Proactive Measures for Mitigating Financial Statement Fraud

“Falsifying financial accounts,” commonly known as “cooking the books,” is a phrase referring to the practice of manipulating financial statements to commit accounting deceit. A historic example of this is the case of Enron, the U.S. energy firm, which, based on accounting fraud, maintained its operations until it collapsed in 2001. The fallout of this led to the enactment of the Sarbanes-Oxley Act in 2002.

The Sarbanes-Oxley Act, or “SOX,” was introduced to mitigate the likelihood of accounting fraud and ensure reliable financial reporting among public trading companies. Despite the existence of such a law, financial deceit can still occur, resulting in significant losses for shareholders due to plummeting stock prices.

Moreover, such fraudulent activities often lead to legal repercussions for the involved company, adversely impacting its financial status, competitiveness, and reputation.

Can Internal Checks and Measures Help to Counter Fraud? Indeed.

In most cases of accounting fraud involving financial statement manipulation, the deceit occurs due to weak or non-existent internal checks that give company executives the chance to engage in fraudulent activities.

A company’s internal controls are safeguards against the misrepresentation of financial outcomes, irrespective of whether the misstatements result from deliberate fraud or honest mistakes. Internal controls reassure the audit committee, board of directors, and senior management of the dependability of the company’s financial reporting and compliance with relevant laws and regulations.

The implementation of various types of internal controls to enhance transparency and accountability in the system is crucial. Multiple checks and balances dissuade employees from misrepresenting financial data and engaging in fraudulent activities and deceptive accounting behaviors.

A system combining internal controls and audit trails, along with stringent documentation requirements, verification, and approval processes, can enhance fraud detection and prevention, ultimately reducing fraud risk and safeguarding the organization from potential harm.

What Do Internal Controls Over Financial Reporting Entail? Internal controls refer to the practices adopted by a company to ensure adherence to its rules. As per the framework established by the Committee on Sponsoring Organizations (COSO), a robust internal control mechanism aids the company in achieving:

  • Trustworthy financial reporting
  • Compliance with rules and regulations
  • Robust business operations

As per the COSO framework, an effective internal control system must consist of five interconnected “components,” originating from the company’s daily operations:

  1. The control environment at the topmost level of the firm. This includes factors such as the ethical “tone at the top” and the efficacy of the board’s audit committee in overseeing financial reporting at the topmost level.
  2. Risk assessment for evaluating risks associated with the different processes and data sources used to generate the company’s financial reporting.
  3. Control activities to address the identified risks.
  4. Information gathering and communication to disseminate information about risks to those responsible for financial reporting or risk management.
  5. Monitoring to ensure ongoing vigilance in operations, compliance, and financial reporting as the company evolves.

Internal Controls to Prevent Financial Statement Fraud The internal controls to address the risk of fraudulent financial statements and reports begin at the accounting transaction level. They can also be established outside the accounting function to enhance financial process oversight, maintain the integrity of financial statements, and fortify the company’s operations.

The following internal controls are basic steps any business can take to reduce fraud risk.

Segregation of Duties The principle of “segregation of duties” dictates that no single person in the accounting department should be entrusted with multiple responsibilities that could enable that person to commit fraud. Duties such as record-keeping, authorization, and review activities should be divided among different employees. Segregation minimizes the risk of error and inappropriate actions that may lead to fraud.

At a minimum, organizations should segregate the duties for:

  • Receiving cash or checks
  • Preparing deposits
  • Managing cash receipts and deposits
  • Reconciling deposits and other transactions
  • Writing checks
  • Preparing financial statements

Institute a Reconciliation Process A systematic, formal reconciliation process for all key accounts is a crucial internal control. For example, all incoming check logs should be reconciled against deposits. Regular review of bank statements and canceled checks is essential to ensure that invoices are not issued out of sequence, which could indicate missing reviews and fraudulent activities.

Reviewing canceled checks (processed and cleared by the bank) is critical to ensure that only authorized personnel sign checks. It’s also necessary to confirm that all endorsements, reimbursements, and expenditures are appropriate and that all vendors are legitimate.

In line with the segregation of duties, a person independent of bookkeeping or check-signing responsibilities should be in charge of reconciliation. The reconciliation report should be signed and dated by this authorized person to document that the reconciliation was performed, when, and by whom.

All employees should be made aware that accounts will be reviewed and reconciled regularly, and any discrepancies will be thoroughly investigated. This awareness can decrease the temptation to manipulate financial statements.

Employ an External Auditor Financial statement fraud is often committed by management. Therefore, an auditor with reputable credentials should review financial statements annually to prevent this from happening. (In the United States, for example, annual external audits are a legal requirement for publicly traded companies.)

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Ensure Board of Directors Oversight The board of directors should supervise all operations and management. Specifically, the board should:

  • Compare actual revenue and expenditures with budgeted income and expenses to identify and investigate significant variations, mismatches, or errors.
  • Review the check register or general ledger.
  • Ensure that approval of all financial and audit procedures, as well as significant expenditures, are documented.
  • Evaluate the performance of C-suite executives against written job descriptions.
  • Require independent external auditors to present the annual financial statements.

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Review Inventory, Journal Entries, and Electronic Transfers Internal controls to review inventory, equipment, and other assets are also crucial. Inventory counts should be conducted randomly throughout the year by a person who isn’t incentivized to misreport. General journal entries should also be reviewed at least monthly. Any large or unusual amounts should be noted and investigated as potential warning signs.

Wire transfers, especially to offshore bank accounts, are a common method of fraud. Therefore, audit or compliance officers should regularly review such transactions to ensure that all are legitimate, involve authorized parties, and are supported by appropriate documentation.

Establish a Strong Ethical Tone at the Top A robust environment of internal accounting controls can only exist with a strong ethical tone at the top. Management should display ethical behavior, uphold integrity and honesty, and lead by example. All ethics, values, and procedures should be communicated across the organization through written policies.

Policies should be created for the following:

  • Cash disbursements, receipts, and reconciliations
  • Expense and travel reimbursements
  • Petty cash access, receipts, and reconciliation
  • Voiding checks
  • Blank check access and storage
  • Purchasing guidelines
  • Conflicts of interest

The consequences of violating these procedures should also be documented and straightforward. Every policy should be approved by board members.

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Establish a Fraud Hotline A confidential hotline for reporting fraud allows employees to safely report any potential manipulation of financial statements. When whistleblowers are protected, they are more likely to feel safe raising a red flag and are less likely to leave the organization. Insiders are your best chance of detecting and preventing fraud. (SOX requires all publicly traded companies to establish internal hotlines. Other laws require companies to strive to prevent retaliation against whistleblowers.)

Utilize ZenRisk to Diminish the Risk of Fraud Financial statement fraud might not be as prevalent or recognizable as other types of fraud, such as asset misappropriation. However, it can still cause serious problems for your organization. Adequate internal controls can shield your organization from such frauds.

Minimize the risk of financial statement fraud by improving visibility into your risk environment with ZenRisk from QuickBooks Data Recovery Services. Identify relevant risks, enhance risk assessments, and understand where they’re changing to reduce your risk of fraud.

ZenRisk offers a single source of truth to help you streamline your risk management program. Policies and procedures are revision-controlled and easy to find in the document repository. Workflow management features offer easy tracking, automated reminders, and audit trails. Insightful reporting and dashboards provide visibility to gaps and high-risk areas to meet auditing standards.