Cooking the books?

Despite operating in the toughest corporate governance regime in recent history, Australian boards and company management may not be as vigilant as they should be when it comes to financial reporting fraud.

In KPMG ’s 2004 Fraud Survey financial reporting fraud was identified as the most costly form of fraud. Of the reported incidents, three were nominated by respondents as being the largest single case of fraud that occurred within the entity in the survey period. Although the largest reported misstatement was $10 million, it is likely that there are significantly higher misstatements that were not reported.

“This sense of complacency means many companies here are not as proactive as they should be in putting in place mechanisms to detect financial reporting fraud. Unless Australian companies pick up their game, we may see more financial statement fraud scandals,” warns KPMG Forensic partner, Gary Gill.

“Financial reporting fraud usually occurs as the result of three factors: incentives and pressures; opportunity; and where it’s possible for the perpetrator to rationalise their actions. For example, we’re finding that in many cases corporate criminals, particularly senior management, had aggressive compensation schemes based on unrealistic profit targets. In addition, boards and audit committees are not sufficiently aware of the risks and are not as vigilant as they should be in scrutinising changes in accounting treatments and policies, thereby creating the opportunity. Finally, where there’s a cavalier corporate culture it’s easier for fraudsters to rationalise their actions.”

By far the most prevalent type of financial reporting fraud involves some type of overstatement of revenues by recording revenues prematurely or by creating fictitious revenue transactions. However, almost as common is the overstatement of assets by recording fictitious assets or assets not owned, capitalising items that should be expensed, inflating existing asset values through the use of higher market values, and understating receivable allowances.

“It is worth remembering that financial reporting fraud does not only involve the most senior management of an organisation. In many cases I have investigated, middle managers manipulated reported earnings of their divisions or business units, often to influence their remuneration,” Gill reveals.

He says there are four general motivations for financial reporting fraud, whether in Australia or elsewhere: to retain employment; qualify for bonuses or other performance-based remuneration; cover up poor performance; and meet shareholder and market expectations.

The top 10 warning signs of risk of potential financial reporting fraud are:

1. The remuneration of senior management is heavily performance-based and linked to unrealistic performance hurdles.

2. The CEO is alternately a bully and charming.

3. The CEO takes a keen interest in basic accounting entries.

4. The company’s operation represents only one person’s vision.

5. The corporate organisation structure is unnecessarily complex.

6. The board does not understand all aspects of the business.

7. Senior people have a flamboyant lifestyle.

8. The balance sheet includes deferred expenses.

9. Non-core business activities generate high revenues.

10. Large round-number journal entries at year-end. l