21/5/2020 Financial Statement Fraud Risk Escalates in Pandemic - CFO Journal.

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Financial Statement Fraud Risk

Escalates in Pandemic
The business and economic turmoil brought on by the COVID-19 pandemic has produced
conditions often associated with the fraud triangle: pressure, opportunity, rationalization.

The rapid advance of the new

coronavirus has placed
significant strain on organizations
and individuals alike. As
disruption persists and
organizations try to adapt to new
realities, they may need to be
more watchful than ever for the
risk of fraud associated with
financial statements.

Financial statement fraud is the

costliest type of occupational
fraud that can affect
organizations, according to the
Association of Certified Fraud
Examiners’ 2020 Report to the
Nation. The report notes financial
statement manipulations cause
financial damage to organizations more rapidly than any other type of illicit schemes.

As explained in the “fraud triangle” theory set forth by Donald R. Cressey, three elements are
typically present in fraud events—pressure, opportunity, and rationalization. Consider how recent
events related to the global pandemic have created an environment that is consistent with or
could promote these three elements.

Pressure. Many organizations are dealing with enormous shifts in their normal business models
and huge declines in revenue with some triaging supply chain disruption and cash shortfalls.
These conditions can lead to significant challenges with liquidity, working capital, and shareholder
expectations.

Opportunity. At the same time, many organizations have rapidly deployed remote work
arrangements or other changes in staffing. Perhaps because of illness or family needs, people
may not be available to discharge their normal duties within the financial reporting supply chain.
Their access to needed tools or documentation may be disrupted, as well. Such concerns may
strain or alter internal controls that are meant to promote reliable financial reporting, including
segregation of duties and IT access restrictions.

Rationalization. As various pressures mount, the line separating acceptable from unacceptable
behavior can become blurry. Some people may take actions or manipulate resources in ways
they otherwise wouldn’t consider. These individuals may rationalize their conduct during times of
crisis with views such as “I have nothing to lose.” or “This money is due to me anyway.”

Financial Reporting Risks to Scrutinize

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At a time when most organizations can ill afford further financial setbacks or other disruptions, the
following summaries provide a road map of potential areas where business leaders with risk
management responsibilities may need to increase their focus on fraud risk.

Revenue recognition. To make up for decreased consumer spending, some individualas within
organizations may endeavor to deliberately fabricate revenues to boost bottom lines and show
that management was able to persevere in a challenging customer or business environment. The
current accounting standard on revenue recognition requires organizations to arrive at several
judgments and estimates, some of which could be subject to manipulation or misstatement in
ways that could increase the recognition of revenue.

Allowances and reserves. Companies have numerous valuation accounts, allowances, and
reserves that are based on estimates, assumptions, and judgments. These line items are related
to inventory, accounts receivable, insurance claims incurred but not recorded, income taxes,
contingent liabilities, and more. Some in management could potentially be motivated to
intentionally manage these reserves in ways that would minimize charges to the bottom line.

Valuations and impairments. Organizations use forecasts as a critical element in the valuation
of many assets, such as inventory, certain financial instruments and investments, and some long-
term contracts. This includes any goodwill on corporate balance sheets.

Disruptions to supply chains and volatility in financial markets could make it challenging for
organizations to record such assets at their net realizable or fair value. Given the inherent
uncertainty in valuing such assets in turbulent times, some organizations may search for ways to
inappropriately delay the recording of losses or attempt to overvalue certain assets as a way to
overstate reported results or generate insurance recoveries.

Restructuring charges. Given the strong probability of outbreak-related financial losses,

affected companies may seek to write off underperforming assets or record charges. This might
result from larger organizational restructurings, divestitures, or closure of business units. In some
cases, companies may seek to include charges that are either marginally associated with the
impact of COVID-19 or not associated at all.

Treatment of expenses. Outbreak-related costs may be substantial, and some managers may
attempt to spread out the costs over a few years rather than expensing them as incurred. It might
be tempting to rationalize that some expenses can be capitalized so they can be deducted over
several accounting periods rather than expensed in the current period as required by accounting
rules.

‘Some people may take actions or manipulate resources in ways they otherwise
wouldn’t consider. ’

Disclosure. Some employees may look for creative ways to mask the full effects of the pandemic
by manipulating disclosures. With qualifying language or concealment of facts, a rosier—and
potentially inaccurate—picture could be painted for investors regarding risks, uncertainties,
contingencies, and representations contained in public statements and regulatory filings.

As an example, concerns may arise with respect to companies’ or their counterparties’ ability to
satisfy contractual obligations, which may or may not be fully described in disclosures.
Disclosures should include an assessment of whether reliance on force majeure provisions or
common law principles of nonperformance may apply. The adequacy and sufficiency of such
disclosures can lead to claims of securities fraud by regulators and investors.

Margins. Many companies are already experiencing significant declines in revenue; closures of
plants, facilities, and storefronts; reduced transaction fees; and declines in assets under

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21/5/2020 Financial Statement Fraud Risk Escalates in Pandemic - CFO Journal. - WSJ
management, all while paying their employees and supporting current-state cost structures. Each
of these actions increases the risk that an organization’s profit margins could be manipulated.
There are many ways in which this can be accomplished, and they differ considerably within
organizations. As such, companies may need to consider their own specific risks in this area so
they are alert to potential inappropriate behavior.

Other Areas to Monitor

In addition to numerous potential motivations to improve operating results, some organizations

might consider risks associated with various asset misappropriation schemes, such as submitting
fabricated invoices, adding non-existent employees to the payroll, establishing fictitious vendors,
tampering checks by altering payee information, or submitting fraudulent travel and entertainment
claims.

Internal control over financial reporting should also rank high among risk management priorities.
Control override may be regarded by some as a legitimate way to navigate significant disruption,
but it is also a common fraud maneuver. Controls that warrant scrutiny include segregation of
duties, delegation of authority, and IT access.

What’s more, given recent disruption, modifications to existing control structures may not happen
with the same speed. New controls may be implemented without sufficient assessment and
testing of their design and effectiveness. This may increase the opportunity for fraud to occur.
Plaintiffs’ securities firms may seek to capitalize on stock price drops resulting from the crisis,
leading to an onslaught of new case filings.

—by Anthony Campanelli, Kevin Corbett, and Christopher Georgiou, all partners in the Forensics
practice of Deloitte Financial Advisory Services LLP

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Data USA COVID-19

May 21, 2020, 3:00 pm

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