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Two Common Types of Financial Fraud That Can Hurt Your Business

Business owners need to be on the lookout for symptoms of fraud within their companies. From petty theft at the lower levels to major white-collar crime in more responsible positions, internal fraud can crop up even among the most trusted staff members. The first step in detecting and preventing fraud is to know the warning signs. Here are some clues, along with the two types of financial fraud that can damage your business.

Many financial frauds and deceptions fall into two basic categories:

  1. Misstatements on company financial reports (balance sheets, income statements, and so forth).

  2. Misappropriation of company assets.

While the first type of fraud may seem more theoretical and therefore less worrisome, it can hurt your company almost as badly as the second kind -- which is definitely not theoretical. Why? When a company's financial records are inaccurate due to deception or fraud, you might make poor business decisions because you relied on bogus information. Even worse, lenders and other potential sources of capital might lose confidence in your company after the financial reporting errors are discovered. In some cases, it's "one strike and you're out."

Of course, when company assets are misappropriated (a polite way of saying "stolen"), the damage is very direct. If the misappropriations are serious and the stolen assets cannot be recovered, your business could be dealt a financial blow so crippling that recovery is difficult or impossible.

For these reasons, it's important to understand the risk factors that tend to be associated with these types of fraud. Some of the most important factors are listed below. (Source: Statement on Auditing Standards No. 99 or SAS 99)

Risk Factors Associated With Fraudulent Financial Statements

  • The company's financial stability or profitability is being threatened by economic events, industry conditions, or company-specific issues.

  • The business is experiencing significant declines in customer demand for its products or services.

  • The company is suffering from recurring negative cash flow or the repeated inability to sustain positive cash flow.

  • Management is under excessive pressure to meet financial targets.

  • The books include significant related party transactions that seem unusual or difficult to understand.

  • Significant banking activities or subsidiary operations are carried out in foreign jurisdictions ("offshore") without a clear business justification.

  • The business has a complicated structure without a clear business justification.

  • Internal financial controls and accounting systems are inadequate.

  • Management has an excessive interest in maintaining or increasing favorable earnings trends or the stock price.

  • Management fails to correct known financial reporting shortcomings.

  • Management repeatedly attempts to justify questionable bookkeeping by arguing the numbers involved are immaterial.

Risk Factors Associated With Misappropriation of Assets

  • Management or employees with access to cash and other "portable" assets are under financial stress (due to bad investments, divorce, family illness, college expenses, and so forth).

  • Future employee layoffs are known or expected.

  • The company generates large amounts of cash or holds inventory items that are small in size but large in value.

  • There is inadequate segregation of financial duties or asset handling duties.

  • There are inadequate records for assets (for example, poor inventory accounting).

  • The company fails to reconcile asset records in a complete and timely fashion (for example, monthly bank statements are not reconciled and inventory records are not proved).

Conclusion: If your company has any of these risk factors, consider bringing in a professional to evaluate the situation and shore up weak areas. Otherwise, it could only be a matter of time before your business is hurt by financial report misstatements, misappropriations of assets -- or both.

About Romanchuk & Co.

Romanchuk & Co. is a boutique investment banking and CPA advisory firm, dedicated to providing candid, independent, and sound financial insight and consulting services to lower middle market companies and their owners. With a focused expertise in energy, power, infrastructure and oilfield services, construction and niche manufacturing, we specialize in sell-side M&A advisory services, advising owners on the preparation and sale of their company, assisting them in identifying strategic opportunities and then helping them to execute upon those strategies. Through our CPA advisory practice, we provide independent business valuations, financial due diligence services, forensic accounting investigations, litigation support and restructuring advisory services.

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