Balance sheet becomes breeding ground for fraud.

The balance sheet used to be the backwater of financial statement fraud. Now, though, balance sheet frauds have become more complex and the potential rewards much greater as the balance sheet has grown in importance and as the fraudsters have devised more sophisticated ways to implement their schemes.

A balance sheet represents a firm's financial position as of a certain date. Under GAAP, most assets on a balance sheet are recorded at their original historical cost and, absent an impairment, are not adjusted as their market values change. Through the urging of the SEC, though, accounting standards-setters over the last decade have moved closer to reflecting values for assets and liabilities at current prices, especially if the values of those assets and liabilities are volatile and subject to significant change over short periods of time.

For example, securities held in trading accounts and financial derivatives are now marked to their market values. Even presumably less volatile assets such as plant and equipment, under certain circumstances, can be written down (though not up) to fair value under FAS 121 and its recent successor, FAS 144. Thus the balance sheet, with some justification, has gained more importance as it has become a more accurate reflection of current values of assets and liabilities. Lenders and investors, then, have come to place more reliance on the balance sheet. Indeed, numerous academic studies have tracked the relationship between a firm's book value (i.e., its shareholders' equity as reflected on its balance sheet) and its market value and found that book value contains meaningful information for investors looking for undervalued stocks.

Fraudsters manipulate balance sheets either directly through the booking of incorrect accounting entries or indirectly by keeping transactions off the books entirely. The latter category, the indirect method, has grown significantly in sophistication and importance.

The motives for balance-sheet manipulation frequently relate to reporting requirements established by lenders, rating agencies and regulators who tend to focus more heavily on balance-sheet items. A typical bank revolving loan covenant, for example, may set out the following requirements: a minimum amount of shareholders' equity, a maximum debt-to-equity ratio, and/or a minimum current ratio.

If the borrowing company's balance-sheet accounts violate the loan covenants, two events occur: the firm may be in default under the terms of the loan and subject to accelerated repayment of the loan, and the firm may be precluded from any future loan advances.

Therefore, the fraudster may wish to increase the stated value of short-term assets, such as receivables and inventory, in order to improve a current ratio. Or, the fraudster may need to keep the debt-to-equity ratio down by not recording liabilities.

Charles R. Lundelius, Jr., CPA/ASV, is a senior managing director with FTI Consulting Inc., in Washington, DC. This is adapted from "Financial Reporting Fraud: A Practical Guide to Detection and Internal Controls," 2003, AICPA.