Auditors and Detecting Financial Fraud

Outside auditors should be able to provide reassurance that a company’s financial statements are free from misstatements. Auditors are not required to detect financial fraud – only to verify the accuracy of the financial statement.

• The SEC requires auditors to employ “professional skepticism” to information provided by management, especially when produced in a questionable manner. This includes “invoices for large amounts with vague descriptions,” and “invoices with related parties with descriptions that are outside the normal course of business.”
• There are red flags for fraudulent reporting, such as improper revenue recognition.

Failure to Detect Fraud: the Madoff Ponzi Scheme Fraud

The Bernie Madoff Ponzi scheme is one of the most famous examples of a failure to detect financial statement fraud. In a Ponzi scheme, fraudsters solicit investors for a fake investment opportunity and keep most of the money for themselves. Any returns that investors receive are paid for by newer investors and are not legitimate returns on an investment. Ponzi schemes often feature an element of financial statement fraud – the fraudsters will provide falsified financial statements or fictional audit opinions to potential investors to create the impression of authenticity.

Competent accountants should be able to catch the signs of investment fraud. Accountant David Friehling was charged in connection with the Bernie Madoff Ponzi scheme, following allegations that he certified fake financial records. He allegedly simply “rubber-stamped” financial records without giving them the required detailed review, which helped Madoff perpetrate his $65 billion securities fraud. David Friehling’s father, David Kugel, allegedly helped Bernie Madoff create fake trading records to make his scheme seem legitimate to new investors. Without these false financial statements, the Madoff Ponzi scheme may not have been able to maintain the appearance of success.

Accounting Fraud and the Sarbanes-Oxley Act

The Sarbanes-Oxley Act of 2002 put stricter requirements in place for financial reporting. This Act followed the Enron Scandal. Enron accountants used shell companies to hide the company’s debt, and when the company’s scheme collapsed, employees who had infested their retirement funds into company stock suffered catastrophic losses.

Most cases of financial statement fraud involve some type of accounting fraud. Accounting records should accurately reflect the company’s profits as well as its debts and expenses. These numbers should paint an accurate picture of the company’s overall financial health.

Can I Recover from Investment Losses Following Fraudulent Financial Reporting?

If you discover that you suffered investment losses following financial statement fraud, you may still be able to recover. Your brokerage firm is responsible for researching an investment before approving it for recommendation to clients. If they did not perform their due diligence on an investment product, you may be able to recover losses. Contact Kurta Law for a free case evaluation. Call (877) 600-0098 or info@kurtalawfirm.com.