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How to Detect & Prevent Financial Statement Fraud

5 Apr 2023
How to Detect Prevent Financial Statement Fraud

In recent years, financial fraud has become more common. While individuals may commit identity fraud or submit fraudulent documents when applying for mortgages or other personal loans, businesses are more likely to cheat with bribery, payroll schemes, or financial statement fraud. One study shows that small and midsize business lending fraud has increased 6.9% since 2020.

Corrupt business leaders use financial statement fraud to get loans and capital funding for which they don’t legitimately qualify. They do this by intentionally misrepresenting the company’s financial data, creating the appearance of a stronger company. It’s crucial for lenders to detect and prevent financial statement fraud, so they can avoid making loans that are likely to become uncollectible.

What Is Financial Statement Fraud?

When a company intentionally misrepresents its financial data, it participates in financial statement fraud. Typically, one or more individuals in a company with access to the organization’s accounting and bookkeeping systems commit this type of fraud. They may do it for personal gains, such as a bonus for meeting goals, or to inflate the worth of the company to achieve a higher valuation or secure business funding.

When a lender doesn’t detect a fraudulent financial statement and makes a loan based on that information, the lending organization is at risk. First, the loan is more likely to go into default and become uncollectible. In addition, if the organization’s financial fraud is uncovered, company leaders may face criminal charges, and the prospect of collecting on the loan will become even slimmer.

Types of Financial Statement Fraud

Fraudulent business leaders have several common approaches to falsifying financial statements. Usually, a fake financial statement will include one or more of the following four types of fraud.

  1. Bogus revenue

    Financial statements can be falsified by including sales and revenue that have not been legitimately earned. That may include entering sales to fake customers or fake sales to legitimate customers, or altering dates to make asset values and cash flows appear better than they actually are.

  2. Unrealized revenue

    Sometimes a fraudster will post revenue items that have not actually been sold. That might include posting sales before they are made, recreating invoices from past-due accounts, or pre-billing for future sales.

  3. Asset manipulation

    A company can boost its value on paper by overstating the value of its assets or including assets that it doesn’t actually own.

  4. Incorrect accounting records

    Simply changing the numbers or dates is a common way to create financial statement fraud. A fraudster may include false expenses, keep liabilities off the balance sheet, alter dates to reflect inaccurate cash flow, or overstate revenue by recording false sales numbers.

    Financial statement fraud is often discussed in terms of how it affects investors, as they are misinformed about the value of their investment and often lose the funds they invested, especially after the fraud is uncovered. However, lenders are also victims of financial statement fraud, and they can be affected by such fraud by officials in companies of all sizes, not just large public companies.

    When a lender doesn’t detect a fraudulent financial statement and makes a loan based on that information, the lending organization is at risk. First, the loan is more likely to go into default and require going into collections. In addition, if the organization’s financial fraud is uncovered, company leaders may face criminal charges, and the loan may become uncollectible.

The Warning Signs of Financial Statement Fraud

By detecting financial statement fraud early, lenders can avoid the problems of making loans based on fraudulent information. Warning signs to watch for that can help lenders detect it sooner include the following:

Growing revenues without growth in cash flow.

If a company’s sales increase substantially, its cash flow will usually increase. If financial statements show big increases in sales, but cash flow doesn’t match, that could be a sign of false reporting on the financial statement.

Consistent sales growth while competitors struggle.

When lenders review a company’s financial statements, it’s a good idea to research the company’s industry and the progress of other players in the industry. If competitors have struggled to meet sales goals for some time, but the company applying for financing reports consistent and long-term sales growth, consider further investigation.

Significant surge in performance in the final quarter of the year.

If a financial statement shows a huge sales or revenue increase during the fiscal year’s final reporting period, consider it a warning sign. That could signal that someone in the company manipulated the books when it became clear that the company may not meet its goals for the year.

Misstatements, inconsistencies, or omissions of key information.

A legitimate financial statement should include all key information without inconsistencies. Investigate further if a loan applicant submits financial statements with important information omitted or misstated.

Insiders trading company stock.

If company leaders have recently cashed out on significant stock options, that’s a sign of potentially fraudulent financial reporting.

Financial Statement Fraud Detection

If you flag any of the warning signs or otherwise suspect that a commercial loan applicant has submitted false financial statements, don’t ignore that suspicion. Instead, take steps to review the documents more closely and make a conscious effort to identify potentially fake documents.

It can be helpful to have several human reviewers examine the documents closely and conduct detailed research into the loan applicant’s operations to verify the statements. However, software-based tools like Ocrolus Detect that automate the fraud detection process can make it even easier to detect fraud and take the necessary steps to stop it.

Automate Your Financial Statement Fraud Detection with Ocrolus

Automation can help detect fraud faster than simply using manual methods to flag false documents. By using automation software such as Ocrolus Detect, lenders can reduce the risk of fraud with increased accuracy. They can also increase their efficiency and minimize the pressure of manual reviews.

Try Detect now and see how easy it is to verify bank statements, financial statements, and other documents, transforming your financial fraud detection process and preventing costly losses down the line. With Ocrolus Detect, your business can uncover potential financial statement fraud faster; you’ll be empowered to make quicker lending decisions and confidently approve more borrowers.