Definition: Fraudulent financial reporting is the intentional misrepresentation of a firm’s financial statements with the aim to give investors a mistaken impression about the firm’s operating performance and profitability.
What Does Fraudulent Financial Reporting Mean?
Fraudulent financial reporting takes place in the context of earnings management. The management changes the accounting policies, or the way estimates are calculated with the intention to improve the firm’s results.
Fraudulent financial reporting occurs due to:
- personal incentives
- pressures from the market
- lack of ethics
- deliberate compliance with the projections of financial analysts
- attempts to affect the price of stock
Fraudulent reporting can be controlled with external auditing, regulations and an independent board of directors. However, an ethical corporate culture is the main prerequisite for fair financial reporting.
Let’s look at an example.
A senior accountant deliberately manipulates the firm’s expenses and liabilities on the financial statement to improve the overall performance of the firm and convince investors that the company is not in debt and can face its liabilities in due time.
Typically, accountants or analysts manipulate operating expenses to increase the net income, while others list the operating expenses as capital on the balance sheet. In both cases, this is fraudulent financial reporting as it not only misrepresents the firm’s financial position, but it is aims to deceive investors.
Another example is the manipulation of projected earnings growth. For instance, a company that is consistently increasing its profit margin by 8%, all of a sudden presents an estimate for a profit margin growth of 15%.
If the firm’s fundamentals cannot support this projection, it most likely means that the figure is manipulated to get the financial statements approved by the board of directors and affect the stock price. However, this shows a lack of ethics and lack of corporate control.