Fraud involves a “scheme or artifice” to convince someone to give up property or cash based on false pretenses. Fraud occurs if an individual knowingly lies about an important or key fact in a transaction or relationship, and the other party relies on that misrepresentation of fact and suffers harm.
Accounting fraud is a white-collar (business) crime. The person or company committing accounting fraud obtains a financial advantage by:
- Using false statements, lies, or misrepresentations;
- Hiding or concealing important information; or
- Using deceptive conduct
This type of fraud commonly occurs when a company falsifies or manipulates the information on its accounting books or financial statements. For example, a company’s accountant may make false entries in the business’s financial statements to give the appearance the company is worth more than it is. Relying on the false information, investors then purchase stock. When the accurate value of the company is revealed, the investors learn they have been defrauded.
Accounting fraud is punishable by time in jail or prison, monetary fines, financial recompensation to the victim(s), or all three.
How is Accounting Fraud Committed?
Accounting fraud can be committed in a variety of ways. These include:
- Deliberately (intentionally) overstating company profits
- Deliberately not recording expenses. When a company intentionally does not record some or all of the expenses of doing business (such as payments of rent, salaries, or taxes), the company makes its income look higher than it actually is
- Reporting a transaction as completed when in fact the transaction is still pending. A common example of this activity occurs in sales transactions. When a company reports a favorable sale as concluded when it is in fact still underway, it misrepresents its profitability
- Misstating company assets. Assets include equipment, inventory, business supplies, and investments. A business’s ownership or control of assets is a large part of calculating its value as a going concern. Overstatement of assets gives the impression that the company is worth more than it really is
- Misstating liabilities. Liabilities are a company’s financial debts or obligations. Debts include money owed to banks and other creditors. If the company understates its liabilities, it makes it look like the assets are worth more than they are.
- When the amount of company debt exceeds the amount of company assets, the company is referred to as “asset-deficient.” An asset-deficient company is prone to bankruptcy because its assets are insufficient to cover liabilities. Misrepresenting debts as smaller than they are gives the misleading impression that a company is generating money when it is not.
How Do You Prove Accounting Fraud?
First, investors who suffer financial losses due to accounting fraud may file a complaint with the Federal Securities and Exchange Commission (SEC). The SEC will investigate the complaint, and if the complaint is valid, the SEC may file a civil or administrative proceeding against the company.
Second, investors may sue the company on their own behalf. To prove accounting fraud:
- A victim must demonstrate the company deliberately falsified financial records. “Deliberate” means intentional or on purpose. It cannot have been accidental or due to an accounting oversight.
- The victim must prove the intent was to deceive them. Proving intent, or a “guilty mind,” can be difficult. To demonstrate intent, one must prove an employee or accountant knew the correct facts of financial statements and chose to misrepresent those facts. A victim often relies on the knowledge of a so-called “whistleblower.” A whistleblower is an individual who informs on a company that has engaged in fraudulent activity. In 2002, a federal law known as the Sarbanes-Oxley Act was passed. This law prevents whistleblowers from being retaliated against for reporting accounting fraud.
- The victim must show the misrepresentation misled them. The victim must show that they took steps due to the misleading misrepresentations – bought stock, for example – and that they lost money as a result.
For example, assume a company wanted to convince people to invest in their company. They falsified their financial records to show (1) that they were making a profit and (2) had no outstanding debts. This was dishonest – these representations were deliberate misrepresentations of the facts.
The victim believed that buying shares of stock in the company was a wise way to invest their money, but after investing, they discovered that the company was fast losing money and used their investment to avoid creditors rather than to build wealth. The victim has lost all the money they invested in the company. Accounting fraud has occurred.
What are the Penalties for Accounting Fraud?
When preparing financial statements, accountants must follow what are known as Generally Accepted Accounting Principles (GAAP). GAAP consists of accounting principles that the law considers the authoritative or proper way to conduct accounting. Federal law requires that companies that are publicly traded, and that release financial statements to the public, follow GAAP guidelines. The purpose of GAAP is to create consistent accounting and reporting standards. This allows investors to evaluate a company’s financial worth properly.
GAAP principles form the beginning point of every company’s internal compliance program. Companies must also impose internal policies and controls to ensure that GAAP is adhered to. In any report of accounting information, the preparer must indicate whether or not the information contained within the statements complies with GAAP. Failure to comply with GAAP, whether unintentionally or on purpose, materially misrepresents a company’s financial condition and causes serious financial hardship to those who rely on the misrepresentations.
Both individual investors and the government can sue civilly over violations of GAAP. The SEC can sue in federal court or before a federal administrative law judge. If the SEC prevails, the SEC can obtain remedies, including civil money penalties, disgorgement (payment to individuals who have been defrauded), and monetary fines.
Moreover, accounting fraud is a crime under state and federal law. Individuals who commit accounting fraud expose themselves to personal criminal prosecution. If the accountant, employee, or officer who committed the fraud is found guilty, then this person can be subject to prison time in an action brought by the federal Department of Justice. It doesn’t matter whether the falsification was taken at a person’s discretion or the direction of an employer.
The law can hold individuals and companies responsible under a conspiracy theory. Furthermore, employers may be liable for employees’ actions if investigators determine the employer should have known about the violation.
When accounting fraud violates state (as opposed to federal) law, a victim may report the fraud to their state’s SEC equivalent or that state’s Attorney General. The Attorney General may file a lawsuit against the company on one or more victims’ behalf.
Do I Need the Help of a Lawyer if I Suspect Accounting Fraud?
If you believe you have been a victim of accounting fraud or work for a company where you believe such fraud is taking place, then you should contact the SEC or your state’s Attorney General.
If you have been charged with accounting fraud or know you will be, you will want to contact a fraud lawyer. Accounting fraud is a serious crime, and the consequences may be serious and long-lasting. If necessary, an attorney can review your case, determine what defenses may be available to you, and represent you during any court proceedings.
