On Dec. 2, 2001, energy behemoth Enron shocked the world with its widely-publicized bankruptcy after the firm was busted for committing egregious accounting fraud. Its dubious tactics were aimed at artificially improving the appearance of the firm's financial outlook by creating off-balance-sheet special purpose vehicles (SPVs) that hid liabilities and inflated earnings. But in late 2000, The Wall Street Journal caught wind of the firm's shady dealings, which ultimately led to the then-largest U.S. bankruptcy in history. And after the dust settled, a new regulatory infrastructure was created to mitigate future fraudulent dealings.
- Financial statement fraud occurs when corporations misrepresent or deceive investors into believing that they are more profitable than they actually are.
- Enron's 2001 bankruptcy in 2001 led to the creation of the Sarbanes-Oxley Act of 2002, which expands reporting requirements for all U.S. public companies.
- Tell-tale signs of accounting fraud include growing revenues without a corresponding growth in cash flows, consistent sales growth while competitors are struggling, and a significant surge in a company's performance within the final reporting period of the fiscal year.
- There are a few methods to inconsistencies, including vertical and horizontal financial statement analysis or by using the total assets as a comparison benchmark.
Detecting Financial Statement Fraud
What Is Financial Statement Fraud?
The Association of Certified Fraud Examiners (ACFE) defines accounting 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." Put simply, financial statement fraud occurs when a company alters the figures on its financial statements to make it appear more profitable than it actually is, which is what happened in the case of Enron.
Financial statement fraud is a deliberate action wherein an individual "cooks the books" to either mislead investors.
According to the ACFE, financial statement fraud is the least common type of fraud in the corporate world, accounting for only 10% of detected cases. But when it does occur, it is the most costly type of crime, resulting in a median loss of $954,000. Compare this to the most common and least costly type of fraud—asset misappropriation, which accounts for 85% of cases and a median loss of only $100,000. Nearly one-third of all fraud cases were the result of insufficient internal controls. About half of all the fraud reported in the world were executed 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 major threats that contribute to white-collar crime. The agency states that most cases involve accounting schemes where share 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's the outright fabrication of statements. This most famously occurred when disgraced investment advisor Bernie Madoff collectively bilked some 4,800 clients out of nearly $65 billion by conducting an elaborate Ponzi scheme that involved wholly falsifying account statements.
Financial statement fraud can take multiple forms, including:
- Overstating revenues by recording future expected sales
- Inflating an asset's net worth by knowingly failing to apply an appropriate depreciation schedule
- Hiding obligations and/or liabilities from a company's balance sheet
- Incorrectly disclosing related-party transactions and structured finance deals
Another type of financial statement fraud involves cookie-jar accounting practices, where firms understate revenues in one accounting period and maintain them as a reserve for future periods with worse performances, in a broader effort to temper the appearance of volatility.
The Sarbanes-Oxley Act of 2002
The Sarbanes-Oxley Act of 2002 is a federal law that expands reporting requirements for all U.S. public company boards, management, and public accounting firms. The Act, often abbreviated as Sarbanes–Oxley or SOX, was established by Congress to ensure that companies report their financials honestly and to protect investors.
The rules and policies outlined in SOX are enforced by the Securities and Exchange Commission (SEC) and broadly focus on the following principal areas:
- Corporate responsibility
- Increased criminal punishment
- Accounting regulation
- New protections
The law is not voluntary., which means that all companies must comply. Those that don't adhere to the are subject to fines, penalties, and even prosecution.
Financial Statement Fraud Red Flags
Financial statement red flags can signal potentially fraudulent practices. The most common warning signs include:
- Accounting anomalies, such as growing revenues without a corresponding growth in cash flows.
- Consistent sales growth while competitors are struggling.
- A significant surge in a company's performance within the final reporting period of a fiscal year.
- Depreciation methods and estimates of assets' useful life that don't correspond to those of the overall industry.
- Weak internal corporate governance, which increases the likelihood of financial statement fraud occurring unchecked.
- Outsized frequency of complex third-party transactions, many of which do not add tangible value, and can be used to conceal balance sheet debt.
- The sudden replacement of an auditor resulting in missing paperwork.
- A disproportionate amount of management compensation derived from bonuses based on short-term targets, which incentivizes fraud.
Financial Statement Fraud Detection Methods
While spotting red flags is difficult, 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.
Comparative ratio analysis likewise helps analysts and auditors spot accounting irregularities. 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, including asset quality, depreciation, gross margin, and leverage. After combining the variables into 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 put laws in place that make sure companies report their financials truthfully while protecting the best interests of investors. But while there are protections in place, it also helps that investors know what they need to look out for when reviewing a company's financial statements. Knowing the red flags can help individuals detect unscrupulous accounting practices and stay one step ahead of bad actors attempting to hide losses, launder money, or otherwise defraud unsuspecting investors.