9/6/2019 Detecting Financial Statement Fraud

CORPORATE FINANCE & ACCOUNTING FINANCIAL STATEMENTS

Detecting Financial Statement Fraud

BY ARTHUR PINKASOVITCH | Updated Jun 30, 2019

Looking back at Enron, perhaps the company best known for committing accounting fraud, you
can see the many methods that were utilized in order to improve the appearance of its financial
statements. Through the use of off-balance sheet special purpose vehicles, the firm hid its
liabilities and inflated its earnings. In 1999, limited partnerships were created for the purpose of
purchasing Enron shares as a mean of improving performance of its stock. It all worked for a
while. But Enron's aggressive accounting practices and financial statement manipulation began
to spiral out of control, and its doings were eventually uncovered by The Wall Street Journal.
Shortly after, on December 2, 2001, Enron filed for Chapter 11 in what was the largest U.S.
bankruptcy in history, only to be surpassed by WorldCom less than a year later.

https://www.investopedia.com/articles/financial-theory/11/detecting-financial-fraud.asp 1/11
9/6/2019 Detecting Financial Statement Fraud

The U.S. government responded with preventative measures. Despite passage of the Sarbanes-
Oxley Act – a direct result of the Enron, WorldCom and Tyco scandals – financial statement
improprieties remain too common an occurrence. And complex accounting fraud such as that
practiced at Enron is usually extremely difficult for the average retail investor to discover.
However, there are some basic red flags that help. After all, the Enron fraud was not exposed by
high-paid Ivy League MBA-holding Wall Street analysts, but by news reporters who used journal
articles and public filings in their due diligence process. Being first on the scene to uncover a
fraudulent company can be very lucrative from a short seller's perspective and can be rather
beneficial to a skeptical investor who is weighing in the overall market sentiment.

Advertisement

https://www.investopedia.com/articles/financial-theory/11/detecting-financial-fraud.asp 2/11
9/6/2019 Detecting Financial Statement Fraud

Advertisement

What Is Financial Statement Fraud?

According to a study conducted by the Association of Certified Fraud Examiners (ACFE),
fraudulent financial statement accounts for approximately 10% of incidents concerning white
collar crime. Asset misappropriation and corruption tend to occur at a much greater frequency,
yet the financial impact of these latter crimes is much less severe. ACFE defines 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." Greed and work pressure are the most common factors pushing
management to deceive investors and creditors.

https://www.investopedia.com/articles/financial-theory/11/detecting-financial-fraud.asp 3/11
9/6/2019 Detecting Financial Statement Fraud

Financial statement fraud can surface in many different forms, although once deceptive
accounting practices are initiated, various systems of manipulation will be utilized to maintain
the appearance of sustainability. Common approaches to artificially improving the appearance
of the financials include: overstating revenues by recording future expected sales, understating
expenses through such means as capitalizing operating expenses, inflating assets' net worth by
knowingly failing to apply an appropriate depreciation schedule, hiding obligations off of the
company's balance sheet and incorrect disclosure of related-party transactions and structured
finance deals.

Five basic types of financial statement fraud exist:

Advertisement

https://www.investopedia.com/articles/financial-theory/11/detecting-financial-fraud.asp 4/11
9/6/2019 Detecting Financial Statement Fraud

Advertisement

fictitious sales
improper expense recognition
incorrect asset valuation
hidden liabilities
unsuitable disclosures

https://www.investopedia.com/articles/financial-theory/11/detecting-financial-fraud.asp 5/11
9/6/2019 Detecting Financial Statement Fraud

Another type of financial statement fraud involves cookie-jar accounting practices, a procedure
by which a firm will understate revenues in one accounting period and maintain them as a
reserve for future periods with worse performance. Such procedures remove the appearance of
volatility from the operations.

And then, of course, there is the total fabrication of statements. In the spring of 2000, financial
fraud investigator Harry Markopolos approached the SEC, claiming that the $65 billion wealth
management business of Bernard Madoff was fraudulent. After modeling Madoff's portfolio,
Markopolos realized that the consistent returns achieved were impossible. For example,
according to an interview with the Certified Fraud Investigator, he "concluded that for Madoff to
execute the trading strategy he said he was using he would have had to buy more options on
the Chicago Board Options Exchange than actually existed." Fortunately, this sort of fraud is
pretty rare.

Detecting Financial Statement Fraud

https://www.investopedia.com/articles/financial-theory/11/detecting-financial-fraud.asp 6/11
9/6/2019 Detecting Financial Statement Fraud
Detecting Financial Statement Fraud

Financial Statement Fraud Red Flags

Financial statement red flags provide a general overview of the warning signs investors should
take note of. They do not necessarily indicate an occurrence of financial statement fraud, but
merely signal that further in-depth research must be conducted to assess the validity of the
corporate documents. Creditors would find such information useful to ensure that loans are not
provided to firms operating with an elevated amount of risk. Investors, on the other hand, may
want to take note of the following factors to discover new shorting opportunities.

The most common financial statement fraud red flags:

Accounting anomalies, such as growing revenues without a corresponding growth in cash

flows. Sales are much easier to manipulate than cash flow but the two should move more or
less in tandem over time.
Consistent sales growth while established competitors are experiencing periods of weak
performance. Of course, this may be due to efficient business operations rather than
fraudulent activity.
A rapid and unexplainable rise in the number of day's sales in receivables in addition to
growing inventories. This suggests obsolete goods for which the firm records fictitious future
sales.
A significant surge in the company's performance within the final reporting period of fiscal
year. The company may be under immense pressure to meet analysts' expectations.
The company maintains consistent gross profit margins while its industry is facing pricing
pressure. This can potentially indicate failure to recognize expenses or aggressive revenue
recognition.
A large buildup of fixed assets. An unexpected accumulation of fixed assets can flag the
usage of operating expense capitalization, rather than expense recognition.

Depreciation methods and estimates of assets' useful life that do not correspond to those of
the overall industry. An overstated life of an asset will decrease the annual depreciation
expense.
A weak system of internal control. Strong corporate governance and internal controls
processes minimize the likelihood that financial statement fraud will go unnoticed.
Outsized frequency of complex related-party or third-party transactions, many of which do
not add tangible value (can be used to conceal debt off the balance sheet).
The firm is on the brink of breaching their debt covenants. To avoid technical default,
management may be forced to fraudulently adjust its leverage ratios.
https://www.investopedia.com/articles/financial-theory/11/detecting-financial-fraud.asp 7/11
9/6/2019 Detecting Financial Statement Fraud
management may be forced to fraudulently adjust its leverage ratios.

The auditor was replaced, resulting in a missed accounting period. Auditor replacement can
signal a dysfunctional relationship while missed accounting period provides extra time to
"fix" financials.
A disproportionate amount of management compensation is derived from bonuses based
on short term targets. This provides incentive to commit fraud.

Something just feels off about the corporation's business model, financial statements or
operations

Financial Statement Fraud Detection Methods

Spotting red flags can be extremely challenging as firms that are engaged in fraudulent
activities will attempt to portray the image of financial stability and normal business
operations. 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 asAdvertisement
the point of reference, financial information is represented as a percentage of
the base years' figures. Likewise, unexplainable variations in percentages can serve as a red flag
requiring further analysis.

Comparative ratio analysis also allows analysts and auditors to spot discrepancies within the
firm's financial statements. 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. Asset quality, depreciation, gross margin, leverage, and
other variables are factored into the analysis. Combining the variables into the model, an M-
score is calculated; a value greater than -2.22 warrants further investigation as the firm may be
manipulating its earnings while an M-score less than -2.22 suggests that the company is not a
manipulator Similar to most other ratio-related strategies, the full picture can only be accurately
portrayed once the multiples are compared to the industry and to the specific firm's historical
Advertisement
average.

The Bottom Line

Having proper knowledge of the red flags to avoid companies indulging in unscrupulous
https://www.investopedia.com/articles/financial-theory/11/detecting-financial-fraud.asp 8/11
9/6/2019 Detecting Financial Statement Fraud
Having proper knowledge of the red flags to avoid companies indulging in unscrupulous
accounting practices is a useful tool to ensure the safety of your investments.
"Compete Risk Free with $100,000 in Virtual Cash

Put your trading skills to the test with our FREE Stock Simulator. Compete with thousands of
Investopedia traders and trade your way to the top! Submit trades in a virtual environment
before you start risking your own money. Practice trading strategies so that when you're ready
to enter the realAdvertisement
market, you've had the practice you need. Try our Stock Simulator today >>

Compare Investment Accounts

Advertiser Disclosure

Related Articles
FINANCIAL STATEMENTS
Look For These Red Flags In The Income Statement

FINANCIAL RATIOS
Financial Ratios to Spot Companies In Financial Distress

https://www.investopedia.com/articles/financial-theory/11/detecting-financial-fraud.asp 9/11
9/6/2019 Detecting Financial Statement Fraud

CRIME & FRAUD

How to Spot Financial Statement Manipulation

FINANCIAL STATEMENTS
Spotting Creative Accounting on the Balance Sheet

CRIME & FRAUD

Common Clues Of Financial Statement Manipulation

CRIME & FRAUD

The Biggest Stock Scams of All Time

Partner Links

Learn to trade stocks by investing $100,000

virtual dollars...

Sign up for our daily newsletters

Trade like a top hedge fund manager using

technical analysis and double your wealth...

https://www.investopedia.com/articles/financial-theory/11/detecting-financial-fraud.asp 10/11
9/6/2019 Detecting Financial Statement Fraud

Related Terms
Aggressive Accounting
Aggressive accounting refers to accounting practices designed to overstate a company's financial
performance, whether legally or illegally. more

Restatement Definition
A restatement is an act of revising one or more of a company’s previous financial statements to correct an
error. more

Creative Accounting Definition

Creative accounting consists of accounting practices that follow required laws and regulations, but
deviate from what those standards intend to accomplish. more

Enron
Enron was a U.S. energy-trading and utilities company that perpetrated one of the biggest accounting
frauds in history. more

Financial Shenanigans
Financial shenanigans are actions designed to misrepresent the true financial performance or financial
position of a company or entity. more

What Are Financial Forensics?

Financial forensics is a field that combines criminal investigation skills with financial auditing skills to
identify criminal financial activity. more

About Us Contact Terms of Use

Advertise Privacy Policy Careers

Investopedia is part of the Dotdash publishing family.

The Balance | Lifewire | TripSavvy | The Spruce and more

https://www.investopedia.com/articles/financial-theory/11/detecting-financial-fraud.asp 11/11