Financial fraud and financial statements – Part 2

Part 1 of this series, which appeared in Le Monde Juridique (Volume 26 – Issue 4), focused on Financial Statement Fraud (FSF). It discussed some of the general issues surrounding this type of fraud, which, on average, causes the most financial damage per occurrence. Now that you’re a little more aware of their significance, what are some of the FSF-specific issues to keep in mind? Let's start by discussing the disclosure of related-party transactions. In this financial age of collecting management companies where each project often has its own company, the list of related parties can quickly grow. What about transactions with executives? What about transactions with companies owned by common investors?

Why are related parties important?

Related-party transactions are becoming increasingly important to those who draft tax laws and accounting standards. This should also be the case for financial statement users, not just when determining whether a benefit or advantage has been conferred on a related party or when confirming whether the fair market value of the transaction has been met.

Take the Enron story, for example, where millions of dollars were hidden in nearly 2,000 Enron-related shell companies. Through these related companies, Enron could not only sell products to itself many times over, but also book investments in these companies that were only operating on paper. In those days, there were far fewer regulations or standards that required disclosure of these large sums of money than there are today. If these rules had been in place, users of Enron's financial statements might have observed that the proportionality of these investments did not hold up and might have asked more questions. They would have realized that there was no real value in these transactions and that the money was in fact being used in other ways.

Disclosure of related-party transactions is primarily the responsibility of directors. Indeed, often only they are in a position to know all the parties who are actually involved in the transactions. Unfortunately, decisions not to disclose such transactions are choices that can be made to overstate profits and assets or, on the contrary, understate liabilities and expenses. But what happens when a company enters into a transaction with a party related to one or more employees without knowing it?

Remember that it may be normal for a company to enter into transactions with related parties. Thus, the failure to disclose a related-party transaction could be just a mistake; it is not necessarily an attempt to conceal the transaction. Nonetheless, the importance of evaluating and identifying related-party transactions is paramount to sound corporate governance in general. The use of repeated related-party transactions, which can often be indicative of so-called aggressive accounting and financial techniques, can, furthermore, affect the tone set by senior management.

An interesting fact about this appetite for repeat related-party transactions comes from a study by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in the aftermath of Enron. The study determined that in the United States, companies charged with fraud by the Securities and Exchange Commission (SEC) reported more related-party transactions than those that were never charged.

Who should care?

Users of financial statements all have an interest in the proper disclosure and measurement of related-party transactions. So do executives. However, not everyone is well versed in the subject, and your clients may not be. Consider your clients who are minority or passive shareholders, or who have a smaller stake in the business. How can they be sure that management is being transparent when entering into these types of transactions? Do they suspect products and services that may come from those close to senior management or parties related to employees?

Vigilance around related-party transactions is also required in the context of a business acquisition. You may have clients who have recently acquired a company where they are unsure whether these transactions were properly disclosed or properly valued.

What to watch for?

As stated earlier, while not a definite indicator of financial statement fraud, the presence of a significant amount of related-party transactions should prompt users to ask additional questions. Here are some examples of related-party transactions to keep an eye out for.

1. Loans to related companies: Sometimes a company may wish to “self-finance” by obtaining loans from related parties on favourable terms. This involves a transfer of funds between two companies. Loan modifications and loan forgiveness between related parties that may result in the recognition of a gain or loss should also be carefully analyzed. It’s also important to analyze interest rates.
2. Sales to or purchases from related parties where the relationship has not been disclosed: Sales to or purchases from related parties are often made on more favourable terms than a similar transaction with a third party.
3. Service fees charged to related parties: Similar to the previous point, the addition of service fees or management fees between related parties can be a way to artificially inflate revenues and transfer funds on demand between related companies.
4. Valuation of investments in related companies: This is also a way of transferring wealth from one company to another as needed, which may result in the overvaluation of assets and ownership interests.

If you have doubts or suspicions about the financial statements that have been submitted to you, it is critical to reach out to a qualified and experienced team that includes a forensic accountant.