Detect financial statement fraud

After the energy giant Enron was arrested for serious accounting fraud on December 2, 2001, its widely publicized bankruptcy shocked the world.Its dubious strategy aims to artificially improve the appearance of the company’s financial prospects by creating off-balance sheet special purpose vehicles (SPVs) that hide liabilities and exaggerate returns. But in late 2000, the Wall Street Journal Smell of the company’s shady transactions, which eventually led to the largest bankruptcy case in American history at that time.After the dust settled, a new regulatory infrastructure was created to reduce future fraudulent transactions.

Key points

  • Financial statement fraud occurs when companies misrepresent or deceive investors into believing that they are more profitable than they actually are.
  • Enron’s 2001 bankruptcy led to the formulation of the Sarbanes-Oxley Act of 2002, which expanded the reporting requirements for all U.S. listed companies.
  • Obvious signs of accounting fraud include revenue growth without a corresponding increase in cash flow, continued sales growth despite competitors’ struggling, and a substantial increase in the company’s performance during the final reporting period of the fiscal year.
  • There are several ways to resolve inconsistencies, including vertical and horizontal financial statement analysis or using total assets as a benchmark for comparison.

Detect financial statement fraud

What is financial statement fraud?

The Association of Registered Fraud Examiners (ACFE) defines accounting fraud as “deception or misrepresentation made by an individual or entity knowing that the misrepresentation may cause the individual or entity or other parties to obtain unauthorized benefits”. In short, when a company changes the data on its financial statements to make it look more profitable than it actually is, financial statement fraud occurs. This is the case of Enron.

Financial statement fraud is a deliberate act in which individuals “cook” 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 detected cases. But when it did happen, it was the most expensive type of crime, with a median loss of $954,000. Compare this with the most common and lowest-cost type of fraud—asset embezzlement, which accounts for 85% of cases, and the median loss is only $100,000.Nearly one-third of fraud cases are caused by insufficient internal controls.Approximately half of all frauds reported in the world were carried out in the United States and Canada, with a total of 895 reported cases, accounting for 46%.of

The FBI lists corporate fraud (including financial statement fraud) as one of the main threats leading to white-collar crime. The agency said that most of the cases involved accounting plans, in which stock prices, financial data and other valuation methods were manipulated to make listed companies look more profitable.of

Types of financial statement fraud

Then came the completely fabricated statement. For example, when Bernie Madoff, a discredited investment consultant, collectively defrauded approximately 4,800 customers from nearly $65 billion by implementing a carefully planned Ponzi scheme involving completely falsified account statements. This happened.

Financial statement fraud can take many forms, including:

Another type of financial statement fraud involves the same accounting practice, that is, companies underestimate revenue during an accounting period and use it as a reserve for periods of poor performance in the future, with broader efforts to mitigate the emergence of volatility.

Sarbanes-Oxley Act of 2002

The Sarbanes-Oxley Act of 2002 is a federal law that expands the reporting requirements for the boards, management, and public accounting firms of all U.S. public companies. The bill, usually abbreviated as Sarbanes-Oxley or SOX, is enacted by Congress to ensure that companies honestly report their financial status and protect investors.

The rules and policies outlined in SOX are enforced by the U.S. Securities and Exchange Commission (SEC), focusing on the following main areas:

  1. Corporate Responsibility
  2. Aggravated penalties
  3. Accounting supervision
  4. New protection measures

The law is not voluntary. This means that all companies must comply.Those who do not comply will be fined, punished and even prosecuted.

Financial statement fraud red flags

Red flags in financial statements may indicate potential fraud. The most common warning signs include:

  • Accounting anomalies, such as revenue growth without a corresponding increase in cash flow.
  • While competitors are struggling, sales continue to grow.
  • The company’s performance during the final reporting period of a fiscal year has increased significantly.
  • Depreciation methods that are inconsistent with the entire industry and the estimation of the useful life of assets.
  • Weak internal corporate governance, which increases the possibility of unchecked financial statement fraud.
  • The frequency of complex third-party transactions is too high, many of which do not add tangible value and can be used to hide balance sheet debt.
  • The sudden change of auditors resulted in loss of paperwork.
  • Disproportionate management compensation from bonuses based on short-term goals can stimulate fraud.

Financial statement fraud detection method

Although it is difficult to detect red flags, vertical and horizontal financial statement analysis introduces a direct method of fraud detection. Longitudinal analysis involves taking each item in the income statement as a percentage of revenue, and is more likely to become a year-on-year trend that is a potential indicator of concern.

A similar approach can also be applied to balance sheets, using total assets as a benchmark for comparison to monitor major deviations from normal activities. Horizontal analysis uses a similar method, that is, instead of using accounts as a reference point, financial information is expressed as a percentage of the base year’s data.

Comparative ratio analysis also helps analysts and auditors find accounting irregularities. By analyzing the ratio, it is possible to determine and analyze the information about the daily sales of accounts receivable, the leverage ratio and other important indicators, and analyze the inconsistencies.

A mathematical method called the Beneish model evaluates eight ratios to determine the likelihood of earnings manipulation, including asset quality, depreciation, gross profit margin, and leverage. After combining the variables into the model, calculate the M score. Values ​​greater than -2.22 require further investigation, and M-scores less than -2.22 indicate that the company is not a manipulator.

Bottom line

Federal authorities have enacted laws to ensure that companies truthfully report financial conditions while protecting the best interests of investors. However, although there are protective measures, it also helps investors understand what they need to pay attention to when reviewing the company’s financial statements. Understanding red flags can help individuals spot unethical accounting practices and stay one step ahead of bad actors who try to cover up losses, launder money, or otherwise deceive unsuspecting investors.

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