New report highlights common financial statement fraud themes from SEC enforcement actions

The Anti-Fraud Collaboration has issued a new report on the most common financial statement fraud themes noted in SEC enforcement actions between January 2014 and June 2019. The study’s objective was to identify the areas of higher fraud risk and provide insights for those responsible for financial reporting.

The report, Mitigating the Risk of Common Fraud Schemes: Insights from SEC Enforcement Actions, analyzed 204 enforcement actions related to financial statement frauds, from which 140 fraud schemes were identified. Its findings and commentary on fraud deterrence and detection are particularly timely because of the increased risk of financial reporting fraud amid the coronavirus pandemic.

The types of business challenges noted in the report’s enforcement cases include reduced demand; higher supplier costs; and pressures to meet forecasts and analyst expectations, all of which are present and heightened in the current environment. The SEC’s Division of Enforcement opened 150 COVID-related investigations and recommended several COVID-related fraud actions in the period from mid-March to September 2020 alone.

The report’s analysis of SEC data found the most common types of financial statement fraud were improper revenue recognition (43%), reserves manipulation (24%), inventory misstatement (11%), and loan impairment issues (11%).

Improper revenue recognition appeared as the most prevalent fraud area in almost every year of the study, resulting from timing, valuation, fictitious revenues, and use of the percentage of completion method. In the area of reserve manipulation, the report highlights how the new accounting requirements for measurement of credit losses under ASC 326 (CECL) require more judgment from senior management and encourage companies to consider additional potential fraud risks as they adopt the new accounting model.

False or intentionally incomplete financial statement disclosures, internal control material weaknesses, and unsupported journal entries were also observed to be significant areas for fraud.

External auditors play an important role in deterring and detecting fraud. The report notes they are one link in the financial reporting chain, and current business challenges and remote audits create enhanced risks for auditors.

The report highlights the industries in which fraud was most frequently noted in enforcement actions. These include technology services companies (17%), finance (13%), energy (11%), and manufacturing (9%). There was a parallel between the most common types of fraud and these industry sectors; for example, technology services companies have complex revenue recognition issues and finance and energy firms struggle with reserve and loan impairment.

The findings were based on SEC filers of all sizes. Seventy-nine of the analyzed enforcement actions (39%) were against companies with market cap under $250 million, 44 (22%) were against small-cap companies, and 22 (11%) were against mid- and large-cap companies.

Public company chief financial officers (54%) were the most commonly charged employees, followed by chief executive officers (31%). Factors and root causes that can contribute to fraud include the tone set by company management, business challenges in a high-pressure environment, and inexperienced personnel.

Employees lacking experience and training are less able to identify and address fraud, according to the report. This can include complex accounting standards, internal controls, and awareness of fraud schemes perpetrated by others. 

Areas of deficiencies must also be evaluated. 

According to the report, public companies can effectively fight fraud by exercising professional skepticism through independent thinking, having a questioning mindset throughout the financial reporting process, focusing attention on potential high-risk areas for the company and its industry, and conducting both quantitative and qualitative risk assessments on a regular basis.

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