Accounting fraud, creative accounting and forensic audit

Accounting fraud is the second largest group of so-called employment frauds. The Association of Certified Fraud Examiners defines employment fraud as the abuse of employment for personal enrichment by the intentional use or misuse of the property and other resources of the employer. The International Standard on Auditing, ISA 240, states that misstatements in financial statements can arise from error or fraud, with the distinguishing factor being the action – unintentional or intentional.

In the 2022 ACFE report, which tracked over 2,000 cases in 133 countries, nearly half of all employment fraud cases came from the following business areas:

• traffic 15%
• accounting 12%
• top management 11%
• trade 11%

Organizations lose approximately 5% of their revenue annually due to these types of fraud. The median value of the fraud cases monitored is approximately $117,000. The average value is up to $1.7 million.

Accounting fraud can be divided into four subcategories:

1. fraudulent financial reporting schemes
2. embezzlement of property
3. proceeds and assets created or obtained through fraud
4. expenses and obligations for unjustified purposes

Such a breakdown can be reduced to two key categories – fraudulent reporting and misappropriation of assets , as the next two points are practically related to them.

Overstatement of earnings and fictitious earnings are the most common fraudulent practices in financial reporting. Within this, " earnings management " or. manipulation of sales is one of the most common activities. It is usually carried out in two forms:

• Revenues that are generated through regular business activities are recognized early.
• Fictitious revenues from fake sales are recorded, mostly to fake customers

Further adjustments to the statements are made by not reporting real costs or by intentionally understating them. Misleading valuation and reporting of assets accounts for a significant proportion of the cases detected, with more than half involving inventories.

Accounting fraud associated with misappropriation of assets represents a vast area of ​​economic crime and financial offenses. An alternative classification of these frauds according to the so-called five accounting cycles, within which they typically occur:

1. sale and collection of receivables,
2. purchase of goods and services and related payments,
3. the area of ​​wages and employee agenda,
4. inventory management and warehouse operations,
5. regular reporting and inventory of accounts.

Accounting fraud is now more difficult to detect and its impact is often greater than in the past. Modern fraudsters are intelligent, have new technologies at their disposal and are able to effectively cover their tracks. However, there are still signs, so-called "red flags", that do not require advanced methods to detect. If we actively look for them in the process of checking or auditing financial statements , there is a high chance of detecting fraud at an early stage

• Searching for secret reserves - most often fictitious liabilities to non-existent partners, we look for accounting cases that are overdue longer than others.
• Distinguishing excessive expenses or business losses from basic techniques of draining funds from a business.
• Detecting fraud at the micro-level during investigations, audits, and risk management system preparation – it is during these activities that situations may arise where fraudsters learn to avoid detection, or it may inspire previously impartial persons to commit fraud.
• A situation of disorganization - if accounting records, books, and records are kept in a poor quality and chaotic manner, this creates opportunities for fraud and also helps the perpetrator to cover his tracks.
• Catastrophic situations - natural disasters or accidents such as fires are ideal camouflage for fraudulent activities, document manipulation, and also cover up asset misappropriation such as theft and misuse of property for private purposes, etc.
• Organizations in autopilot mode - if the organization's authorities are not present or do not pay attention to fraud prevention, they leave the business to its own devices, as the behavior of employees and managers can lead to negligence and even fraudulent actions.
• Lack of rotation of duties or long-term exposure to the same area – in larger organizations, employee rotation and periodic replacement of managers is common practice for both operational and fraud risks.

Accounting fraud is caused by the actions of specific individuals or groups, but it can also be caused by procedural gaps in the organization in the following areas:

Overall management structure

• ethics and compliance principles are not in place
• Awareness of existing company policy is insufficient
• regular training is not provided
• A low-key management tone to ensure compliance with internal guidelines

Internal control

• absence of regular internal compliance checks and testing
• failure to take action to eliminate inspection findings
• failure to review high-risk transactions

Accounting and records management

• expenses recorded in the wrong accounts
• lack of attachments and documentation

Trading with third parties

• No checks are carried out on potential business partners
• lack of oversight of third-party transactions
• the justification for payments to third parties is not clearly captured

The topic of accounting fraud is often associated with creative accounting , which is on the border between flexibility and manipulation. The term creative accounting does not have a uniform definition - in the USA it often includes fraud, in the UK it is more about the legal use of flexibility in accounting standards. One of the professional definitions speaks of "adjusting accounts in favor of the preparer within the rules" .

If these practices are in line with IFRS/GAAP , they can help a company stabilize its results and obtain financing. However, critics point out the risk of misinforming investors and ethical issues. While the flexibility of IFRS allows for professional judgment, it also opens the door to possible manipulation. In Europe, as in the US, the principle is that accounting should faithfully reflect economic reality. Flexibility in the rules exists precisely to enable this goal – not weaken it. However, creative accounting often uses this flexibility to its own advantage, thereby moving away from the original purpose of transparency.

Terms related to creative accounting, which we can understand as its subcategories:

• Aggressive accounting – deliberate selection of procedures to influence financial results, often outside the IFRS/GAAP framework.
• Earnings management – ​​the manipulation of sales to meet management goals.
• Income smoothing – a technique for eliminating fluctuations in profits through accounting adjustments.
• Misleading financial reporting – deliberate misrepresentation or omission of information in statements.

The five main creative accounting strategies involve specific techniques that can border on fraud:

1. Inflating income – e.g. premature recognition of sales, fictitious transactions, incorrect reporting of loans.
2. Reducing expenses – creating reserves, tax optimization, "big bath" depreciation, capitalization of costs.
3. Asset overvaluation – revaluation of assets, overvaluation of goodwill and brand, so-called "window dressing".
4. Reducing liabilities – using off-balance sheet structures and reclassifying liabilities.
5. Cash flow adjustment – ​​striving for the highest possible operating inflow and lowest possible cash outflow.

Creative accounting is not only applied with the intention of deceiving, but also in the absence of clear rules. Its practices arise in response to new challenges in practice that theory or legislation have not yet solved. In some cases, it is a legitimate search for the most appropriate accounting approach - in others, it is a balancing act on the edge of the law due to the insufficient quality of accounting rules. 

After financial scandals break out, the question almost always arises: Why didn't the audit reveal it?

Many people think that the role of an auditor is to detect every fraud. However, the truth is that a standard financial audit is not an investigation. Its goal is to confirm the factual accuracy of accounting statements, not to uncover sophisticated schemes or manipulations. Auditors usually work with samples of documentation and verify the flows within the accounts, not the background of the events themselves.

In such situations, forensic accounting comes into play – a combination of accounting, auditing and investigative skills aimed at identifying, analyzing and documenting fraudulent behavior. In practice, this term often overlaps with forensic auditing , which can be divided into two main areas:

1. Litigation support – expert opinions and calculations of economic damages, e.g. in breach of contract, insolvency proceedings, licensing disputes or intellectual property claims.
2. Investigative accounting – cases of accounting, insurance, invoicing or securities-related fraud.

A key feature of forensic auditing is the ability to look beyond the financial statements and perceive the broader economic reality. Manipulation of statements is considered fraud by a forensic auditor, although the law does not always consider it a crime. Forensic auditing thus provides a bridge between accounting, law and investigation, and provides evidence for courts and arbitration bodies. In an era of complex corporate structures and increasing demands for data integrity, forensics is becoming increasingly important – as a tool for restoring trust and protecting the integrity of financial information.

Forensic auditing uses two groups of fraud detection methods: supervised methods, which model known fraud patterns but suffer from low accuracy in rare cases, and unsupervised methods, which detect anomalies without prior data categorization.

Some of the forensic audit techniques used in investigations are:

• Digital forensics – analysis of electronic traces in IT devices to detect suspicious activities.
• Benford's Law – a statistical method using the probability distribution of numbers to detect unusual patterns in data.
• Trend analysis – identifying unusual activities that fall outside the company's normal seasonal or cyclical patterns.
• Testing of defense mechanisms – verifying the functionality of internal controls and preventive measures against fraud.
• Personal interviews – targeted conversations with employees to obtain information and verify suspicions.

Digital technologies today play a key role in forensic investigations – they allow evidence to be legally collected, analyzed and presented in a manner that is also accepted in court proceedings. Forensic audit methods often follow standard control and audit approaches, but are specific in that they focus on the burden of proof and the judicial usability of findings. Forensic audit and accounting form an important pillar of the fight against financial crime.

Sources:

1. Association of Certified Fraud Examiners: https://www.acfe.com/-/media/files/acfe/pdfs/chapter/howtodetectandpreventfinancialstatementfraud2019_chapter-excerpt.ashx ; https://legacy.acfe.com/report-to-the-nations/2022/
2. Committee of Sponsoring Organizations of the Treadway Commission: https://www.acfe.com/fraud-resources/fraud-risk-tools---coso/fraud-risk-management-guide 
3. Global Forensic Audit & Investigation (www.globalforensic.in), 2023: Handbook on forensic accounting & fraud prevention.
4. Golden – Skalak – Clayton, 2005: A guide to forensic accounting investigation.
5. Jones, 2011: Creative accounting, fraud and international accounting scandals.
6. Mulford-Comiskey, 2002: The financial numbers game: Detecting creative accounting practices.
7. Pedneault – Rudewicz – Sheetz – Silverstone, 2012: Forensic Accounting and Fraud Investigation.
8. Tumpach, 2011: Bilančné podvody pri zostavení ročnej účtovnej závierky podľa IFRS. In: Finančný manažér.
9. Burák, 2019: Daňová kreativita V. – niektoré finty najbohatších

Images in order: Triangle - various sources, iStock: 1330010441, Depositphotos: 421311430, 296322916, 195657716, Jones (2011), Depositphotos: 467334656, 466892414, 163146816, 338614110, 9085931