What is accounting fraud? Explanation of Fraud Cases, Causes, Prevention Measures and Investigation Responses

Accounting irregularities that occur within a company can cause serious financial loss and loss of confidence in the company. This article provides a definition of accounting fraud, its risks, preventive measures to prevent it from occurring, and effective investigative responses when it does occur.

Definition of accounting irregularities and the difference between window dressing and improper accounting

What is accounting irregularities and why do they occur? Basic definitions and issues will be explained.

What is accounting irregularities?

Fraudulent accounting is the intentional falsification of financial information prepared by a company. It is the act of falsifying financial status by recording fictitious sales or expenses or by concealing information necessary to properly understand the state of the business.

Difference from improper accounting and window dressing

Similar terms to accounting irregularities include improper accounting and window dressing. The difference between improper accounting and fraudulent accounting is that improper accounting involves human errors, such as mistakes or lack of knowledge on the part of the person in charge, whether intentional or unintentional.

Window dressing is the same as fraudulent accounting in that it intentionally falsifies financial conditions, but it differs in that it refers only to the act of making business conditions appear better than they actually are. Conversely, the act of making it appear that profits are not being generated is called reverse window dressing.

Background and causes of accounting irregularities

The most common motive for accounting irregularities is to conceal distrust in management. In order to avoid losing access to loans on favorable terms from financial institutions or being held accountable by shareholders, companies try to make it appear that they are in good business condition.

Conversely, the reason for falsifying the financial statements to make them appear unprofitable is to reduce the amount of taxes paid. They make it look as if profits are decreasing by reducing sales and padding expenses.

These motives, combined with an environment in which fraud can occur due to inadequate oversight and other factors, and an ethos of justification that all companies do what they do, lead to accounting fraud.

Risks and Impact of Accounting Fraud on Companies

Accounting irregularities can result in criminal and civil liability. Criminal liability may include charges of fraud and illegal dividend payments. In terms of civil liability, the company may be sued for damages by a third party, such as a bank that was forced to provide a loan based on false financial conditions, or a shareholder whose stock price has plummeted.

If the taxpayer declares less tax due to a mistake or misunderstanding, an additional tax for underreporting will be imposed. If the taxpayer is found to have maliciously evaded tax, as in the case of accounting irregularities, a heavy additional tax at an even higher rate will be imposed.

In addition to the economic loss, the company loses social credibility as a company that has committed illegal acts. This can lead to a situation that threatens the very existence of the company, such as the inability to obtain loans from banks and other financial institutions.

Actual cases of accounting irregularities at listed companies in Japan

What kind of accounting irregularities have actually occurred? Here are some examples from data published by the Financial Services Agency.

Overstatement of sales by a subsidiary (TSE First Section, service industry)

Company A (a subsidiary of Company C), a sales and maintenance company for copiers and other equipment, and Company B, an equipment rental company, had an agreement that Company B would install copiers and other equipment at its stores and pay Company A for the equipment. However, Company A posted fictitious sales on the premise that it would compensate Company B for the rental fees, disguising the installation of the equipment in its stores. Other accounting irregularities included fictitious recording of unearned sales and understatement of cost of sales due to unrecorded purchases.

As a result, Company C, the parent company of Company A, recorded excessive net income. The Securities and Exchange Surveillance Commission issued a recommendation for the payment of a surcharge of 35.65 million yen.

The reasons for the surcharge were alleged to be inadequate governance of Company C's subsidiaries, a lack of understanding of the business model, and an over-emphasis on budget and performance management.

Overstatement of sales (TSE Second Section, outsourcing services industry)

Company D, which provides call center services on a contract basis, padded its operating hours by pretending that operators who were absent from work were at work. By overcharging clients, the company overstated its sales. The watchdog recommended a surcharge payment order of 12 million yen.

The reason for this was that the call center lacked awareness of the need to comply with "operation and management rules" governing day-to-day business operations, and that the management division also relied on incorrect data provided by the on-site manager in billing sales.

Understatement of cost of sales, etc. (First Section of the Tokyo Stock Exchange, electrical equipment industry)

Under the direction of a highly influential accountant at the time, Company E had engaged in a long and wide range of fraudulent accounting procedures, including understatement of cost of sales by recording fictitious year-end inventories, and had posted excessive net income and net assets. The watchdog recommended a surcharge payment order in the amount of 2,163,334,996 yen.

The reasons for this were the concentration of accounting authority in the hands of a single person, a corporate culture that placed little emphasis on proper accounting procedures, and inadequate internal checks.

(Source: Financial Services Agency, "Disclosure Inspection Casebook," https://www.fsa.go.jp/sesc/jirei/kaiji/20210730/1.pdf )

Measures to prevent accounting irregularities

How can accounting irregularities be prevented? This section explains the measures that companies should take.

Strengthening the internal control system and its importance

Strengthening the internal monitoring system is extremely important. Instead of concentrating authority in the hands of a single person, a system should be established in which roles are assigned and transactions and contracts are mutually checked. It is also effective to establish an audit department as part of the monitoring system. In this case, the audit department should be independent from the company, with the authority to investigate even directors and officers without limitation.

Establishment of a whistleblower/whistleblower system

The whistleblower system is a system to set up a contact point for directors, officers, employees, etc. to encourage reporting of illegal activities within the company. The longer it takes to uncover accounting irregularities, the more common they become and the larger they become. Having an internal whistleblower system in place will serve as a deterrent to fraud and lead to early detection. In such cases, it is important to establish a system that includes protection for whistleblowers so that they can feel comfortable in making a report.

Compliance education for management and employees, fostering a culture that does not tolerate misconduct

Compliance training for management and employees is also effective. Making them aware that accounting irregularities are criminal acts and punishable under criminal law will serve as a deterrent. Letting them know that it is a major blow to the company's management will also encourage employees to whistleblow. Make sure that the entire company is aware that misconduct will not be tolerated, and let them know about the consultation service and where they can file a complaint.

Establish and strengthen a system for consultation with outside experts.

If employees are aware that if anything suspicious is found, it will be thoroughly investigated, it will serve as a deterrent to fraud. It is also effective to consult with an investigation company that can conduct forensic investigations to collect and analyze financial and transactional data, so that you can immediately cooperate with the company if something goes wrong.

→ What is the Whistleblower System (Whistleblower System)? Explanation of the benefits of introducing the system and the process of handling whistleblowing.

Forensic Investigation" is Indispensable for Investigating Accounting Fraud

When accounting fraud is suspected, a forensic investigation by a professional investigation company is effective. The following is a detailed explanation of what kind of investigation it is and how effective it is.

What is a forensic investigation?

It is a forensic investigation that collects and analyzes information related to a case to reveal evidence of criminal or fraudulent activity. By determining the cause of the crime, measures can be taken to prevent recurrence, and by clarifying responsibility, it is possible to prepare for litigation should it develop into a lawsuit.

Why Digital Forensic Investigations are Effective in Accounting Fraud Investigations

Digital forensics, a branch of forensic science, is an investigation that collects and analyzes data stored on digital devices in order to uncover evidence of crime or fraud. When accounting irregularities are suspected, evidence of hidden backroom deals and money movements must be found. Since evidence of fraud often comes not only from documents but also from electronic data such as emails and chats, digital forensics is effective in analyzing them.

Financial data and documents, emails, chats, call logs, and other evidence must be preserved.

If documents, e-mails, chats or call logs have already been deleted, they need to be restored from backups or the data needs to be restored. Requires the expertise and knowledge of an investigative firm specializing in digital forensic investigations.

Efficient forensic investigation using AI

The use of AI (Artificial Intelligence) is an essential tool in modern forensic investigations that deal with huge amounts of data. Utilizing AI, which excels at analyzing large volumes of data, not only makes investigations more efficient, but also improves the accuracy of investigations by allowing specialists to focus their resources.

→ What is forensic investigation? Explanation of necessary cases, cautions, and examples

Points to keep in mind when requesting an investigation of accounting irregularities

Important points and selection criteria when requesting a forensic investigation of accounting irregularities to a professional investigation company are explained.

Key Points in Selecting a Forensic Investigation Company

When selecting an investigation company, the key factors are the tools and technical capabilities used by the investigation company, as well as past investigation results. The results of an investigation will vary depending on the facilities of the investigation company and the proficiency of its engineers. The use of AI is also important.

A company with a large number of survey results will be able to select the appropriate method for each case and respond at a reasonable cost, since it has accumulated high technical capabilities and know-how in data recovery. In particular, whether the company has a track record of requests from listed companies, the police, or government agencies is an important factor in determining reliability.

Costs at the time of request and how to determine them

Forensic investigations require a high level of expertise. When a vendor is hired to conduct a forensic investigation, the cost includes the cost of data processing and retrieval, as well as the analysis and analysis (review) of the potential evidence and data hosting, with the review process usually accounting for the majority of the cost. The final amount varies greatly depending on the scope and content of the investigation, and can range from tens of thousands of yen to several million yen.

Furthermore, awareness of the use of AI in surveys has recently been spreading, and significant cost advantages can be gained by utilizing AI to dramatically improve the efficiency of surveys. When gathering estimates, be sure to ask for the total cost, including AI and review, and compare not only the unit cost but also the overall cost.

For accounting fraud investigations, leave it to FRONTEO, the leading forensic investigation company!

FRONTEO, which boasts a wealth of experience in fraud investigations, is strong in its ability to propose and investigate solutions by responding to incidents speedily and leading to resolution.

In today's forensic investigations, the use of AI (Artificial Intelligence) is essential to handle huge amounts of digital data, and FRONTEO can quickly process large volumes of data using its self-developed AI engine. FRONTEO also has in-house developed software to handle a wide range of cases, enabling us to conduct forensic investigations quickly and at a high cost-performance ratio.

We are also fully capable of handling difficult investigations based on the knowledge we have gained from our overwhelming number of cases, and we respond quickly in case of emergency. We strive to minimize damage and prevent recurrence.

→ For inquiries about forensic investigation, please contact us.

→ FRONTEO's Forensic Investigation Service page

→ What is an internal fraud investigation? Introducing common fraud techniques, how to respond to them, and examples of investigations.