Trust …But Verify

I recently wrote an article entitled ”Not every good-looking financial statement tells the truth” that was published in the Puget Sound Business Journal on March 9, 2012. This article relates some of my experience with financial statements that were deliberately falsified. The link to the PSBJ for my article is at the bottom of this blog entry.

When I wrote the article, space constraints prevented me from listing more examples. Some of these examples are presented below.

Trust… But Verify

During the Cold War, President Ronald Reagan was asked how he knew that the USSR would abide by their agreement to reduce their nuclear weapons. His reply was “Trust – but Verify”. We need to apply the same process to financial statements.

Clearly, business people make very important decisions based on the financial statements that they receive. Unfortunately, in my years of being a CPA in public practice, and a Controller and Chief Financial Officer in private industry, I have seen many financial statements that were purposely falsified. Let me tell a few of those stories.

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While working at a public accounting firm, I brought in a new client. Since I was in the tax department, the audit of the client’s records was conducted by “Sam” from our accounting & audit department. Early in the engagement, Sam told me that the client has asked him to falsify the financial statements by reducing the company’s income. Odd, since normally clients want their income increased!

I talked with the client who explained that he wanted to understate his income since the payments he was making for the purchase of the business were based upon the financial results of his business. Sam and I told him that we would not falsify the financial statements. The icing on the cake was that the person to whom he was making the business purchase payments …… and wanted to defraud……was his mother!

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A new client, who had a B&B, asked my assistance in creating financial statements so he could obtain a much needed loan. During this process, he sent me financial information, albeit in dribs and drabs. One day he sent me the balance sheet that he had prepared for the banker. I looked at the balance sheet and noted that he had omitted several significant liabilities. I called him to inquire why some liabilities were missing. His answer was that the balance sheet “looks better that way”. Clearly, he had no compunction about falsifying financial statements that were going to his bank.

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A client was considering buying a small business. Based on the financial statements supplied by the seller, I made projections of the income and expense for the next 5 years. The results looked very good. At my insistence, my client engaged a CPA firm to look at the financial records of the seller. This was done so that we could determine whether or not we could trust the financials supplied by the seller. Long story short, the seller’s financials were materially misstated. My client walked away from the purchase.

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The last example is a local startup company that had received large amounts of funding. One day, a company employee found copies of company financial statements. Not wanting this important information to be left around, he gave the reports to the controller. The controller looked at the statements and realized that he had never seen financial statements with these numbers! Clearly, someone had prepared financial statements showing the company to be much more profitable than they actually were. The Board Members and the corporate attorney were contacted. An interim CFO was brought in to prepare accurate financial statements for an emergency board meeting.

The upshot of this was that the CEO and CFO were preparing and presenting the false financial statements to the board and investors to make it appear that they were in better financial condition than they were. I read in the newspaper that they were both arrested by the US Marshalls Service and subsequently sentenced to prison.

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So what can you do to protect yourself from relying on falsified financial statements? As I said in my published article “There are two solutions. First, you can place reliance in financial statements audited by a reputable Certified Public Accounting firm. Second, you can send your own trusted CPA who has your interest at heart, into the business to determine if the financial statements fairly represent the financial condition and operational results of the company”.

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Want to see the published article? Obviously if you get the paper, you can read the article. If you do not get the paper, the following link will pull up my article. The downside of the link is that, for the first 30 days after publication, the link may only work for subscribers. After that the link works for everyone. The link to my latest PSBJ article is:  http://www.bizjournals.com/seattle/print-edition/2012/03/09/not-every-good-looking-financial.html

Please feel free to leave your comments. Thank you.

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