Be alert to the signals of financial statement fraud

Financial statement fraud has been defined as the deliberate misrepresentation of the financial health of the company – either by intentional misstatements or omission of dollar amounts within the company’s financial statement.

Without access to the internal books of the company, it’s difficult for an outside user to detect fraud.

But there are certain signals or red flags that indicate something in the company is out of the ordinary and needs to be investigated further.

The more red flags encountered, the higher the possibility that a fraud watch has turned into a fraud warning.

So where do you start to look for red flags?

The SEC, at the direction of the Sarbanes-Oxley Act, studied enforcement actions over a five-year period from 1997-2002 “to identify areas of issuer financial reporting that are most susceptible to fraud, inappropriate manipulation, or inappropriate earnings management.”

The SEC determined that out of 227 enforcement investigations during that period, 126 involved improper revenue recognition, and 101 involved improper expense recognition – with some companies engaged in both.

The following were some of the most common improper revenue recognition schemes discovered in the study:

Related Party Transactions Parmalat used special purpose entities (SPEs) to misrepresent debt from SPEs as sales and not as cash from creditors.

Channel stuffing Bristol-Myers Squibb improperly inflated sales by offering discounts if drug stores would purchase more drugs than needed.

Sham sales Enron sold a Nigerian energy barge to Merrill Lynch at the end of one year with a promise to purchase the barge during the beginning of the next year.

Swap sales Global Crossing traded assets with Qwest at inflated revenue values.

Nonrecurring income as operating income Krispy Kreme sold franchises but listed the franchise sales as part of doughnut sales.

Quarters kept open Computer Associates extended reporting periods and backdated license agreements to improve earnings.

There is an old saying that “Cash is king,” but cash may also be a knight in shining armor.

Look at the source of cash – is it from operations?

Many of the transactions listed above resulted in very little cash. Management wanted earnings at all costs. The cash differential from the balance sheet reveals only an increase or decrease in cash, not the source of cash.

That is the purpose of the statement of cash funds flow. The statement is segmented into three sources of cash: operating, investing and financing.

Cash from operating activity provides the needed clues as to the quality of the earnings. If sales are fictitious, it follows that accounts receivable will have to match in fiction as well. Cash is too easily verifiable and thus most fraud perpetrators dare not inflate the cash account.

Enron had $100 billion in revenue in its last full year yet possessed only $1 billion in cash at the end of the year. Simply stated, for every $1 of revenue Enron generated, only 1 cent was held at the end of the year. If net income is higher than cash flow, then this is a clue that something may be amiss.

Most of the public companies that were found to have committed financial statement fraud have one consistent ingredient – the assistance of top management.

Does the tone at the top foster an atmosphere encouraging proper internal controls, or does it foster an atmosphere of increasing earnings at all cost?

The pressure of meeting the numbers causes some managers to cross over the line into the fraud zone. Investors should be diligent in observing how the management tone impacts internal controls.

The red flags in financial statement fraud provide the observer with early warnings that something is amiss. Deeper inquiries are needed and a thorough verification process must be undertaken to complete the necessary due diligence.

Twelve red flags to financial statement fraud

1. Numerous late financial statement filings
2. Frequent restatements of financial statements
3. Disputes between auditors and managers
4. Lack of adequate internal controls
5. Unusual related-party transactions
6. Significant decisions being made by a few individuals or a select group
7. Inexperienced board – few financial experts
8. More inside vs. outside board members
9. Footnotes appearing to alter the accounting methods, estimates and assumptions
10. Compensation agreements indicating bonuses and stock options are awarded based on key financial targets or ratios
11. A thriving firm in a struggling industry
12. Sudden increase in revenues with only a vague explanation provided

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