ComplianceLegalJanuary 29, 2021

Committing bookkeeping fraud using false statements

Fraud is often committed by business owners who misreport financial transactions by "playing with their books."

Cooking the books to pacify or please investors and/or lenders is an age-old practice, generally perpetrated by business owners or managers, not accountants. It is a recipe for creating false statements in abundance.

Booking revenue you hope or expect to receive soon, or deferring reporting expenses already incurred (or doing the reverse of one or both) is the first part of the recipe. Misstating inventories, failing to disclose contingent liabilities such as possible lawsuits or questionable insurance claims, and a host of other practices are often employed to get a firm over a rough patch . . . with every good intention of amending the books at a later point in time.

In a small business, this can be a dangerous exercise in self-deception. In a large business, this would be appropriately known as fraud.

Incentive pay systems are fertile ground for fraud

The fraud: One of the most common false statement frauds revolves around incentive pay systems.

Mr. Stone, CEO of Incognito, Inc., will earn a bonus of $50K if the company's operating profit exceeds a million dollars this quarter. However, business is a bit slow and expenses have been a little high recently. So Mr. Stone makes some choices. "Let's just hold on to a few of these unusual expenses and run them through next quarter. And I know we're going to land that big account across town any day so let's count on it now and "virtually ship" 2,000 widgets to them today . . . credit sales, debit receivables, credit inventory, debit cost of sales. Now those earnings look better, don't they? And I'll be sure to reverse those items in a few weeks."

"Oh yes, and let's not put that footnote on the financial statement about possible contingent liability for a lawsuit that may well be filed if our insurance company denies that old claim."

The flaw: Mr. Stone can get his bookkeeper to handle those "adjusting" entries for him, because guess who is the bookkeeper's boss?

There are no checks and balances in the financial reporting. And let's not forget the built-in conflicts of interest.

The fix: There aren't many good answers here. Theoretically, corporate boards are supposed to watch out for truthful reporting to protect shareholder interests . . . but often these are the folks who establish the incentive systems as well as the chain of command. If the bookkeeper/accountant/CFO/auditor answered directly to the board that would help . . . but as a practical matter this rarely happens.

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