On December 2, 2001, energy behemoth Enron Corporation shocked the world with its widely-publicized bankruptcy, after the firm was busted for committing egregious accounting fraud. Its many dubious methodologies were aimed at artificially improving the appearance of the firm's financial outlook by creating off-balance sheet special purpose vehicles 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.

Key Takeaways

  • After energy stalwart, Enron Corporation declared bankruptcy in 2001 in the wake of massive balance sheet irregularities, the Sarbanes-Oxley Act of 2002 was created to expand reporting requirements for all U.S. public companies, in an effort to reduce accounting fraud.
  • Sarbanes-Oxley aims to supplement existing laws dealing with security regulation, including the Securities Exchange Act of 1934.
  • 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.
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Detecting Financial Statement Fraud

Sarbanes-Oxley

The Sarbanes-Oxley Act of 2002 (often abbreviated as Sarbanes–Oxley or SOX) is a federal U.S. law that expanded reporting requirements for all U.S. public company boards, management, and public accounting firms. The rules and policies outlined in SOX are enforced by the Securities and Exchange Commission (SEC) and broadly focus on the following principal areas:

  1. Corporate responsibility
  2. Increased criminal punishment
  3. Accounting regulation
  4. New protections

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." 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/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.

And then there's the outright fabrication of statements. This most famously occurred when disgraced investment advisor Bernard 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 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.

Financial statement fraud represents approximately 10% of all white-collar crimes.

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

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.