There are basically only three ways that someone can cook the books if they want to falsely show more positive results than truth. Better stated, there are only three categories of book-cooking, with innumerable specific adjustments within those categories that can be made with the result of creating intentionally misleading financial reports.
These are:
1. Overstating revenues or assets or accelerating their recognition.
2. Understating expenses or liabilities, or deferring their recognition.
3. Misstating or omitting other material facts which have financial impact.
Two wonderful communicators remind us of the very best ways to discover financial mischief: Warren Buffett loves to say that "you should never invest in a business that you don't understand," and Ronald Reagan often nodded and said "Trust, But Verify." Usually, the more complicated the financial statements, the easier they are to manipulate for an improper purpose, and usually the more that specific entries can be confirmed by undisputed, third-party evidence, the less likely that a false number can survive for long.
A perfect place to start the process is Statement on Auditing Standards No. 99, Consideration of Fraud in financial statements. If the team uses this basic checklist, then at least the possibility of fraud will have been actively discussed early in the review process, and the team will have concentrated on the ways in which these particular books might be cooked, with increased alertness hopefully resulting.
Some other general caveats:
First, if the company uses "SPEs," – special purpose entities, immediately put them under a special microscope until you are confident that there is a really critical business purpose for an SPE to exist at all, and not just an attempt to make the balance sheet look better than simple reality would dictate.
The same automatic skepticism should be triggered when one assesses any transaction or expense involving any affiliate, not just an SPE. Expect always to see "sunshine and oversight," meaning voluntary and entirely full disclosure of all details, supported by third-party receipts or other equivalent evidence, and independent review and supervision to confirm the entire fairness of every expenditure. And remember that credit card vouchers are not receipts; they are only some, often inaccurate, evidence that someone paid something, not whether the payment was proper or was not later reversed.
Second, think about why someone would falsify entries, and whether he has the chance to do so, and whether he is under pressure to do so. Usually false financial statements start with someone convincing himself that these numbers really need changing, or that these assets really need misappropriating, and this rationalization often results in modest false adjustments at first, intended to be corrected later or earned away. If the managers think that only reported results are important, then they are far more likely to create them one way or the other. To do this, there must be the opportunity to do it, and almost always there is some pressure to change the numbers, sometimes internally generated, and sometimes for personal benefit, but perhaps resulting simply from misguided good intentions, to make the company look better than reality, often in reaction to a domineering senior executive.
Third, have the outside auditors recently been changed? Ask why. And confirm why. This is key, since very often a company that cooks the books also has had a recent change in auditors, or has very weak auditors to begin with. And think about the Internal Audit Department. Are they highly qualified? Are they properly staffed? Do they report around the management directly to a really independent (and really qualified) Audit Committee? Are their reports first cleared with Management and only released after massage? Exactly just how trustworthy are their reviews?
So let's look at 10 Red Flag Areas, a "Top 10 List" which would highlight and, hopefully, expose most instances of financial chicanery if they are carefully considered and applied:
1. Revenues and Assets Can be Fabricated; Cash Rarely
As noted below, the vast majority of business fraud events involve someone stealing something, from money to widgets to staplers, but the vast majority of damages from business fraud result from someone falsifying the financial statements. And most of those cases involve creating revenues where none in fact exist, or in taking real revenues and falsely increasing them.
The most common way to increase revenues improperly is to simply make them up, by inventing fictitious revenues. This approach usually does not endure much real scrutiny, since
- False revenues usually do not withstand customer confirmation requests, if answered.
- False accounts receivable usually are not paid, except by customer oversight or complicity.
- Revenues and Accounts Receivable go up from the falsehood, but cash is usually not created.
Accurate cash flow statements, which are verified, are therefore absolutely essential to confirm revenues.
Bernie Madoff, for example, just made it all up, and had accountants willing to sign anything. One routine call by the regulators to confirm just one of his phantom bank deposits would have blown his scheme many years before it eventually came to light. Professional traders said for ages that he was cheating, but no one ever simply asked to see the cash. No one ever said "Show me the money!"
Sometimes unscrupulous vendors blithely deliver more than was ordered, or cavalierly charge more than was agreed, and unordered or overpriced products may, through oversight, wind up in inventory until long after delivery, when the customer is suddenly awash in widgets and discovers that lots of them were never ordered in the first place, or that he overpaid for what was actually delivered.
In timing cases, specific revenues may actually be earned someday, but just not yet, since there are conditions yet to be satisfied, sometimes as simple as creation and delivery of the products underlying the sales. Where there are such conditions still to be accomplished, then saying that the revenues are really earned in usually just not true, at least not yet, and maybe not ever. And modest timing differences are often the start of a false revenue scheme – "we'll just borrow some from next quarter and then make it up . . .," and then the problems grow . . . and grow . . .
So, distrust revenues that bounce up just before a reporting date, like a year-end or quarter-end. For example, Refco's revenues and balance sheet looked a lot less positive just a week after their financial reports were delivered, since the false entries had to be quickly reversed. Sadly, no one checked.
As noted above, most specific instances of financial frauds involve assets, typically their theft or misappropriation, such as bogus or overstated expenses, or misstatement of asset values. For example, if more inventory value is assigned to a sale, then profits and taxes go down, which used to be common with some private companies as a means to reduce their taxes. Then the company gets sold, and the owners want to be paid for all that inventory still actually sitting in the yard!
Obviously if revenues are overstated, then the balancing assets, accounts receivable, are also overstated, since the underlying revenues are non-existent. Fictional A/R usually takes longer to collect! So worry about Days Sales Outstanding if that number suddenly increases from historic levels. Why are bills suddenly not being paid as promptly as before?
The value of an asset also requires candor and correctness about its useful life, with knock-on effects on depreciation deductions and the timing of required expenses for replacements. Atlantic Computer was loved by investors because the company never valued the remaining life of their leased computers; instead, they secretly gave their customers rights to just terminate their leases early and walk away. Olympus used acquisitions at wildly inflated prices to set the stage for writing off massive earlier undisclosed losses.
GAAP now requires constant asset identification and fair market valuation, especially if the assets and related good will were acquired and now are no longer earning at rates sufficient to justify their valuations. These are good rules. Apply them.
But to repeat again, the numbers involved in financial statement fraud are geometrically greater than the losses attributable to simple theft. Geometrically.
2. Understating Expenses or Liabilities.
Usually, expenses that can be deferred until another day have positive effects on the P&L statements, since they might not have to be deducted until later. But if they really are accruable now, then they should be booked now. Simple as that.
So wonder about expenses that don't seem to follow the historic levels, and don't seem to increase as the business grows. In some notorious cases, senior management would take a compensation holiday just before year-end results were due, and make up the payments to themselves later in the next year. Or bills are ignored or are filed quietly away. Usually this creates aberrations and can be caught by confirmation calls with unhappy vendors, wondering where their payments are.
Padded expense accounts are unfortunately still rampant, and remember again that credit card slips are not receipts—they are only evidence of payment. Hotel bills and vendor statements are receipts.
Sometimes other liabilities are diluted or ignored, until they finally become either too large or too certain, or both. For example, management might ignore warranty claims that clearly foretell that major product problems exist and will not go away.
3. Misstated and Undisclosed Material Facts.
If material facts that could adversely affect financial condition are undisclosed or are misstated, the calculation of their effects obviously must await the inevitable day of reckoning. Are price increases being resisted? Are new competitors' products taking business away? Is an anticipated patent likely to be weaker than planned? Are returns being accepted on overly generous terms? If unit volumes really are going up, why isn't the plant also more busy? Is overtime increasing as it should if sales are really increasing?
"ZZZZ Best" became a famous fraud for cleaning a skyscraper when the tallest building in town was only four stories high. Sometimes you have to go see. Take the road trip!
Sometimes undisclosed facts can involve basic commercial practices that reveal that the business model might be based on a foundation of sand. These are often the most difficult to define and assess with confidence, and if discovered they will usually be the subject of vigorous debates with management.
For just one of countless examples, the recent massive mortgage meltdown was predicated on a lending business, virtually required by government regulators, where loans could be repaid only if the assets pledged to secure them continually increased in value. Bank financial statements never frankly disclosed that incredible risk. Other business practices are not only illegal, but also undermine the worth of the entire business. For example, bribes in violation of the federal FCPA and state and local laws, once discovered, can be expected to cost the company far more than the profits generated by the bribes. Sales resulting from illicit price-fixing with competitors may well someday results in fines and penalties and civil recoveries several times the illegal profits. Study of the financial statements alone will rarely turn up such basic business defects, unless the results themselves just seem too good to be true, as discussed below.
And recall Warren Buffett – the more complicated the footnotes, the less able you are to really understand them. Keep at it until you do.
With these three categories in mind, let's now look at the specific principal red flags which could suggest that we might have a problem.
4. What is Value?
In your due diligence exercises, it is always worthwhile to keep nearby the core, essential thought that every investment is worth the current value of the future cash that it will produce. Never more, never less. Sometimes simple mob psychology will provide that value, as it did with hula hoops, and pet rocks, and beanie babies, and WorldCom, and Facebook, and sometimes well managed businesses will continue to produce cash forever and a day. The challenge is in determining which is which, and to be sure that the 'mob psychology' companies' financial statements adequately disclose that their fortunes might be momentary.
5. Look for Bubbles.
Remember what they used to say in Chicago: "'Once is happenstance. Twice is coincidence. The third time it's enemy action." Why are the company's sales increasing this quickly? Was management just threatened by the Board to improve results or else? Is management suddenly really this much smarter?
Look for the expected, logical consequences of the financial results to confirm them, or else question if those sales are really real. Look at the historic ratios among the company's key numbers and see if the ratios have varied. Are Days Sales Outstanding in relation to Sales suddenly getting longer . . . and longer? Are expenses which should be variable for some reason suddenly steadier than sales? If sales and accounts receivable really increase, then inventories should go down, and cost of goods sold should go up. Is this happening? Is cash not increasing in about the same ratio as revenues? Why not? Are warranty claims and returns increasing? Are capital expenditures (which are amortized and not currently expensed) going up without clear explanations? Why? Why not? WorldCom created earnings by improperly capitalizing billions of expenses.
Use of the "Beneish Ratios" has become a quick litmus test to point to areas requiring close study. These ratios highlight (1) sales growth, (2) decline in gross margins, (3) weakening asset quality, (4) increasing days' sales in receivables, and (5) growth in selling, general & administrative expenses versus sales. The Beneish approach also looks at depreciation rates, leverage, and total accruals in relation to assets, and the Beneish Model produces a score that raises the red flag higher as the final calculation result increases. This approach is far from perfect, but is often very helpful in assessing the true quality of a company's performance.
6. Check Out the Competition.
Everyone in the same business is usually subject to the same or similar challenges and vicissitudes, and if the competition's ratios are constantly less impressive than the business under study, then one must wonder why. Check out the quick ratios that are commonly used to assess businesses. Is inventory too high, maybe not adequately deducted from sales? Are accounts receivable increasing faster than cash, maybe because some customers have legitimate objections? Are variable expenses, like sales commissions and freight charges, not increasing in line with sales?
Since most companies are honest, there usually are legitimate answers to all these questions, but ask them, and then verify the answers.
7. Pass Around the Whistles.
Especially when considering the substantial rewards available these days for whistleblowers, the snitch is often the first hint of an accounting problem. Unhappy employees, especially someone recently terminated, can be an absolute wealth of knowledge. Exit interviews should be mandatory. Companies often also complain about their competitors' business practices that suggest more. It is extremely difficult to compete with someone paying bribes, if you do not.
It is a sad statistic that almost every exposure of substantial financial fraud resulted from someone dropping a dime on the insiders. So when this happens, of course trust the responses that you get from management. And then go and verify them independently
8. Look at the People.
If the salesmen are driving Priuses and the financial staff are all in Porsches, why exactly is that?
What is the demeanor of management versus the key financial staff? Are the staff dominated? Do they have the 'juice' to correct a questionable entry, or to stand there until it is corrected? Does management refuse to admit defeat, to the point that they are willing to fabricate victory?
Is there a key financial employee who just never takes a vacation? Walk in one day and send her to the airport for a free week away. And ask her to leave her laptop. She needs a new model. And you need to look at the old one.
And remember that if the books are wrong, almost always the CEO and the CFO are aware of why, or at the least are planting their heads firmly in the sand, hoping against hope.
9. "Can I Ask a Stupid Question?" Surprise!
An amazing recurring fact in the constant failures to discover financial fraud is that the examiners saw a red flag, but felt embarrassed to ask the obvious questions because they might have been seen to be inexperienced or at least unsophisticated as compared to the level of all of those allegedly smarter people in the room.
Don't be shy. It will usually quietly delight you when you just say "Can I ask a stupid question," and no one knows the answer!
Refco, Enron, WorldCom, Bernie, almost all of the massive modern frauds, could have been caught instantly if the auditors had gone back shortly after the financial statement dates and asked a stupid question – like "show me the cash statements as of today," and then re-checked the numbers independently, such as by actually calling the banks. As noted above, most frauds are concentrated with specific dates in mind. In Refco, the difference between the balance sheet on its IPO date and a few weeks later was many hundreds of millions. It would have been even easier to have caught Madoff, since any basic due diligence would have blown the game.
And always make sure that 'surprise' audits are really surprises. In this day and age, it often takes just minutes to change records if someone new is suddenly looking. In days of yore, New York brokers were told the dates that they could expect their auditors to arrive in three of their financial quarters, so they could reserve rooms and order lunch. So the companies knew immediately that their required 'surprise' audit would occur during the remaining quarter! Richard Whitney, the fabled crooked NYSE President, was caught one day when he told the Exchange's lawyer (a CL&M partner) that some missing securities were upstairs in the safe, and the lawyer asked him to please go get them. Trust, but verify.
10. Is This Business Just Too Good to be True?
If financial statements sometimes are just too good to be true, given all the surrounding circumstances, then sometimes they are, because they are not true. Bernie Madoff's performance was simply unbelievable. So was Enron's and Worldcom's. Et cetera. All is not gold that glitters. And two plus two usually make four. Be pleased to see the results. Then go find out exactly where they came from.
With all of the complaints about Sarbanes-Oxley's internal controls and Dodd-Frank's whistleblower rewards, keep in mind that financial statement fraud is typically committed by senior management overriding required internal controls. Someone is gaming the system, and the system is just too weak to catch it.
But usually it is never just one number that can be fixed without knock-on effects dictated by the rules of double entries and the tiresome checks and double-checks that are essential to rigorous accounting. At some point, something looks unusual. Something just doesn't jell. Listen carefully to the explanation. Good. Now go and verify it.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
