What is Accounting Fraud? Definition & Examples - Zoho Practice

What is accounting fraud?

Accounting fraud is when a company's financial statements or tax returns are intentionally manipulated to project better financial health than what is real. An organization might exaggerate its revenue, understate its costs or liabilities, or inflate its assets. This is usually done to gain more investors, create a better financial image about the brand, or for personal gains on behalf of the company by a member of staff, an accountant, or the company itself. It is important to note that manipulating numbers is a criminal offense and the people involved could face legal consequences.

Is creative accounting the same as accounting fraud?

No, not really.

Creative accounting is when companies use accounting methods that may not really be against the law to make their financial performance look better than the reality. Companies might make their profits seem steady, change how they calculate the loss of value of their assets, or only report income when it suits them. While it might not be against the law, it's not really an ethical practice in the world of accounting.

Accounting fraud, on the other hand is when companies deliberately lie or play with their financial numbers to trick investors, lenders, or others. It goes way beyond what the rules say can be done and is illegal. The top examples of accounting fraud are making up sales numbers, hiding debts, making fake transactions, or manipulating financial reports.

What kind of activities make up accounting fraud?

Altering real revenue

When a company over states its revenue, the company is committing accounting fraud. For example, if a company is underperforming in terms of revenue and is not making enough profit, and still intends to project false profits to maintain better status among investors and customers, then it is a clear use case of accounting fraud. They most likely may do this to boost their share value and cover up any negative perceptions.

Here are some warning signs to identify revenue manipulation:

• Keeping the books open after the end of the reporting period to log more sales.
• Recording income before the actual sale of goods or services happens.
• Delivering goods or services well ahead or before an actual purchase takes place.
• Sending goods to a warehouse in a different location and recording them as a sale.
• Not finalizing invoices within the reporting period.

Not recording expenses

When a company keeps its expenses intentionally "off the books," understates its expenses, and overstates its income, it is deliberately committing accounting fraud. While in reality the company may be losing money, a false impression is created about the net income it receives.

Forging assets and liabilities

Sometimes, companies commit accounting fraud by stating they own more assets and owe less money than they actually do. For example, a company might claim to have a lot of valuable assets, but not as many bills to pay. This gives out a projection like the company has  a lot of money in the short term.

Consider a company with $1 million in assets and $5 million in liabilities. If the company states that it has $5 million in assets and only owe (liability) $500,000, it is not being honest about how much money it has to cover its bills. This can trick people into thinking the company is in a better financial position than it really is.

Here are the activities that denote an underlying asset and liabilities manipulation:

• Not tracking expenses.
• Recording incorrect depreciation rates.
• Not disclosing contingent liabilities.

Manipulating inventory

Inventory accounting is highly important as companies generate income when the inventories are sold. Also, the revenue will be recorded in the Cost Of Goods Sold in the income statement. Some companies manipulate the inventory to show a decrease or increase in revenue for that particular year. 

• Watch out for these activities to find out if there's evidence of inventory manipulation:
• Adjusting the cost of products sold to show increased earnings.
• Concealing cash as an inventory asset.

Boosting the balance sheet

Manipulating the balance sheet can lead to inflated stock prices, access to more credit, and higher executive bonuses, all of which serve the fraudulent interests of those involved in the scheme. Ultimately, it's a deceptive way to maintain or boost a company's reputation and financial standing, even when its true financial condition is deteriorating.

Here are  a few malicious activities that may indicate potential accounting fraud:

• Manipulating the value of fixed assets and stating them beyond the actual value.
• Changing the sales via account receivables without recording doubtful debt.

What signs indicate accounting fraud in financial statements?

When the statements show the company makes more money, but there is not any actual cash is an indication of active financial fraud.

• The company shows consistent growth in sales while the entire market and its competitors are struggling.
• The company's performance spikes questionably in the reports that are generated in the final quarter of the year.
• There are frequent complicated, unexplained third-party transactions that have no logical reasoning or purpose.
• Unexplained items listed in the reconciliation with no invoices or valid records.
• Growth in sales without matching or corresponding growth in inventories or the opposite.

Now, to conclude, here are a few ways in which you can prevent accounting fraud.

Strong internal controls

Implement robust internal accounting controls, emphasizing the segregation of duties and utilizing security measures like passwords and access logs to deter fraud attempts. Regular reconciliation ensures alignment with external sources, such as bank statements.

Periodic financial audits

Conduct routine audits of financial statements to assess control effectiveness and uncover weaknesses. External audits foster accountability and discourage dishonest behavior among employees.

Ethical leadership

Establish a culture of integrity and honesty starting from the top. Leaders should exemplify ethical values, provide fraud awareness training, and communicate consequences for misconduct.

Accounting software

Utilize an accounting software that detects policy violations, automates accounting processes, enforces segregation of duties, and implements strict approval mechanisms, reducing vulnerability to unauthorized transactions.

Reporting hotline

Create an internal reporting system or hotline, ensuring anonymity to encourage employees to report fraud suspicions. Studies show that such systems significantly increase fraud detection rates.

Balanced compensation

Avoid tying management bonuses and compensation solely to short-term goals, which can incentivize unethical behavior. Focus on long-term value creation to deter fraudulent activities.

Trust your instincts

Pay attention to any unsettling signs in financial statements and investigate further if key accounting personnel provide vague or misleading information, as these may indicate fraudulent activities.