The Southbourne Tax Group: Detecting Financial Statement Fraud

Looking back at Enron, perhaps the company best known for committing accounting fraud, you can see the many methods that were utilized in order to fraudulently improve the appearance of its financial statements. Through the use of off balance sheet special purpose vehicles the firm continued to hide its liabilities and inflate its earnings. In 1999, limited partnerships were created for the purpose of purchasing Enron shares as a mean of improving performance of its stock. That year, the company returned 56% to its shareholders, which was followed by another 87% appreciation at the onset of the new millennium. As Enron's aggressive accounting practices and financial statement manipulation began to spiral out of control, the scandal was eventually uncovered by the Wall Street Journal. Shortly after, on December 2, 2001 Enron filed for Chapter 11 in what was the largest U.S. bankruptcy in history … only to be surpassed by WorldCom less than a year later.

Complex accounting fraud such as that practiced at Enron is usually extremely difficult for the average retail investor to discover. However, there are some basic red flags that help during the preliminary stages of the investigation. After all, the Enron fraud was not exposed by high paid Ivy League MBA holding Wall Street analysts, but by news reporters who used journal articles and public filings in their due diligence process. Despite passage of Sarbanes-Oxley, financial statement fraud remains too common an occurrence, often damaging people's retirement and educational savings. Being first on the scene to uncover a fraudulent company can be very lucrative from a short seller's perspective and can be rather beneficial to a skeptical investor who is weighing in the overall market sentiment. (After the infamous collapse of companies like Tyco, Enron and WorldCom, the government responded to try and prevent it from happening again.

What Is Financial Statement Fraud?

According to a study conducted by the Association of Certified Fraud Examiners (ACFE), fraudulent financial statement accounts for approximately 10% of incidents concerning white collar crime. Asset misappropriation and corruption tend to occur at a much greater frequency, yet the financial impact of these latter crimes is much less severe. ACFE defines fraud as "deception or misrepresentation that an individual or entity makes knowing that the misrepresentation could result in some unauthorized benefit to the individual or to the entity or some other party." Greed and work pressure are the most common factors pushing management to deceive investors and creditors.

Financial statement fraud can surface in many different forms, although once deceptive accounting practices are initiated, various systems of manipulation will be utilized to maintain the appearance of sustainability. Common approaches to artificially improving the appearance of the financials include: overstating revenues by recording future expected sales, understating expenses through such means as capitalizing operating expenses, inflating assets' net worth by knowingly failing to apply an appropriate depreciation schedule, hiding obligations off of the company's balance sheet and incorrect disclosure of related party transactions and structured finance deals. Another alternative to financial statement fraud involves cookie-jar accounting practices, a procedure by which a firm will understate revenues in one accounting period and maintain them as a reserve for future periods with worse performance. Such procedures remove the appearance of volatility from the operations.

Financial Statement Fraud Red Flags

Financial statement red flags provide a general overview of the warning signs investors should take note of. They do not necessarily indicate an undoubted occurrence of financial statement fraud, but merely signal that further in-depth research must be conducted to assess the validity of the corporate documents. Creditors would find such information useful to ensure that loans are not provided to firms operating with an elevated amount of risk. Investors, on the other hand, may want to take note of the following factors to discover new shorting opportunities. Government regulators, however, aim to catch and punish fraud to ensure the transparency and reliability of the financial markets.

Five basic types of financial statement fraud exist:

• fictitious sales
• improper expense recognition
• incorrect asset valuation
• hidden liabilities and
• unsuitable disclosures

Effectively spotting these fraudulent disclosures involves keeping an open eye for the most common financial statement fraud red flags:

• Accounting anomalies, such as growing revenues without a corresponding growth in cash flows. Sales are much easier to manipulate than cash flow but the two should move more or less in tandem over time.
• Consistent sales growth while established competitors are experiencing periods of weak performance. Note that this may be due to efficient business operations rather than fraudulent activity.
• A rapid and unexplainable rise in the number of day's sales in receivables in addition to growing inventories. This suggests obsolete goods for which the firm records fictitious future sales.
• A significant surge in the company's performance within the final reporting period of fiscal year. The company may be under immense pressure to meet analysts' expectations.
• The company maintains consistent gross profit margins while its industry is facing pricing pressure. This can potentially indicate failure to recognize expenses or aggressive revenue recognition.
• A large buildup of fixed assets. An unexpected accumulation of fixed assets can flag the usage of operating expense capitalization, rather than expense recognition.
• Depreciation methods and estimates of assets' useful life that do not correspond to the overall industry. An overstated life of an asset will decrease the annual depreciation expense.
• A weak system of internal control. Strong corporate governance and internal controls processes minimize the likelihood that financial statement fraud will go unnoticed.
• Outsized frequency of complex related-party or third-party transactions, many of which do not add tangible value (can be used to conceal debt off the balance sheet).
• The firm is on the brink of breaching their debt covenants. To avoid technical default, management may be forced to fraudulently adjust its leverage ratios.
• The auditor was replaced, resulting in a missed accounting period. Auditor replacement can signal a dysfunctional relationship while missed accounting period provides extra time to "fix" financials.
• A disproportionate amount of managements' compensation is derived from bonuses based on short term targets. This provides incentive to commit fraud.
• Something just feels off about the corporation's business model, financial statements or operations

Financial Statement Fraud Detection Methods

Spotting red flags can be extremely challenging as firms that are engaged in fraudulent activities will attempt to portray the image of financial stability and normal business operations. Vertical and horizontal financial statement analysis introduces a straightforward approach to fraud detection. Vertical analysis involves taking every item in the income statement as a percentage of revenue and comparing the year-over-year trends that could be a potential flag cause of concern. A similar approach can also be applied to the balance sheet, using total assets as the comparison benchmark, to monitor significant deviations from normal activity. Horizontal analysis implements a similar approach whereby rather than having an account serve as the point of reference, financial information is represented as a percentage of the base years' figures. Likewise, unexplainable variations in percentages can serve as a red flag requiring further analysis.

Comparative ratio analysis also allows analysts and auditors to spot discrepancies within the firm's financial statements. By analyzing ratios, information regarding day's sales in receivables, leverage multiples and other vital metrics can be determined and analyzed for inconsistencies. A mathematical approach, known as the Beneish Model, evaluates eight ratios to determine the likelihood of earnings manipulation. Asset quality, depreciation, gross margin, leverage and other variables are factored into the analysis. Combining the variables into the model, an M-score is calculated; a value greater than -2.22 warrants further investigation as the firm may be manipulating its earnings while an M-score less than -2.22 suggests that the company is not a manipulator Similar to most other ratio-related strategies, the full picture can only be accurately portrayed once the multiples are compared to the industry and to the specific firm's historical average. (Learn why this ratio may be a good alternative to the current, cash and quick ratios.

The Bottom Line

In the spring of 2000 financial fraud investigator Harry Markopolos approached the SEC, claiming that the wealth management business of Bernard Madoff was fraudulent. After modeling Madoff's portfolio, Markopolos realized that the consistent returns achieved by Madoff were impossible. For example, according to an interview with the Certified Fraud Investigator, he "concluded that for Madoff to execute the trading strategy he said he was using he would have had to buy more options on the Chicago Board Options Exchange than actually existed." Although, Markopolos' warnings went unnoticed, in 2009 Madoff was charged with operating a $65 billion Ponzi scheme.

Instances such as this are rare since fraudulent behavior is often caught before it has a chance to escalate to such levels. Having proper knowledge of the red flags to avoid companies indulging in unscrupulous accounting practices is a useful tool to ensure the safety of your investments.