Some Ways to detect Accounting Fraud
1) I am new to investing, so i dunno, don ask me.
2) If the team wants to cheat, there are multiple ways to cheat, it is very hard to catch.
3) Audited financials can look harmless and factual until they are discovered.
4) Never assume everything you read is true and fair, even if the auditors say so (they r jus paid employees).
Use your own due diligence, thats why we call it DYODD.
5) You want to see the operating performance for the past 3-5 years and its TTM, trailing 12 months performance. Don look at 1 year, look at multiple years.
In the classic book, Security Analysis, Benjamin Graham and David Dodd highlighted the importance of a careful and fundamental evaluation of a company’s business and financial statements.
What motivates a company to overstate earnings? Both investors and creditors are interested in the level of profits of a company. The higher the earnings or profit, the more can be returned to investors and creditors or invested for the future. If management want to make themselves look better to creditors or investors, they may be motivated to play accounting games to make earnings appear better than they actually are, especially if managers’ compensation is linked to earnings or share price.
A company's financial health can be gauged through three statements - balance sheet, profit and loss account and cash flow accounts.
A balance sheet records a company's assets (land, machinery, inventory, cash balance, investments, loans given), liabilities (loans taken, income tax payable, tax liabilities) and owner's equity. The accounting equation is a given and must always
balance—hence the term balance sheet.
The income statement shows the revenues from operating the
business, the associated expenses, gains and losses, and the net profit over a
timeframe. It is a primary source for measuring the profitability of the
Cash Flow statement tells us where cash is coming from (inflow) and how it is being used (outflow). There are three types of cash flow-operating cash flow (sale of goods, revenue from services, interest/dividend received, payment for purchases, payment for operating expenses), investing cash flow (sale and purchase of assets, sale and purchase of debt/equity, loans advanced to others) and financial cash flow (issue of equity shares, borrowing, repayment of debt).
The income and cash flow statements are directly tied to the
change in the balance sheet over the period as shown. Any
increase or decrease in net income from the income statement results in an
increase or decrease in retained earnings and hence owners’ equity on the
balance sheet. Similarly, any increase or decrease in cash from the cash flow
statement is directly reflected in the change in the cash level on the balance
sheet. In this manner the financial statements are all tied together, and those
companies that want to artificially make themselves look better cannot
manipulate one financial statement without impacting either another financial
statement or an offsetting item on the same financial statement
Let’s say that a company increases its revenue by making a legitimate cash for services sale to a customer. Revenues and Earnings increase. On the balance sheet , owners’ equity increases as a result of Earnings increasing, and cash increases as a result of cash.
A similar result would occur if the sale were made on credit terms. Initially, accounts receivable would increase rather than cash, as the customer has not yet paid. However, when the customer pays, the accounts receivable balance will decrease and the cash balance will increase. This should occur in a fairly short window of time depending on the credit terms granted.
However, if a company increases its revenue by making a fictitious sale, no cash is received. They cannot simply increase revenue without recording some adjustment on the balance sheet; otherwise, the balance sheet would not balance. Owners’ equity would increase from the increase in Earnings, while assets and liabilities would remain the same, and the accounting system will not allow this.
For the accounting equation and balance sheet to balance, a company recording fictitious revenue must also either overstate assets or understate liabilities. The most common offset is to overstate assets through an increase in accounts receivable. Because cash is never received, the accounts receivable balance will not go down in the future and in fact will increase rapidly over time—it keeps getting bigger and bigger and bigger. In such frauds there is a limit, and eventually the bubble must burst. Elevated accounts receivable growth relative to revenues can be a sign of inflated revenues.
The most common motivation for accounting games comes from a desire to make earnings look better than they actually are. This can be accomplished by overstating revenues or understating expenses or losses.
In any of these cases, the company’s earnings and retained earnings on the balance sheet will be overstated. In order for it to balance, the company must overstate assets, understate liabilities or understate some other equity account.
The most common is overstating assets. The company reporting
fictitious revenue with no cash collected will have their accounts receivable
grows continuously over time.
In other cases, the company may report revenue even before the transaction has taken place. In such cases, accounts receivable will increase in a rate faster than it should.
Overstating Financial Position
Overstating financial position is an accounting ploy used to make a balance sheet look stronger usually by understating liabilities of the company. The company cannot simply remove liabilities from balance sheet without impacting other aspects of the balance sheet. If liabilities are understated, then either assets must be understated or owners equity must be overstated.
In this case, where assets or liabilities are
understated, a company may attempt to transfer them to some special-purpose
entity. How does this help improve the financial position, aren’t assets a good
Owner’s Equity: 2,000,000
Net Earnings: 500,000
Common Ratios are Liabilities to Assets and Return on Assets (Net Earnings/Total Assets). In this case, liabilities to assets is 0.8 or 80% and return on assets is 0.05 or 5%. If this company were able to remove 5 million of assets and liabilities from its balance sheet by accounting magic, it would look like below
Owner’s Equity: 2,000,000
Net Earnings: 500,000
Liabilities to assets is now 0.6 or 60% and return on assets is 0.10 or 10%. This company look less risky (lower level of debt) and more profitable (higher return on assets).
OTHER RED FLAGS
Some manipulations are difficult to detect even for finance professionals. Here are some indicators of rot in a company's financial books.
Reported earnings consistently higher than cash flow: If cash flow from operating activities of a company is consistently less than the reported net income, it is a warning sign. The investor must ask why operating earnings are not turning into cash.
Sudden increase in inventory/sales ratio: This indicates the company may be inflating assets such as inventories.
Increase in other income: Revenue sources recorded under other income are non-recurring and may include earnings from asset sales and closure of debt or debt restructuring. However, sources of earnings are seldom disclosed under this head. A sudden spurt should raise eyebrows.
Financial ratios not in line with industry peers: This could be due to inflated earnings, asset valuation or understating of expenses and liabilities.
Too many off-balance sheet transactions: If a company has been expanding by creating special purpose entities and has entered into many lease contracts, it is possible a lot of liabilities are not reflected in its balance sheet.
Learn from any mistakes (even if it is not your fault) and grow from there. Have a great CNY and Huat big big!
k, thanks, bye, Grandpa.