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Revealed: One common FSF scheme your business MUST be aware of

by , 05 September 2013
Financial Statement Fraud (FSF) happens when assets, revenues and profits are deliberately overstated. Or when liabilities, expenses and losses are intentionally understated in financial statements. Luckily, there's a way to avoid fraud on your financial statements. Read on to discover the two types of FSF you need to be aware of and how to identify their red flags...

While some businesses commit FSF to get out of financial or liquidity problems, it's detrimental in the long run. That's because the person who makes these fraudulent recordings can face criminal charges.

According to the Practical Accountancy Loose Leaf, the two critical things to know about FSF are that:

  • FSF schemes take a long time to detect. It could take years to see the true impact of FSF.
  • Although the FSF category makes up only 8% of reported fraud cases, at R9 million they cause the greatest median loss.

That's why it's crucial you're aware of the most common FSF scheme and ways to spot the red flags in your financial statement.

Could your business be facing this common FSF scheme?

FSF scheme: Timing differences/revenue recognition

This is also known as improper treatment of sales. This fraud category's the most common form of financial statement fraud. Fraudsters use it to hide the real numbers of a bad accounting quarter or two.

Timing differences happen when the revenue or expenses are reflected in the wrong periods. This can increase or decrease earnings, by changing the revenue or expenses between periods.

Timing differences can occur in the following ways:

  1. Premature revenue recognition;
  2. Long-term contracts;
  3. Channel stuffing; or
  4. Recording expenses in the wrong period.

Let's look at each one in more detail.

#1: Premature Revenue Recognition: It's difficult to spot premature recognition because it looks like sales criteria are met. Here's a checklist you can use:

  • Evidence of a sales agreement exists;
  • Delivery of the goods or services happened;
  • The seller's price's fixed to the buyers price; and
  • Collectability of the goods or rendering of the service's assured.

#2: Long-term contracts: If long-term contracts are negotiated, you must recognise revenue over the contracts lifecycle. Otherwise, this can put your business into a position where managers can manipulate the anticipated revenue to be received per year.

For example, construction companies use two methods to record revenue:

  1. As a percentage-of-completion method; or
  2. The completed-contract method.

Depending on the method, expenses can be hidden away so any contract overruns aren't reflected, and revenues are prematurely recognised.

#3: Channel stuffing: This is where a company, or a sales force within a company, inflates its sales figures. They force more products through a distribution channel than the channels capable of selling.

This is also known as 'trade loading'. Companies do this to try inflating sales figures.

#4: Record expenses in the wrong period: Expenses are pushed into the wrong periods. Companies do this for different reasons, but the results are that the current period's earnings are inflated. Then in the next period, the earnings are reduced by the same margin.

So what are the Timing Differences red flags?

  • If your business doesn't generate positive cash flow but reports positive earnings;
  • Similar and high value transactions or Special Purpose Entities (SPEs);
  • Unusual increase in gross margin;
  • Unusual growth in the days' sales in receivables ratio (average daily sales);
  • Unusual decline in the day's purchases in AP ratio (average daily purchases); and
  • Rapid growth compared to other companies in the industry.

While this FSF scheme is complex, you can detect it and protect your company if you learn to spot the red flags.

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