Accounting fraud is the intentional manipulation of financial statements to create a false appearance of corporate financial health. Furthermore, it involves an employee, accountant, or the organization itself misleading investors and shareholders. A company can falsify its financial statements by overstating its revenue, not recording expenses, and misstating assets and liabilities.

Key Takeaways

  • Accounting fraud is the illegal alteration of a company's financial statements in order to manipulate a company's apparent health or to hide profits or losses.
  • Overstating revenue, failing to record expenses, and misstating assets and liabilities are all ways to commit accounting fraud.
  • The Enron scandal is one of the most famous examples of accounting fraud in history.

Understanding Accounting Fraud

For accounting fraud to take place, a firm must deliberately falsify financial records. Consider a firm that makes an estimate that must be revised later. No accounting fraud has taken place because the errors were not deliberate. Now suppose the CEO of a publicly-traded company knowingly makes false statements about the firm's prospects. The Securities and Exchange Commission (SEC) may well charge that CEO with fraud. However, it is not accounting fraud because no financial records were falsified.

Always be careful when alleging accounting fraud. Fraud requires intent, which can be difficult to prove.

Overstating Revenue

A company can commit accounting fraud if it overstates its revenue. Suppose company ABC is actually operating at a loss and not generating enough revenue. To cover up this situation, the firm might claim to be producing more income on financial statements than it does in reality. On its statements, the company's profits would be inflated. If the company overstates its revenues, it would drive up the firm's share price and create a false image of financial health.

Unrecorded Expenses

Another type of accounting fraud takes place when a company does not record its expenses. The company's net income is overstated, and its costs are understated on the income statement. This type of accounting fraud creates a false impression of how much net income a company is receiving. In reality, it may be losing money.

Misstating Assets and Liabilities

Another form of accounting fraud occurs when a company overstates its assets or understates its liabilities. For example, a company might overstate its current assets and understate its current liabilities. This type of fraud misrepresents a company's short-term liquidity.

Suppose a company has current assets of $1 million, and its current liabilities are $5 million. If the company overstates its current assets and understates its current liabilities, it is misrepresenting its liquidity. The company could state that it has $5 million in current assets and $500,000 in current liabilities. Then, potential investors will believe that the company has enough liquid assets to cover all of its liabilities.

A Real World Example of Accounting Fraud

The Enron scandal is one of the most famous examples of accounting fraud in history. Enron used off-balance-sheet entities to hide the company's debts from investors and creditors. Although using such entities was not illegal in itself, Enron's failure to disclose the necessary details of its dealings constituted accounting fraud. As the true extent of Enron's debts became known to the public, its share price collapsed. By the end of 2001, Enron declared bankruptcy.

The consequences of accounting fraud were severe in the Enron case. Criminal charges were brought against many of the company's top executives, and some of them were sent to prison. The scandal also eventually destroyed accounting giant Arthur Andersen LLP, which handled Enron's books.