Keep an Eye Out for These Red Flags

Being a forensic accountant, I thought I’d share the red flags I look for while investigating companies’ financial statements. Looking at the world’s biggest accounting scandals: Enron, Tyco and WorldCom, several measures were utilized to enhance the appearance of their financial statements. Financial fraud can be uncovered by almost anybody. After all, the Enron scandal was not uncovered by a forensic accountant or a Wall Street analyst, but by news reporters who used journal articles and public findings in their due diligence process.

A study conducted by the Association of Certified Fraud Examiners revealed that fraudulent financial statements account for 10 percent of white-collar crime. 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 the entity or some other party."

Committing accounting frauds in a vague sense can be looked at as telling a lie; a person cannot just lie once and get away with it, they have to tell other lies to cover up their initial lie. Similarly, accounting frauds also involve a vicious cycle of committing fraud to conceal suspicious activity.

Companies commonly resort to these practices to augment the appearance of their balance sheets: inflating assets’ net worth by not appropriately showing depreciation, understating expenses by capitalizing operating expenses, overstating revenues by recording future expected sales, concealing liabilities and obligations and incorrect disclosure of third party transactions.

Enron Corporation hid its liabilities and inflated its earnings through the use of off-balance-sheet special purpose entities.

Source: Forbes

Enron’s CEO used ‘Mark-to-Market’ accounting to hide financial loses. For example, Enron would build a power plant and immediately claim the projected profits in its books. If the actual revenue generated from the plant was less than the projected profit then Enron would transfer it to an off the books corporation where the loss would go unrecorded. They would thereby make the company look more profitable than it actually was.

Following the Enron scandal, the Sarbanes-Oxley Act was signed into law in 2002. One of the researchers stated it is a "mirror image of Enron: the company's perceived corporate governance failings are matched virtually point for point in the principal provisions of the Act." (Deakin and Konzelmann, 2003). The act provided stricter regulations and acts against accounting fraud. The Financial Accounting Standards Board also raised its levels of ethical conduct.

General red flags to look for include:

· Reported earnings grow at an exponential rate but cash flows decline.

· Revenue that multiplies at a rate much higher than any company in that particular industry.

· A rapid increase in the number of days sales in receivables in addition to growing inventories.

· Depreciation methods that do not correspond to those of the overall industry.

· A suspicious number of third party transactions can be used to conceal debt off the balance sheet.

In my years of experience as a forensic account, I've seen that a red flag or a culmination of various red flags is an obvious sign of suspicious activity. It helps any analyst or accountant in digging deeper and tracking the origin of the fraud.

References:

1. Bratton, William W. (May 2002). "Does Corporate Law Protect the Interests of Shareholders and Other Stakeholders?: Enron and the Dark Side of Shareholder Value". Tulane Law Review. New Orleans: Tulane University Law School(1275).

2. Healy, Paul M.; Palepu, Krishna G. (Spring 2003). "The Fall of Enron". Journal of Economic Perspectives.