Common Fraud Schemes

Illumeo Customer Success's Profile

Many types of fraudulent activities occur within the day-to-day business operations of a company.  Locating these activities and stopping them after they have occurred can be extremely costly for a company.  It is more cost-effective for a company to mitigate the fraud risks before they happen by being aware of the most common fraud schemes and how to prevent them from happening.  Some of the most common schemes are to (1) increase income, (2) manipulate reserves, (3) misstate inventory, (4) manipulate loan impairments and (5) provide misleading disclosures.    

(1) Schemes to Increase Income

Some of the most noted types of fraud schemes are ones that increase income through revenue recognition.  Some of the most common revenue recognition fraud schemes include the following:

  • Falsifying customers or customer contracts

  • Accelerating revenue even though all recognition criteria have not been met

  • Recognizing revenue for inventory shipped on consignment

  • Failing to account for special terms, concessions, or discounts

  • Manipulating percentage of completion

  • Failing to account for returns properly

The most recent accounting guidance for revenue recognition is found in Financial Accounting Standards Board (FASB) Accounting Standards Update (ASU) 2020-05, Revenue from Contracts with Customers (Topic 606).  An important way to help mitigate risk is for management to study this update and gain an understanding of fraud risks that may occur with this new guidance.  

(2) Schemes to Manipulate Reserves

One of the other prevalent methods for committing fraud is through the manipulation of various reserve accounts.  Some of the most common reserve manipulation fraud schemes include the following:

  • Making changes to items on the income statement, such as moving costs out of the costs of goods sold to inflate margin

  • Calculating accruals improperly

  • Reducing or manipulating reserve accounts such as accounts receivables, warranties and rebates

(3) Schemes to Misstate Inventory

Using inventory as a way to commit fraud is one of the most common fraud schemes.  Typically the misstatement of inventory is made to increase the inventory recorded on the balance sheet to improve overall financial results or to improve financial metrics.  Some of the ways that inventory is increased fraudulently include:

  • Over-capitalizing costs into inventory to inflate the value

  • Recording fake inventory

  • Adjusting the timing of recording the inventory reserves 

  • Failing to record losses when cost exceeds market value‚Äč

(4) Schemes to Manipulate the Recording of Loan Impairments

While not as prevalent as the schemes above, manipulating the recording of loan impairments is a frequently used way to commit fraud.  In most instances either creditors fail to recognize loan impairments and their associated reserve allowances or loans are improperly reclassified to specific categories that do not require review for impairment.  

(5) Schemes to Disclose Misleading Information in the Financial Statements

Issuing misleading or inaccurate disclosures with the financial statements is also a common fraud scheme.  Often an inaccurate disclosure is issued to hide fraud’s existence or the way fraudulent activities are being carried out.  The financial statement disclosures are extremely important now because they contain COVID-19 pandemic information that is required for disclosure.  It is expected that the requirement of COVID-19 related disclosures will increase the amount of disclosure fraud as the pandemic has affected companies in many negative ways.  Inaccurate disclosures may arise from a company not wanting to disclose poor performance, impairments, or failure to meet expectations.