Bad Investment: Beware of Accounting Fraud

Are you thinking about buying stock in a company? Investing money in a company can be a scary decision for many people. There's a limited amount of money, and most people have to work very hard to save it. Many people depend on their investments to help take care of their lifestyle now and in the future.

Unfortunately, investors have to worry about securities fraud. This means that a company or individual uses illegal actions to get investors to make purchase and sale decisions. There are various types of securities fraud. One common type is accounting fraud.

What's Accounting Fraud?

Accounting fraud is the process of intentionally misrepresentating a company's financial accounting records. It's usually used to make a company's finances look better than what they really are. Shareholders and future investors need accurate financial statements to make knowledgeable decisions.

Fraudulent financial reporting can prevent you from getting an honest look at the financial health of the company, leading to bad investments.

Examples of Accounting Fraud

False information can be used in a variety of ways to manipulate a company's books. This is sometimes called "cooking the books." Some examples include:

  • Overstating revenues & assets
  • Understating costs, expenses, debts or liabilities
  • Not following Generally Accepted Accounting Principles (GAAP)
  • Incorrectly recognizing and reporting when a transaction occurred

GAAP Abuse

GAAP was created to standardize the financial statements of companies. This allows investors to contrast and compare companies to similar guidelines to help make investment decisions. Companies stating they follow GAAP but actually don't are committing financial reporting fraud.

Fudging Revenue

One very common way companies commit accounting fraud is by incorrectly recognizing revenue. This is done by reporting revenue before a sale is complete or before a product has shipped to a buyer. Trying to reach targeted earnings is the most likely reason that companies might recognize revenue prematurely.

Where's the Profit?

Some companies may even try to hide profit. Why? Sometimes it's to avoid paying taxes to the Internal Revenue Service. It may also be done by executives to give themselves inflated bonuses or stock options with the extra money.

Signs of Accounting Fraud

As an investor, you need to make sure the company you're investing in has accurate accounting records. As a business owner or an executive, you must make sure your company isn't committing fraud.

Some tell-tale signs that fraud may be occurring include:

  • Inadequate internal controls
  • No independent audit group to check records
  • Focus on profit at all costs from the top on down
  • Questionable transactions not recorded when they should be
  • Incentives that don't take into account compliance with the laws and GAAP

Preventing Accounting Fraud

There are a number of safeguards companies should take to avoid fraud:

  • The company's operations and organization should be structured so there's supervision at each level
  • Duties should be separated among employees so no one person has complete control over the company books
  • Detailed documentation of all financial transactions should be kept
  • An outside, independent firm should be used to examine the books. This gives the company and investors confidence in the numbers

Investigate, Pay Attention & Train

Any claim of fraud must be followed up by the company. An independent investigation should be used for serious allegations. Suspected fraud, or the results of an investigation confirming fraud was committed, should be reported to the Securities and Exchange Commission.

Also, it's important to pay attention to unusual behavior by employees. For example, an employee who refuses to go on vacation and works a lot after hours may be trying to hide something, which could even mean embezzlement.

Training to avoid fraud should always be offered by companies. After all, accountants need to know GAAP in order to follow it.

No one can completely guarantee that accounting fraud won't happen. However, all of these preventative steps can lessen the likelihood that it will. When it comes to investing your money or protecting the financial health of your company, it's always better to be safe than sorry.

Questions for Your Attorney

  • Do whistleblower laws cover me even if I report suspected behavior and I'm wrong?
  • I purchased stock based on false information from the company. Can I get my money back?
  • How do I protect myself after being accused of committing accounting fraud?
  • As an investor, how do I make sure a company is following the GAAP accounting rules?
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