Question

what is the key learnings from financial statements fraud?

Please find an article on a company that has had a financial statement fraud, attach the article as a doc. and include a brief summary by posting as to the type and cause of the financial statement fraud.

Thank you.

Answer 1

Financial Statement Fraud refers to the conscious feign on the financial state of a firm. This deliberately projected wrong idea about the financial condition can be fabricated by through purposeful misstatement or non-statement of financial transactions with the intention of deceiving others. There are various such forms of financial statement frauds, some of them being the following:

Improper recognition of revenue, Overstatement of assets and understatement of liabilities, embezzlement of assets and also, engaging into inappropriate related party transactions. However, even though some generalization is possible, there are various other forms in which financial statement fraud can be committed.

We all are familiar with the phrase “once bitten twice shy”. Once the forms of financial statement fraud get identified through experience one should be very alert regarding the possibilities of repetition of similar kinds of fraud. Over the years, based on company experience, some of the key lessons learnt from such kinds of fraud are as follows:

• During audit, the external audit’s objectives have to be clearly mentioned so that no loopholes are available. Along with the external, the internal auditing system should also audit loans, underwriting, etc on a regular basis.
• The relationship between the auditor and the client has to be very transparent. Every detail that needs to be conveyed to the client by the auditor and vice-versa should be done. Should any market conditions change, appropriate revaluation needs to be performed if necessary.
• Accounts should be viewed from a fresh perspective year to year, taking into consideration all the changes that took place relevant to business operations.
• High risk areas with potentially damaging consequences should be identified. These risks vary from company to company and no generalization should be made about the nature of risks, based on the prior experiences of firms functioning in completely different departments.
• Sometimes it is possible that some error has been made by the client or the auditor in recording transactions. Whether deliberate or unintentional, the errors can be identified and rectified with appropriate software, making it imperative to install those.

One such case went down as one of the worst in the history of financial statement frauds. Most of us know about how the fall of Lehman Brothers in 2008 plummeted the global financial economy. It was the fourth-largest US investment bank, employing over 20,000 people. Financial markets collapsed, unemployment skyrocketed and US was hit hard! The world this time became a victim of globaliziation. The interconnectedness of countries with USA experienced major ripple effects of Lehman's fall. Their collapse led to global capital erosion in trillions! But this downfall didn’t happen overnight. Lehman was neck-deep in debts, but never disclosed their transactions honestly in the statement of accounts. Lehman’s has been one the classic cases of financial statement fraud, and the world is still recovering from some of its blows.

Lehman’s journey, though not completely smooth, was commendable during the Great Depression of 1930s and other economic disasters in the past. However, when the US housing market crumbled, Lehman fell down like the London Bridge. Among various reason of their downfall including wrongly chosen investments, “misleading accounting gimmicks” stood out as the undisputed cause of the fall. Around $50 billion worth of assets were purposefully misstated in its books of accounts right before filing for bankruptcy in 2008. According to the article, seniors at Lehman’s and auditors were well aware of this fact.

The type under which a fraud like this can be classified is “actionable balance sheet manipulation”. Needless to say, from the classification itself, it is very clear as to where the fraud was committed. Accounts were presented in such a way that apparently made it seem that Lehman sold securities which they planned to buy back shortly. This was a deliberate and calculated step to falsely lower the firm’s debts and make them stand on a higher pedestal made of lies. Since Ernst & Young (responsible for Lehman’s transfer pricing and accounting services) went on with those lies, it is considered to be equally guilty in the Lehman’s case of financial statement fraud. Lehman’s case also highlights the faulty relationship between regulations and management. Loopholes in the regulatory system led to malpractices that went on inflating and finally causing one of the worst financial collapses to be ever recorded in history!

(The article on Lehman's Financial Statement Fraud is from "The New York Times, March 11,2010. Editors are: Michael J. de. la. Merced and Andrew Ross Sorkin. It is Titled: "Report Details How Lehman Hid Its Woes")