Beware of Doctored Financial Statements

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Reprinted with Permission, Camico Mutual Insurance Company.http://www.

No professional wants to be deceived, but sometimes it just happens. Criminals lie to their lawyers, students cheat on tests given by their teachers, and clients alter financial statements prepared by their CPAs.

"Every month," says Suzanne Holl, CAMICO loss prevention manager and CPA, "I talk to at least one policyholder about a financial statement or tax return that a client doctored. "However," adds Holl, who frequently speaks at discussion group and chapter meetings for CPAs, "most CPAs appear unaware of the threat. They seem genuinely surprised when I tell them that clients are altering financial statements and tax returns for personal gain. What's more, this probably happens more than we realize. There are many CPAs who don't report known incidents of doctored financial statements, or who never even discover that their clients are altering the documents."

How They Do It

One of the most common ways a client will alter a financial statement or tax return is to cut and paste the document to improve the bottom line. Or, if the client had a favorable audit in 1999, the client may simply use the same financial statement year after year by changing its date.

Holl tells the story of a CPA whose client lawyer actually admitted to changing his tax returns. "The client," says Holl, "called his CPA and said, I hope you don't mind, but I know you're really busy, so I changed a few things on my tax return..."

In more flagrant cases, such as that described in the War Story featured in this issue of Impact, clients will use a CPA's name, alter what is likely stolen stationery, and prepare their own financial statements.

What You Can Do

How can you protect yourself from clients who alter financial statements? "You really can't be completely certain that a client won' t alter financial statements," says CAMICO vice president of claims and loss prevention Ron Klein. "However, I would recommend client screening as an excellent first line of defense. Don't do business with anyone who is likely to do this type of thing."

The fact is, it isn't easy to recognize a client who would alter financial statements. In one case, the only reason the CPA discovered that his client had fabricated a financial statement is because the bank's loan officer knew the CPA, saw a new address on the letter-head, and called the CPA to congratulate him on his new offices.

Although no single question will determine whether or not a client will alter a financial statement, there are tip-offs. Be wary of prospective or even current clients who desperately need a loan, or whose financial future appears bleak. As with any type of fraud, the client may not initially intend any wrongdoing, but desperate times lead to desperate measures. In addition to recognizing your client's "bad times," be aware of the prosperous times too. It's important to monitor any significant changes in your client's business.

Other indicators may include clients with large amounts of leased equipment or whose receivables have slowed down. Also, during your initial client screening, talk to the prior CPA. Although the prior accountant may not tell you point blank that the client has a history of altering financial statements, he/she may indicate that problems existed and that it would be best to steer clear of the client. Keeping in touch with your client's business and bank relationships may also provide you with clues regarding the quality of your client.

If you discover or even suspect that a client has doctored financial statements or tax returns, call CAMICO. In borderline cases, it's human nature to want to give the client the benefit of the doubt, especially if it involves a long-time client. However, says Klein, "maintain your professional skepticism and take the appropriate action to protect yourself. A third party is relying on erroneous information that has your name on it."

What is Your Liability?

If the creditor issues a loan based on a false financial statement, the bank will probably sue you. You'll have to prove that you didn't prepare the statement and/or weren't in on a conspiracy. Says Klein, "you may have an obligation to make sure that people with information with your name on it have correct information even if you didn't do it. Don't bury your head in the sand. Even though you don't think you have an obligation, the courts might."

If you are called or receive notice from a third party who intends to grant a loan based on information that you don't think you've prepared, call CAMICO.

When you call CAMICO it is likely that you will be advised to disclose what you know to the bank. However, before approaching the bank, approach your client. Explain to your client that if their company doesn't tell the bank it has incorrect information, you are obligated to tell the bank that the information they have was not prepared by your firm.

The next step is to disengage. Never stay with a client that you know has altered financial statements. "Clients that cheat once," says Holl, "usually won't hesitate to cheat again." Further, if the client eventually gets caught for altering financial statements and the case goes to court, you can count on being involved in the lawsuit. Since your firm knew that the client engaged in illegal behavior and yet you maintained your relationship with them, the courts may assume that you knew the client had continued to doctor financial statements, and you may be found liable.

You can't control the actions of your clients, so the best way to protect your firm is to be aware that this problem exists, educate yourself and your staff on preventative measures, and when you're faced with a problem call CAMICO.

Client Screening Tips

  • Find out how the client was referred to you.
  • Ask why the client changed CPA firms
  • Find out if the client changes CPA firms frequently.
  • Question why this client wants you as his/her CPA.
  • Confirm that the engagement is in your firm's area of expertise.
  • Verify that the timing for the engagement is realistic.
  • Interview the prior accountant.
  • Ask the prior accountant if the client has a record of paying bills on time.
  • Review the prior accountant's management letter.
  • Assess the reputation, integrity, and competence of top management and owners.
  • Review the client's financial information (i.e. year-end and interim financial statements).
  • Check the client's references (i.e. banks and lawyers).

The following types of clients may require additional risk-opportunity assessment before accepting an engagement:

  • Clients with poor record-keeping habits.
  • Litigious clients (i.e. clients with a history of suing).
  • Clients and/or engagements that will cause your firm any conflict of interest (actual or potential).
  • Clients involved in a risky business that increases your liability.
  • Clients with a poor financial track record (i.e. bankruptcies, failed businesses).
  • Clients involved in major disputes.

About Camico –

CAMICO is a mutual liability insurance company, owned by its policyholders. In a mutual, any monies remaining after payment of claims and operating costs belong to the policyholders. For example, CAMICO declared dividends of $1.9 million in 1997, $2.3 million in 1998, $2.5 million in 1999 and $2.4 million in 2000. Since its inception CAMICO has worked towards building a stable and financially sound company to fulfill the insurance needs for CPAs. CAMICO's net worth is made up of funds that are held in reserve (called "surplus") to meet regulatory requirements, to sustain a sound financial rating from agencies such as A.M. Best, and, most importantly, to cover claims made against policyholders.

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