Posted: 15 Jul. 2020 8 min. read

Financial statement fraud

Spotlight on heightened risks during the global pandemic

Businesses across all sectors are dealing with disruption as a result of COVID-19 and in many cases are experiencing a challenging period while they try to ensure their business continues to be viable. Such circumstances have unfortunately created a fertile ground for fraud and misconduct risk, including the potential for exaggeration of financial performance and balance sheet strength.

What does this mean for your business?

The primary responsibility for the prevention and detection of fraud, which extends to financial misreporting, rests with the board and senior management as set out in the International Standards on Auditing and the UK Corporate Governance code.

Management and directors should be assessing the heightened risk of fraud presented by the pressures and new working arrangements of COVID-19 and ensure their control environment is able to mitigate such risks.

It is important management include not only their response to the current situation, but continue their assessment through the recovery process as different risks and motivations will arise.

In December of last year, Sir Donald Brydon also completed a review into audit quality and effectiveness in the UK. Amongst the recommendations from his review is a new reporting duty on directors to set out the actions they have taken each year to fulfil their obligations to prevent and detect material fraud against the background of their fraud risk assessment.

COVID-19 has amplified the drivers for financial statement fraud as a result of:

  • Increased pressure from various stakeholders:
    • To report certain other unrelated “bad news” under the cover of COVID-19;
    • To meet bank and other covenants;
    • To maintain the going concern status of the company;
    • To continue to pay employees and suppliers; and
    • To pay dividends.

  • Increased opportunity: The working environment

    In adapting to COVID-19 many businesses have moved to remote working and the existing internal controls framework may be weakened. For example, restrictions on system access rights might lapse in the move to working from home or a loss of staff may cause approvers for journals to change. Businesses will need to be alert to potential gaps in key areas of controls, including appropriate oversight and review controls, segregation of duties, and the availability and quality of supporting documentation.

  • Rationalisation

    There is a risk that individuals may be tempted to view their fraudulent actions as justifiable in the current crisis to protect the company, its workforce or their personal position. They may also believe they are less likely to be caught as the current disruption draws management’s attention to other areas.

Examples of financial statement fraud in the current environment:

  • Failure to fully disclose negative events associated with the impact of COVID-19 on the business’ performance. For example, failure to report the loss of material contracts or to disclose post balance sheet events.
  • Missing or limited scenario analysis. Scenarios that were previously considered remote may now be relevant to stakeholders, for example the impact of an 80% drop in customer numbers or prolonged supply chain disruption. Intentionally excluding them from reporting could impact a reader’s view of the company.
  • Using COVID-19 to mask unrelated past issues such as poor performance or write-offs of underperforming assets, restructurings, sale, or closure of parts of their business that are either marginally associated with the impact from COVID-19 or not associated at all.
  • Manipulation of valuations and impairments and understatement of provisions and write-offs. Businesses continue to suffer from disruptions in the supply chain and significantly reduced demand, which have led to potential inventory obsolescence, volatility in financial markets and overdue receivables from customers facing financial difficulty. Areas susceptible to fraud therefore include inventory, goodwill, investments, financial instruments, long terms contracts and the assessment of bad debts.
  • Inappropriate capitalisation of expenses, which may have increased in the wake of the pandemic, deferring costs over several accounting periods rather than expensing them immediately when incurred.
  • Overstatement of revenue to create a picture of healthy performance, with a linkage to the business’ going concern status.
  • Models, forecasts and KPIs may be edited to produce favourable results so as to avoid impairments and covenant breaches, or to attract new capital finance or short term loans.

How can you mitigate these risks?

Clear communication and tone from the top
Judgement areas in accounting policies have the potential to be significant in the context of market updates and financial reporting. There should be frequent communications between senior management and the board to ensure that any key issues are addressed, decisions are fully documented and outcomes monitored. In addition, management should clearly communicate to all employees that the code of conduct remains in place.

Update your fraud risk assessments
Produce clear documentation that sets out the impact of COVID-19 on your operations, the risk mitigation processes and the implications for financial reporting. You should specifically consider which areas of your financial reporting are subject to a greater degree of judgement and therefore may be at risk of manipulation. Agree and document any modifications that are made to the internal control environment to mitigate this risk. This should be continually reassessed as the situation evolves.

Review internal controls
Segregation of duties should be maintained, with modifications required for any new working arrangements applied consistently and documented. Remote access to company systems should be reviewed so access is limited to the correct individuals. Businesses should seek to maintain normal supporting documentation standards and move to agreed digital alternatives where applicable.

Review monitoring processes
This should include a consideration of new activities, as well as being alert to any unusual transactions which could relate to pre-existing frauds emerging as a result of new working arrangements.

Maintain appropriate records
This should include the documentation of any decisions and the associated approvals process in areas such as journals, accounting estimates, valuations and forecasting.

If you would like to discuss any of the issues raised in this blog, or find out more about our Forensic services, please contact Amber Andrade or Nicola Cookson.

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Amber Andrade

Amber Andrade

Director

Amber Andrade is a Director in Deloitte’s Forensic team. Her practice spans investigations into accounting misstatements, whistle blower allegations, regulatory reviews and skilled person reports, as well as large, complex expert witness and advisory engagements. She works with clients across a variety of industries and as part of the Deloitte Financial Services Disputes leadership team. Amber has significant experience in contentious matters in the financial services sector, where she has prepared many expert accountant reports, requiring her to work closely with clients and their legal teams in a wide variety of high-value, global, disputes and investigations.

Rob Wylie

Rob Wylie

Director

A qualified Chartered accountant, Rob is a Director in the Firm’s Forensic practice. He has over 10 years’ forensic experience working predominantly on investigations into issues such as accounting misstatements, fraud, bribery and corruption, tax evasion and sanctions breaches. He also provides advice on all aspects of the economic crime compliance lifecycle and has assisted clients on complex financial disputes. He has significant experience in working alongside legal teams and responding to regulators’ requests and he provides his services across a wide range of industries.