Is accounting fraud solely a control offense?

by Patrick Müller

06.10.2022

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Is Balance Sheet Manipulation Solely a Control Offense?

My co-author, Dr. Carola Rinker, and I explored this question in our latest book, "Accounting Fraud." In an in-depth conversation with Sylvia Meier, we also shed light on the fine line between legal balance sheet cosmetics and illegal manipulation, the role of IT systems in financial accounting, and discuss preventive measures to uncover such practices. These insights are particularly relevant given the recent scandals involving Wirecard and Greensill.

Happy reading!

Dear Dr. Rinker, Mr. Müller, you have written the book "Accounting Fraud" to prevent balance sheet manipulation. Many companies take advantage of accounting structuring options, but when do we start talking about manipulation? Where is the line?
Dr. Carola Rinker: "The line between legal balance sheet cosmetics and illegal manipulation is not always easy to define. If, for example, a non-existent patent is listed on the balance sheet, it's clear to everyone that this is a violation of accounting regulations. However, when it comes to overvaluation in the balance sheet, this can sometimes be a gray area. There is no single 'correct' value in valuations. But if, for instance, project reports are falsified to manipulate the completion status of an ongoing construction project, the line of legality has been crossed."

The topic of balance sheet manipulation has gained public attention due to high-profile cases like Wirecard and Greensill. The question is often asked: Why weren’t the manipulations discovered earlier? What’s your take?
Dr. Carola Rinker: "An analysis of the balance sheets in these prominent cases often shows that there were already some red flags. For instance, Greensill’s balance sheet exploded from one year to the next. This certainly raises the question of how that was possible. In the case of Wirecard, their margins were much higher compared to competitors, which was never explained plausibly by the former DAX company.
I regularly come across balance sheets that show irregularities. But when, for example, an international company’s headquarters is abroad and the German financial regulator (BaFin) is not responsible, even though the discrepancies occur in Germany, it can become quite complicated."

Investors generally trust the accuracy of financial statements. Are there specific balance sheet items that signal early warning signs?
Dr. Carola Rinker: "It’s hard to give a blanket answer because the structure of the balance sheet depends, among other things, on the company’s industry. A research-intensive company, for example, may have a high amount of intangible assets relative to the total balance sheet. This item is prone to manipulation. Intangible assets are more difficult to value than, say, a machine, making them more vulnerable to manipulation in today’s context."
Patrick Müller: "I agree. The risks and opportunities for manipulation depend on the industry and business models. Theoretically, every balance sheet and income statement item can be manipulated to record non-existent transactions. The reverse case, where existing transactions are not recorded, is also possible. Then there are real transactions, as Carola Rinker mentioned, where valuations are not properly accounted for. That’s why all positions should be reviewed, and it should be clarified whether they involve individual transactions or large volumes of transactions.
Balance sheet manipulation becomes relevant when significant amounts are altered for the company. While large individual amounts are easily identified and checked, positions with numerous transactions offer opportunities to conceal fraudulent activity. In practice, this is often compared to finding a needle in a haystack. However, it’s not that simple. I now think of fraud detection more like a puzzle. It’s not just about the individual events but also about understanding the connections between them and the overall picture."

A Look Inside the Book: Established process deviations or recurring errors as a cover for manipulation

(Image source: Rinker, Carola; Müller, Patrick: Münker, Frank (2022): "Accounting Fraud – Understanding Balance Sheet Manipulation in Practice and Detecting, Investigating, and Preventing It Early Using Data Analysis"; page 68.)

What impact does balance sheet manipulation have on controlling?
Dr. Carola Rinker: "By reporting overly high profits, the results from controlling are also distorted, leading to misinterpretations and potentially poor decision-making. For example, controlling may incorrectly suggest that a new product has a high margin. If, without manipulation, the new product is actually losing money, this becomes a major problem."

What motivates balance sheet manipulation – and who is responsible? Is it always senior management?
Dr. Carola Rinker: "There are many reasons why balance sheets are manipulated. It’s not always top management that is behind the manipulation. But there also needs to be a conducive environment for manipulation to occur. The saying 'opportunity makes the thief' is very fitting here: A weak internal control system makes manipulation easier. In addition to opportunity, motivation and rationalization play a role in the fraud triangle.
Balance sheets are sometimes manipulated for personal financial gain. It’s also common for manipulation to be used to hide a negative business development, with the hope that, for example, overstated revenues will be made up in the following year. If that doesn’t happen, the problem grows worse. To cover up the deception, more manipulations, like document forgery, are often carried out."
Patrick Müller: "The motivation behind fraud can vary from case to case. Manipulation may occur due to the company’s economic situation or the personal financial situation of individuals. Public or shareholder expectations can also play a role. As Carola Rinker mentioned, motivation is just one of several factors that contribute to fraud. Opportunity is particularly crucial, and it’s this corporate opportunity that we address in the book."

A Look Inside the Book: Chapter and Topic Overview

The government has responded to accounting scandals by reforming financial oversight. Do you think this reduces the risk of further large accounting scandals?
Dr. Carola Rinker: "I advocated for the abolition of the two-tier financial oversight system during a hearing before the Bundestag Finance Committee. As the Wirecard case showed, the two-tier system was ineffective in responding quickly. But legal reforms alone aren’t enough to reduce the risk of accounting scandals. A corporate culture that counters these issues is also needed. However, such a culture can’t be legally mandated; it must be lived within the company."
Patrick Müller: "I agree, especially given the technological developments of recent years. As large companies continue to grow, automate their business processes, and add purely digital business models, the audit approaches of internal and external auditors are still very manual and sample-based. This has led to a growing gap between the number and complexity of transactions and the human resources in audit teams. While recent updates to audit standards mention analytics and automation more frequently, specific and up-to-date IT requirements are still limited."

What preventive measures would you recommend to companies?
Patrick Müller: "I like a quote from Roger Odenthal, who works in the field of employee crime. He interprets economic crime, after removing all the side stories, as essentially a control offense. In other words, controls can be used as preventive and detective measures. When it comes to controls, the question is often asked, 'Who controls what?' The responsibility for such controls should be clarified using the so-called 'Three Lines of Defense' model. In our book, we don’t go into the division of responsibilities between operational management, risk management, and internal audit. Our focus is on the substantive and technical control options, which can also be used by external auditors and regulatory authorities.
For example, it's about training, auditing, potentially adjusting, and securing process workflows. Process deviations should be continuously detected and corrected using data analysis. It’s essential to apply the right analytical methods and ensure that the data foundation matches the company’s complexity. In large companies, it’s no longer enough to just audit financial accounting data. Instead, it’s about assigning individual transactions to their originating processes and auditing them. We present various methods and audit steps in the book.
Setting up a whistleblower system and conducting continuous monitoring or continuous auditing can also be helpful.
Personally, I believe that teams conducting audits should have strong data analysis skills and that the respective management should have basic knowledge of data and analytics. Experts from other areas are often brought in for data analysis. In this 'Analytics as a Service' approach, I see the risk that relevant information, domain knowledge, risk areas, analysis selection, findings, and insights could be overlooked or misjudged. Outsourcing the analytics function may be efficient, but I don’t believe it’s the right way forward."

A Look Inside the Book: Real-Time Analytics as Part of Continuous Monitoring and Auditing