Probably the most common way to fake financials is by making profits look better than they really are. How does that happen and why?
Why fake the financials anyway?
Generally, owners and directors of businesses who fake financials do so to make profit figures look better to impress someone else. That someone else might be a banker or it might be external shareholders. But, one thing’s for sure, there will always be something personally rewarding for those responsible. That could be;
- for small business owners it’s all about getting that loan from the bank. They figure that lenders want to see a profitable business. The easiest way to achieve that level of profit, if the business is not actually doing that well, is to fake it.
- the directors of big businesses, more especially the CEO, stand to get a bonus if profit figures are achieved. Also, some of these companies may have debt against which the lenders have placed covenants regarding the level of profit. The directors need to ensure that those covenants are not triggered.
Faking the financials by increasing the revenue figure
Increasing the revenue figure is possibly the easiest option to achieve higher profits. All that the owners or directors have to do is bring sales (or some other form of operational income) into the revenue figure that shouldn’t yet be recorded as such.
For small businesses that’s quite easy to do as the financial reports are probably not audited. And, even if they are, it’s a simple matter to fake a few invoices and then reverse them in the next financial period once the income statement has been finalised.
In larger businesses where financial reports are audited (although the reliability of that in itself is questionable these days) short-term profit performance targets tend to encourage the directors to take a short-term view. So they will do whatever it takes to get the current period’s revenue up to where they need it to be to achieve the targeted profit figure. Whatever they decide to do now might have a negative effect on the next period’s profit but they’ll worry about that later.
Example of fake financials
Actual examples of frauds are common but one of the most recent in South Africa is that of a stock exchange-listed company (in Johannesburg and London) called Tongaat Hulett. The company is a major sugar producer and land owner operating mainly on the east coast of South Africa and in Mozambique.
As the demand for sugar had been falling, the company sold parcels of land on a regular basis. Also, the value of the land used for sugar growing had been increasing because of its location and now far outstripped its original cost.
In the past few years, it now turns out, the company, which was run by a domineering CEO, had been including the value of land sales in its revenue. The problem was that the land had not actually been sold. At least, the CEO’s definition of “sold” was not that of the accounting rules.
Read more on the investigation into Tongaat Hulett here
Faking financials by decreasing operating expenses
The other common way to give profits a rocket is to reduce the total of operating expenses. This is done by moving some of the expenses to another accounting period. That can easily achieved by not processing incoming invoices from suppliers until after the current financial period ends. Even though the goods have already been sold and included in revenue.
Another popular way is to regard some expenses which should be accounted for in the current period “capitalised” expenses. That means the owners/directors argue that the operating expenses in question relate to goods or services that will be sold in future accounting periods. So, in line with accounting convention, the expenses should be accounted for in those same periods in order to match the income with the expenditure.
No doubt there are justifiable reasons for doing this in some circumstances. That’s what the depreciation process is designed to do, after all. But the option can be, and is, abused to boost profits now.
Doesn’t faking the financials increase tax liability?
The question arises, if profits are higher than they should be, doesn’t that mean that tax will be higher than it should be?
To which the answer is yes, generally. The CEO and directors of big businesses are not really concerned about that. They get their bonuses based on operating or pre-tax profit so it’s not a hurdle for them to get over.
Keep in mind that tax is not calculated on accounting profit but on taxable income. And that’s a very different calculation. Just because there’s a bigger profit in the income statement, it doesn’t necessarily mean that the taxable income is higher.
It’s also not uncommon in small businesses that the owner may have more than one set of financial statements. In my time as a banker, I clearly remember customers bringing me their financials with “Bank” written in the top corner of the front page in pencil.
I had no doubt that there would be another set somewhere with “Tax” written on the front page that would show a very different income statement.
Can you spot fake financials as a lender?
This kind of fraudulent activity is very difficult for a banker to spot. Remember that the big accounting frauds that have taken place over the past 20 years or so have occurred in spite of executive boards, corporate governance rules, global auditing firms, and active shareholders.
For small business customers, it’s relatively easy to confirm the revenue shown in the income statement by referring to the credit turnover through the bank account. But that assumes that there is only one bank account. If there’s more than one, you would have to get the statements covering the same period as that of the financial statements to try to make a valid comparison.
It might be possible to track the trend of revenue growth and profit over time to see if there is a period when either or both appear to be out of line. But if the fraud is being consistently applied, that wouldn’t really help very much.
So, in practice it’s difficult to spot fraud. You can only make sure that what is being shown to you looks feasible and is in line with your understanding of the business, the industry and the state of the economy.
Ultimately, your knowledge of the customer, its history and the character of the owners and/or directors is critical.