On December 2, 2001, energy giant Enron shocked the world with its widely publicized bankruptcy after the company was dismantled for committing blatant accounting fraud.His dubious tactics were aimed at artificially improving the appearance of the company’s financial outlook by creating off-balance sheet reception structures (SPVs) that masked liabilities and inflated profits. But at the end of 2000, the Wall Street Journal heard of the company’s shady transactions, which ultimately led to the largest American bankruptcy in the history 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.
- Enron’s bankruptcy in 2001 led to the creation of the Sarbanes-Oxley Act of 2002, which extends the reporting requirements for all U.S. public companies.
- Tell-tale signs of accounting fraud include growing revenues without a corresponding increase in cash flow, steady growth in sales as competitors struggle, and a significant increase in a company’s performance over the last reporting period of the year. ‘exercise.
- There are a few methods of correcting inconsistencies, including vertical and horizontal analysis of financial statements or using total assets as a benchmark.
Detect financial statement fraud
What is financial statement fraud?
The Association of Certified Fraud Examiners (ACFE) defines accounting fraud as “a deception or misrepresentation made by an individual or entity knowing that the misrepresentation could result in an unauthorized advantage for the individual or for the entity or an other part “. Simply put, financial statement fraud occurs when a company changes the numbers in its financial statements to make them appear more profitable than they actually are, which has happened in the case of Enron.
Financial statement fraud is a deliberate action in which an individual “prepares the books” to mislead investors.
According to ACFE, financial statement fraud is the least common type of fraud in the corporate world, accounting for only 10% of 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 expensive type of fraud, asset embezzlement, which accounts for 85% of cases and a median loss of just $ 100,000.Almost a third of all fraud cases were the result of insufficient internal controls.About half of all reported fraud globally was carried out in the United States and Canada, with a total of 895 reported cases or 46%.
The FBI counts corporate fraud, including financial statement fraud, among the top threats that contribute to white-collar crime. The agency says most cases involve accounting schemes in which stock prices, financial data and other valuation methods are manipulated to make a public company appear more profitable.
Types of financial statement fraud
And then there is the outright fabrication of statements. This, for example, happened when disgraced investment adviser Bernie Madoff collectively defrauded some 4,800 clients out of nearly $ 65 billion by carrying out an elaborate Ponzi scheme that involved a complete forgery of account statements.
Financial statement fraud can take many forms, including:
Another type of financial statement fraud involves cookie-junk accounting practices, where companies underestimate the revenue from an accounting period and hold it in reserve for future periods with poorer performance, in a larger effort. to mitigate the appearance of volatility.
The Sarbanes-Oxley Act of 2002
The Sarbanes-Oxley Act of 2002 is federal law that extends the reporting requirements for all boards of directors of public companies, management companies, and public accounting firms in the United States. The law, often shortened to Sarbanes-Oxley or SOX, was established by Congress to ensure that companies honestly report their financial data and to protect investors.
The rules and policies described in SOX are enforced by the Securities and Exchange Commission (SEC) and generally focus on the following main areas:
- Corporate responsibility
- Increase in criminal penalties
- Accounting regulations
- New protections
The law is not voluntary, which means all businesses must comply.Those who do not join face fines, penalties and even prosecution.
Red flags on financial statement fraud
Red flags in financial statements can signal potentially fraudulent practices. The most common warning signs include:
- Accounting anomalies, such as revenue growth without a corresponding growth in cash flow.
- Steady growth in sales while competitors are struggling.
- A significant increase in a company’s performance during the last reporting period of a fiscal year.
- Depreciation methods and estimated useful lives of assets that do not match those of the industry as a whole.
- Poor internal corporate governance, which increases the likelihood of financial statement fraud occurring without control.
- Inordinate frequency of complex transactions with third parties, many of which do not add tangible value and can be used to hide balance sheet debt.
- The sudden replacement of an auditor resulting in missing documents.
- A disproportionate amount of executive compensation derived from bonuses based on short-term objectives, which encourages fraud.
Financial statement fraud detection methods
While it is difficult to spot red flags, vertical and horizontal analysis of financial statements introduces a straightforward approach to fraud detection. Vertical analysis involves taking each item of the income statement as a percentage of revenue and comparing trends year over year that could be a potential cause for concern.
A similar approach can also be applied to the balance sheet, using total assets as a benchmark, to monitor significant deviations from normal activity. Horizontal analysis implements a similar approach, whereby rather than having an account as a benchmark, financial information is represented as a percentage of base year numbers.
Benchmarking ratios also helps analysts and auditors spot accounting irregularities. By analyzing ratios, information regarding daily receivables sales, 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, including asset quality, depreciation, gross margin, and leverage. After combining the variables in the model, an M-score is calculated. A value greater than -2.22 warrants further investigation, while an M score less than -2.22 suggests that the company is not a manipulator.
The bottom line
Federal authorities have laws in place that ensure companies report their financial data truthfully while protecting the best interests of investors. But while there are protections, 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 who try to hide losses, launder money or defraud unsuspecting investors.