Detecting Financial Statement Fraud

On December 2, 2001, energy giant Enron shocked the world with its widely publicized bankruptcy after the company was arrested for commit blatant accounting fraud. His questionable tactics were intended to artificially improve the appearance of the company’s financial outlook by creating off-balance sheets special purpose vehicles (SPV) that hid liabilities and inflated profits. But at the end of 2000, the Wall Street Journal caught wind of the company’s shady dealings, which ultimately led to America’s biggest bankruptcy of the time. And once the dust settled, a new regulatory infrastructure was created to mitigate future fraudulent transactions.

Key points to remember

  • Financial statement fraud occurs when companies misrepresent or deceive investors into believing that they are more profitable than they actually are.
  • The bankruptcy of Enron in 2001 led to the creation of the Sarbanes-Oxley Act of 2002, which extends reporting requirements to all US public companies.
  • Telltale signs of accounting fraud include revenue growth with no corresponding growth in cash flow, steady sales growth as competitors struggle, and a significant increase in a company’s performance over the last reporting period. exercise.
  • There are a few methods for inconsistencies, including vertical and horizontal analysis of financial statements or using total assets as a benchmark for comparison.

Detect financial statement fraud

What is Financial Statement Fraud?

The Association of Certified Fraud Examiners (ACFE) defines accounting fraud as “deceit or misrepresentation that an individual or entity makes with the knowledge that the misrepresentation could result in an unauthorized benefit to the individual or entity or another party”. Simply put, financial statement fraud occurs when a company alters the numbers in its financial statements to make it appear more profitable than it actually is, which happened in the case of Enron. .

Financial statement fraud is a deliberate action in which an individual “sets up the books” to mislead investors.

According to the ACFE, financial statement fraud is the least common type of fraud. fraud in the business world, representing only 10% of the cases detected. But when it does occur, it is the costliest type of crime, resulting in a median loss of $954,000. Compare that to the most common and least costly type of fraud: asset misappropriation, which accounts for 85% of cases and a median loss of just $100,000. Nearly a third of all fraud cases resulted from weak internal controls. About half of all fraud reported globally was executed in the United States and Canada, with a total of 895 reported cases, or 46%.

The FBI lists corporate fraud, including financial statement fraud, as a top threat contributing to white collar crime. The agency says most cases involve accounting schemes where stock prices, financial data and other Evaluation methods are manipulated to make a public company appear more profitable.

Types of Financial Statement Fraud

And then there’s the outright fabrication of statements. This, for example, happened when a disgraced investment adviser Bernie Madoff collectively defrauded some 4,800 customers out of nearly $65 billion by conducting an elaborate investigation Ponzi scheme which involved the total falsification of account statements.

Financial statement fraud can take many forms, including:

Another type of financial statement fraud involves cookie jar accounting practices, where companies underestimate revenues in a accounting period and hold them in reserve for future periods with poorer performance, in a broader effort to temper the onset of volatility.

The Sarbanes-Oxley Act of 2002

The Sarbanes-Oxley Act of 2002 is a federal law that extends reporting requirements to all boards of directors, management and accounting firms of US public companies. The law, often shortened to Sarbanes-Oxley or SOX, was established by Congress to ensure that companies report their financial statements honestly and to protect investors.

The rules and policies described in SOX are enforced by the Security and Exchange Commission (SEC) and broadly focus on the following main areas:

  1. Corporate responsibility
  2. Increase in criminal sanctions
  3. Accounting regulations
  4. New protections

The law is not voluntary, which means that all companies must comply with it. Those who do not comply are subject to fines, penalties and even prosecution.

Financial Statement Fraud Red Flags

Financial statement red flags may report potentially fraudulent practices. The most common warning signs include:

  • Accounting anomaliessuch as growing income without corresponding growth cash flow.
  • Steady sales growth as competitors struggle.
  • A significant increase in a company’s performance over the last reporting period of a fiscal year.
  • Depreciation methods and asset estimates’ useful life which do not correspond to those of the whole industry.
  • Weak internal corporate governancewhich increases the likelihood that financial statement fraud will occur unchecked.
  • Disproportionate frequency of complexes transactions with third partiesmany of which do not add tangible valueand can be used to hide balance sheet debt.
  • The sudden replacement of a Listener resulting in missing documents.
  • A disproportionate amount of executive compensation from bonuses based on short term targets, which encourages fraud.

Financial Statement Fraud Detection Methods

If it is difficult to spot the red, vertical and horizontal flags analysis of financial statements introduces a simple approach to fraud detection. Vertical analysis consists of taking each item of the income statement as a percentage of sales and comparing Year after year trends that could be a potential cause for concern.

A similar approach can also be applied to the balance sheet, using total assets as a point of comparison reference, to monitor significant deviations from normal activity. Horizontal analysis implements a similar approach, in which rather than having an account as a reference point, the financial information is represented as a percentage of the figures for the reference years.

Comparative ratio analysis also helps analysts and listeners identify accounting irregularities. By analyzing ratios, information regarding daily receivables sales, leverage multiples, and other critical metrics can be determined and analyzed for inconsistencies.

A mathematical approach known as Benish Model assesses eight ratios to determine the likelihood of earnings manipulation, including asset quality, impairment, Gross marginand leverage. After combining the variables in the model, an M-score is calculated. A value above -2.22 warrants further investigation, while an M score below -2.22 suggests that the company is not a manipulator.

The essential

Federal authorities have laws in place that ensure companies report their financial statements fairly while protecting the best interests of investors. But while there are protections in place, it also helps investors know what to look out for when reviewing a company’s financial statements. Knowing the red flags can help individuals spot unscrupulous accounting practices and stay ahead of bad actors trying to hide losses, launder money, or defraud unsuspecting investors. .