Misrepresented financial statements don't just make the news, they make the front page. Fraudulent financial reporting has been the center of some of the biggest business news events of the past two decades. Enron, Worldcom, Bally's and Royal Ahold are just a few companies that have fallen over misrepresented financial information, and with most large-scale financial frauds there have been a couple of common threads.
Generally accepted accounting principles provide strict guidelines for the recognition of revenue. When a company relaxes its interpretation of these rules, or ignores them altogether, the income statement becomes misrepresented in the current period, as well as in the overall net income. Additionally, assets can be overstated because there needs to be a debit to offset the overstated revenue credit. Using revenue to manipulate financial statements usually requires booking revenues from the next period early. Consequently, the company is taking revenue from future years and the process is not sustainable, which can eventually lead to discovery of the fraud.
When a company incurs a cost that has no future benefit, accounting standards state that the cost should be "expensed." A company can misrepresent its transactions by switching the debit for the expense to a debit to assets, thus decreasing expenses, increasing net income and increasing assets. This has the effect of making the company appear more profitable and favorably increasing financial statement ratios.
Falsification of Inventory
In retail, inventories represent a large portion of the company's balance sheet. By recording inventories that do not exist, a company can make its asset numerator financial ratio appear better than normal. The procedure also has the effect of reducing the book effect of shrink in the current period. Because of high profile accounting frauds revolving around inventory existence, generally accepted auditing standards require a company's auditor to observe any material inventory counts at year end in most circumstances.
Understatement of Liabilities
Misrepresented financials might not have extra information, but could have something missing. By obtaining loans or other financing and not recording the transactions, a company can improve its debt denominator financial ratios. Because auditors are searching for unrecorded transactions, this representation can be difficult to detect. However, as loans to the company need to be repaid, eventually the company will have to write a check for the loan payment. Therefore, an auditor can get some assurance of the absence of unrecorded liabilities through cash disbursements testing.