Fraudulent financial reports are a serious problem in today’s business. Many analysts are now aware their analysis of financial statements is only as good as the statements themselves, and exploration of faked numbers is of little use to the potential investor. There can be arguments as to what inspires modern-day executives fake their numbers, but one thing is clear: the corporate America cannot afford to fool the investors much longer without losing their faith. Scandals involving Enron, WorldCom and other companies have already set investors on edge, making them suspicious of corporate activities and reporting. The whole functioning of today’s economy is in heavy dependence on the health of the financial system which in turn needs valid information to draw conclusions from. This paper will attempt to research whether it is possible to detect the fraud in financial statements early on and whether these methods will prove to be useful in eliminating fraud in modern-day companies.
A Little History
The scam in financial reporting did not appear in the past decade. In fact, throughout much of the first half of the 20th century, fraud was often used to manipulate stock prices, and to boost the value of some stocks way beyond their realistic valuations.
One of the most famous swindlers, Charles (“Get Rich Quick”) Ponzi launched what later became known as a Ponzi scheme. His business model promised investors sky-high return levels, while in fact it was grounded in the continuous expansion of his scheme to pay the old investors with funds coming from the new entrants. Here the trick was to fool common people, and in the scheme carried out by the famous Ivar Kreuger, he “often switched companies’ assets and liabilities or created fictitious assets when existing ones weren’t enough”, eventually robbing lenders and shareholders out of $500,000,000 (Shilit 1994).
In the second half of the past century, reporting scams were definitely on the rise, perhaps reaching a culmination in 1992 that “might be remembered as the “Year of the Scam” (Shilit 1994). This year was marked by the downfall of a number of companies, including Cascade International, Maxwell Communications, College Bound, Phar-Mor, Comptronix – in about this order. While the public was shaken by the terrible news, it also witnessed the settlement of the two previous scandals including MiniScribe and Lincoln Savings & Loan.
Fraud and Loopholes
One can differentiate between the fraud perpetrated at the company and all sorts of loopholes in the accounting procedures that allow companies to walk away with violating the spirit of Generally Accepted Accounting Principles (GAAP), but not the letter. For instance, when Enron boosted its revenue, it was in fact using one of the loopholes in the then rules that allowed the company to book not only the revenue it earned, but also the amount of transactions it mediated.
Fraud can be detected early with the participation of a team of auditors that are instructed to check on the company’s reporting as independent experts. Although the auditors are not always able to carry out a comprehensive analysis that will allow them to detect fraud, they should look for early warning signs of fraudulent financial reporting that also were named ‘red flags’ (Heiman-Hoffman et al. 1996).
What Can Be the Warning Signs?
A study performed by Vicky B. Heiman-Hoffman, Kimberly P. Morgan, and James M. Patton was based on a survey of auditors that aimed at finding out what early warning signs auditors can identify. As auditor teams are composed, naturally, of human beings, they “generally perceived “attitude” factors to be more important warning signs than “situational” factors” (Heiman-Hoffman et al. 1996). For instance, the auditors tended to see managers who acted in a hostile way towards their team as more likely to perpetrate fraud than others. Obsession with reporting, a history of dishonesty in relations with management, as well as the unduly fervent desire to concentrate all power in the same hands was regarded with suspicion. The auditors also referred to weak internal controls in the business as a potential sign of danger.
At the same time, apart from those ‘attitude’ factors, there are other, more objective criteria that can help an auditor or analyst to identify fraud based on financial reports alone. Such early warning signs of financial fraud were overlooked in the scandal in HealthSouth Corporation whose CEO, Richard Scrushy, was charged with accounting fraud by SEC on March 19, 2003. For instance, the company acquired several rehabilitation clinics and outpatient surgery centers to expand its business in the 1990s, at the time when the return on investment was dropping. Weld, Bergevin and Magrath have found that «all of the components of investment return decreased in the later four-year period» that elapsed between 1998 and 2001 (Weld, et al. 2004). When dropping return on investment is combined with an active acquisition strategy, this can evoke concerns of the auditors or analysts, as a management will not normally try to expand business when returns are falling.
Another early ‘red flag’ that had to wake up teams of analysts that covered the relevant industry was the volatility in the percentage of receivables estimated as uncollectible, changing from 38.9% of gross accounts receivable to 12.2% . In addition, the provision for doubtful accounts in 1999 was distinctly higher than its average previous level. Also, the write-offs for uncollectible receivables were inconsistent (Weld et al 2004). Magrath and Weld believe that «reserves that are not correlated with balance sheet item» (Weld et al 2004 ) can be considered a warning sign that can be used by investors and auditors to detect possibility of fraud in a company.
Thus, there exist specific accounting mechanisms that can alert the business community to the danger of a fraud that can be perpetrated in the company. Certainly, these criteria are not quite reliable and thus can only serve as a relatively useful indication that fraud is going on. However, such ‘red flags’ can force analysts to pay closer attention to the company’s reporting standards.
Is It Possible to Eliminate Fraud?
It is highly unlikely that the business community will reform itself in a way that will take away the incentive to fudge the numbers in order ‘to make the quarter’. Modern businessmen are often under pressure to demonstrate brilliant financial results in order to win acclaim in the community and to keep the stock price up.
At the same time, various regulatory bodies and the business community have to do their best so that instances of fraud are detected earlier. Adequate controls are to be put in place so as to prevent fraud from happening and make it more likely that it will surface before the damage is too big. Maintain internal controls that are adequate to prevent and detect fraudulent reporting. Government bodies, including the Treadway Commission, have issued guidelines that call on companies to “develop and enforce a written code of corporate conduct” and “maintain an effective internal audit function” (Shilit 1994).
Fraud remains a serious problem in today’s business community and is perhaps more topical than ever before. To reduce the risk of fraudulent reporting, regulators have to maintain rigorous procedures that will close loopholes in reporting rules, and analysts and auditors have to look closely at ‘red flags’ that indicate possible fraud. These measures will allow if not to eliminate fraudulent reporting, then to reduce its prevalence.
Heiman-Hoffman, Vicky B., Morgan, Kimberly P., & James M. Patton. “The Warning Signs of Fraudulent Financial Reporting.” Journal of Accountancy 182.4 (1996): 75+.
Schilit, Howard M. “Can We Eliminate Fraud and Other Financial Shenanigans?” USA Today (Society for the Advancement of Education) 123.2592 (September 1994): 83+.
Weld, G. t al. “Anatomy of a Financial Fraud: A Forensic Examination of HealthSouth.” The CPA Journal (2004). 12 Dec. 05 <http://www.nysscpa.org/cpajournal/2004/1004/essentials/p44.htm>.