Fraudulent Financial Reporting
Fraudulent financial reporting is a deliberate misstatement or omission of financial accounting information intended to deceive the investors.
The reasons for fraudulent financial reporting includes (a) pressures from owners, creditors and the markets in general; (b) opportunities for fraud (due to lack of emphasis on business ethics), etc. and (c) incentives and personal conflicts of interests.
Controls designed to prevent fraudulent financial reporting include external auditing, independent board of directors, active regulators, vigilant capital markets and overall ethical corporate culture.
Ten Percent Inc. is a company founded in Juba in 1997 and is engaged in assembling electronic gadgets. The company has a decade long history of growing its net profit margin by 10% or higher. By the third quarter of 2007, the company was able to attain a sales growth of only 6%. The analysts still believed that the company will get to its target of 10%. The CEO of the company owned 0.5 million shares in the company. Just a week after the end of the financial year 2007, the CFO compiled draft income statement and they had managed to earn 8% growth only. The CEO and CFO concluded that this will result in a 15% drop in market capitalization. The CFO was entitled to receive a bonus of 10% if they get the growth target. CEO was able to convince CFO to knock off unearned revenue of $200 million and treat it as earned. This resulted in a net profit margin growth of 11%. The management was able to get the financial statements approved by the board because the directors were not well-versed in accounting principles.
The above example is a situation of fraudulent financial reporting because the management has misstated the revenue and profit and ultimately the assets and retained earnings.
The factors that contributed to the misstatement included pressure from the capital markets, the compensation system, the CEO's shareholding, poor corporate culture and lack of effective corporate governance.
Real life examples of fraudulent financial reporting include Enron, WorldCom, etc.
Written by Obaidullah Jan, ACA, CFA