Financial Statement Fraud: Concealed Liabilities and Expenses

Concealed Liabilities and Expenses

Understating liabilities and expenses is one of the ways financial statements can be manipulated to make a company appear more profitable than it is. Because pre-tax income will increase by the full amount of the expense or liability not recorded, this financial statement fraud method can significantly affect reported earnings with relatively little effort by the fraudster. It is much easier to commit this scheme than to falsify sales transactions. Missing transactions can also be harder for auditors to detect than improperly recorded ones because the missing transactions leave no audit trail.

There are three common methods for concealing liabilities and expenses:

· Omitting liabilities and/or expenses

· Improperly capitalizing costs rather than expensing them

· Failing to disclose warranty costs and product-return liabilities

Liability/Expense Omissions

The preferred and easiest method of concealing liabilities or expenses is to simply fail to record them. Large monetary judgments against a company from a recent court decision might be conveniently ignored. Vendor invoices might be thrown away or stuffed into drawers rather than posted into the accounts payable system, thereby increasing reported earnings by the full amount of the invoices. In a retail environment, debit memos might be created for chargebacks to vendors, supposedly to claim permitted rebates or allowances, but sometimes solely to create additional income. Whether these items are properly recorded in a subsequent accounting period does not change the fraudulent nature of the current financial statements.

Often, perpetrators of liability and expense omissions believe they can conceal their frauds in future periods. They frequently plan to compensate for their omitted liabilities with visions of other income sources, such as profits from future price increases.

Just as they are easy to conceal, omitted liabilities are probably one of the most difficult schemes to uncover. A thorough review of all post-financial-statement-date transactions, such as accounts payable increases and decreases, can aid in the discovery of omitted liabilities in financial statements, as can a computerized analysis of expense records. Additionally, if the auditor requested and was granted unrestricted access to the client's files, a physical search could turn up concealed invoices and unposted liabilities. Investigative interviews of accounts payable and other personnel can reveal unrecorded or delayed items as well.

Current accounting standards require entities to record provisions for contingent liabilities on their financial statements if a present obligation has arisen as a result of a past event, the amount of the liability can be reasonably estimated, and the likelihood of payment is probable.

In July two thousand two, the U.S. SEC filed suit in the United States District Court for the Southern District of New York, charging major cable television producer Adelphia Communications Corporation, its founder John J. Rigas; his three sons, Timothy J. Rigas, Michael J. Rigas, and James P. Rigas; and two senior executives at Adelphia, James R. Brown and Michael C. Mulcahey, in one of the most extensive financial frauds ever to take place at a public company. The SEC charged that Adelphia, at the direction of the individual defendants, one, fraudulently excluded over two point three billion dollars in liabilities from its consolidated financial statements by hiding them in off-balance sheet affiliates; two, falsified operations statistics and inflated Adelphia's earnings to meet Wall Street's expectations; and three, concealed rampant self-dealing by the Rigas Family, including the undisclosed use of corporate funds for Rigas Family stock purchases and the acquisition of luxury condominiums in New York and elsewhere.

With respect to the concealed liabilities, the complaint alleged that between mid-nineteen ninety-nine and the end of two thousand one, John J. Rigas, Timothy J. Rigas, Michael J. Rigas, James P. Rigas, and James R. Brown, with the assistance of Michael C. Mulcahey, caused Adelphia to fraudulently exclude from the Company's annual and quarterly consolidated financial statements over two point three billion dollars in bank debt by deliberately moving those liabilities onto the books of Adelphia's off-balance sheet, unconsolidated affiliates. Failure to record this debt violated financial reporting requirements and precipitated a series of misrepresentations about those liabilities by Adelphia and the defendants, including the creation of one, sham transactions backed by fictitious documents to give the false appearance that Adelphia had repaid debts when, in truth, it had simply moved them to unconsolidated Rigas-controlled entities, and two, misleading financial statements by giving the false impression through the use of footnotes that liabilities listed in the Company's financials included all outstanding bank debt.

In November two thousand two, in exchange for his testimony against the Rigas men, James Brown was released from prosecution by consenting to an entry of a permanent injunction against him for U.S. securities law violations. Additionally, Brown has been permanently barred from becoming an officer or director of a public corporation.

In July two thousand four, after a three-month trial, a federal jury convicted John and Timothy Rigas of conspiracy, securities fraud, and bank fraud. John Rigas received a fifteen-year prison sentence and was fined two thousand three hundred dollars, and Timothy Rigas was sentenced to twenty years in prison. James Rigas was never criminally charged by the Court. In November two thousand five, Michael Rigas pleaded guilty to a charge of making a false entry in a financial record.

In April two thousand five, the SEC filed permanent injunctions against John, Timothy, Michael, and James Rigas, as well as James Brown, Michael Mulcahey, and Adelphia Communications Corporation. The defendants were charged with violating anti-fraud, periodic reporting, recordkeeping, and internal control provisions of U.S. securities laws. In addition, the Rigas family members were barred from ever holding officer or director positions in a public company.