Introduction

Accounting fraud can have devastating consequences for businesses, both financially and legally. By overstating profits, fraudsters can divert valuable resources away from legitimate business activities and make false declarations to government bodies. They may also be liable for tax evasion, fraudulent trading, and other financial crimes.

Every business, even the most meticulously run, makes errors from time to time. But when those mistakes result in accounting fraud, the consequences can be disastrous. In this article, we explore the consequences of overstating profits.

At the end of this article, readers should be able to answer the following questions:

• Why is it bad to overstate profit?

• What happens when profits are overstated?

Background

Businesses frequently paint a positive picture of their operations to attract investors and a select few other stakeholders.

Business owners are extremely insecure about losses or low profits and frequently ask their accountants to create a scenario in which the company is extremely profitable.

Accountants must develop into magicians to make things appear or vanish.

On a related note, the profitability of a business is not related to the accountant’s or finance department’s quality.

Profitability is frequently a result of a complex interplay of factors beyond the control of the individual recording the entries.

While an accountant should have the foresight to recognize when a business is headed for a loss or low profitability and make actionable recommendations to avoid this, this does not guarantee anything.

What exactly is accounting fraud?

Accounting fraud is a crime that occurs when someone dishonestly alters financial statements to misrepresent financial conditions or mislead investors.

Accounting fraud is the fraudulent alteration of a business’s financial statements to misrepresent the business’s actual health or to conceal profits or losses.

Some of the most common types of accounting fraud are intentional overstatement of income, underreporting of expenses, misstatement of assets, misstatement of liabilities, and falsifying financial statements.

One of the most well-known instances of accounting fraud in history is the Enron scandal.

Overstating Profits

There are three ways to overstate the profit of a business:

1. Overstating Sales/Revenue

2. Understating Costs and Expenses

3. Combination of the above

By implementing any of the above, the book profits will appear to be higher than they are.

Overstating revenues

If a business overestimates its income, it may be committing accounting fraud. Assume that company ABC is operating in the red and isn’t earning sufficient income. To conceal the issue, the business may include more revenue on its financial statements than it has earned. The company’s earnings would be boosted by this overstatement. It would increase the company’s share price and create a false picture of financial stability if it overestimates its revenues.

Understating Expenses

When a company fails to record its expenditures, it commits another type of accounting fraud. On the income statement, the company’s net profit appears to be higher than it actually is. This manner of accounting fraud overstates the amount of net income a corporation generates by underreporting expenses incurred.

Consequences of overstating profits

However, as we advise our clients, overstating profits poses a different danger to the business than being misleading and dishonest.

1. Paying tax on unearned profits.

The start point for tax assessment is to file the returns based on the reported figures. For Corporation Income Tax (CIT), the tax is calculated on the profits declared, and if the profits are overstated, the tax figures are automatically increased.

If a company was already experiencing financial difficulties because of losses or low profits, tax liabilities will be added to the mix.

Additionally, there is the Value Added Tax (VAT) to consider. An increase in sales would trigger an increase in VAT due to the government and/or hiding costs/expenses would reduce the chances of claiming input VAT to reduce VAT due.

Imagine paying VAT on sales not made and CIT on profits not earned. Meanwhile, incorporated entities can claim tax benefits for genuine losses, including the ability to carry them forward indefinitely.

2. Paying profit-based compensation

Certain businesses have compensation targets that are linked to the overall performance of the company. Most have them tied to sales numbers. These performance-based payments rise in line with increases in sales and/or profit, but they were not earned.

3. Paying Dividends

Companies and businesses pay out dividends from available profit. It is common for companies that have declared an “exceptionally good year” to declare dividends in situations where the management is not the owners.

This could put additional strain on cash flow, especially if the company was expected to lose money.

Conclusion

Overstating profits can have grave consequences for businesses, both financially and reputation-wise. By knowing the signs of accounting fraud and being strategic in how you handle your finances, you’ll be one step ahead of any fraudulent activity. Stay tuned for more updates on this topic, as we promise to bring you the latest news and developments on this complex and sensitive topic.

Losses or low profitability do occur from time to time, but the solution is not to manipulate the books to reflect something dishonest, which can also have an impact on scarce resources.

It may be more beneficial to take a proactive approach and look at the underlying reasons for the business’s loss.

Contact myCFOng if you need to assess your company’s profitability and develop a strategy for increasing it.