Financial fraud is a risk for any large organization on Wall Street, large or small. Each year companies spend millions trying to understand, detect, and deter potential fraudsters. Of course, there are many different aspects that make up your average profile of fraudsters. Detecting red flags and putting the proper processes in place to deter future fraud is a crucial process.

Detecting Red Flags

There are several red flags that can point to financial statement fraud. These red flags are different from those that might be telling in a case of asset misappropriation. Typically, these red flags are out of the norm for most financial institutions and can point to financial statement fraud. These red flags include the following;

  • Accounting or statement anomalies that may point to doctoring.
  • Exceptionally rapid growth in revenue or profit, faster than industry expected norms.
  • Obvious internal control weaknesses going unchecked.
  • Aggressive or risky financial actions by management.
  • Personality red flags in senior management.

There are also a number of important personality indicators, usually present in top executives or management. Financial statement fraud is almost always conducted by high level executives with low ethical standards. These personality traits can often be difficult to detect, and in some cases may be the very same traits that made them ideal for their position in the first place. Some of the different traits that a potential fraud risk may possess include;

  • Overly domineering or disrespectful to subordinates. Treats them as if they are lesser.
  • Steers internal auditors away from important information. Continually involves themselves in the investigative process outside of their defined scope.
  • Secretive or evasive with financial information.

Financial statement fraud can come in a variety of different forms. They could claim fictitious revenue, conceal liabilities, choose not to disclose important information, or improperly value assets in an effort to improve perceived performance within the company.

The Costs of Fraud

Fraud can be extremely costly for organizations of any size. Financial statement fraud on a large-scale can put an entire organization at risk. Fraud losses have a direct effect on net income, dollar for dollar. Replacing that revenue requires injections that are equal to the amount lost in fraud. So if the profit margin is 10%, revenues have to increase by 10 times the total losses to recover the total affect on net income.

There are many revenue-related transactions and frauds that must be taken into consideration when evaluating potential risk. Knowing the accounts involved with different transactional process can help to detect, identify, and deter fraud in financial statements. Some of the more common schemes in Wall Street financial fraud include;

  • Understating Estimates of all uncollectible accounts receivable.
  • Recording fictitious sales or recognizing future revenues as presently held when selling goods and services to customers.
  • Avoiding the recording of returned goods.
  • Writing off receivables as uncollectible.
  • Record bank transfers as cash received, manipulating cash received.
  • Under-recording purchases and inventory.
  • Overstate returned merchandise.
  • Overstate discounts on purchases during discount periods.
  • Recording non-discounted sales at a discount.
  • Failure to write off obsolete inventory. T
  • Over-estimation of inventory holdings.
  • Failure to record accounts payable.
  • Failure to record Accrued liabilities.
  • Overstatement of assets.
  • Capitalizing expensed assets.

Detecting Fraud

Fraud is always detectable with the proper controls in place. There is always a trail that is left behind by the fraudster, but without proper analysis it can be difficult to catch these obvious issues, especially in an acceptable time frame. Many fraudsters are discovered when they attempt to push their luck beyond their initial successes. After conducting previous frauds, a fraudster may become more bold in their actions, committing fraudulent actions with larger amounts of money.

Nature of Accounting Rules

 In the US, accounting standards are rules-based, as opposed to being principals-based. This allows companies and CPAs to be creative in their accounting, and not prohibited by a variety of different standards. Good examples of this are SPEs and off-balance sheet financing, merger reserves, and pension accounting. It is impossible to make rules that cover every particular accounting situation, and for this reason CPAs and accountants can use creativity for the benefit of the organization.

 Importance of Ratios and Analysis

According to the March/April 2005 issue of Fraud Magazine, one in six cases of financial statement fraud in 2004 resulted in more than $10 million in losses for the organization. A number of ratios can be used to measure sales growth, assets and growth margins, which can help to alert organizations to potential fraud before they would otherwise notice it.

Sales Growth Index

The Sales Growth Index is used by companies to catch fraud in its early stages. Companies that experience large amounts of growth rapidly are large targets for financial statement fraud. The Sales Growth Index is a relatively simple equation;

Sales Growth Index = Sales Current Year / Sales Previous Year

Depending upon the industry, there are certain levels that the Sales Growth Index is expected to fall within. Reported sales outside of expected levels could potentially be a red flag for potential fraud.

Gross Margin Index

The Gross Margin Index measures the margins from one period against the previous period. When the GMI is higher than 1, executives may be pressured to show better numbers, elevating the risk of fraud. The equation is as follows.

Gross Margin Index = (Sales prior year minus cost of goods sold prior year)/sales prior year / (Sales current year minus cost of goods cold current year/sales current year

Asset Quality Index

The AQI measure the proportion of total assets for which the future benefits of that asset are uncertain.

Days sales in receivables index = receivables current year/sales current year / receivables prior year/sales prior year

Companies that have been shown to manipulate earnings have median AQIs of 1 and a mean of 1.254.

The Classic Example of Enron

Enron is the most often cited example of financial statement fraud. In total, their fraudulent activities wee much more advanced than your average. Enron’s fraud included extremely complex financial reports, which helped them to hide the fraudulent activities behind a mountain of paperwork. They didn’t have to simply lie – although they did. Many of their fraudulent activities were conducted out in the open, so long as investigators could put the pieces together.

After incurring huge amounts of debt and losing exclusive rights to pipelines, Enron had very few options to take without harming consumer and investor confidence in the company. They hired McKinsey and Company to assist them with formulating a new business strategy. Their recommendation was to create a “gas bank” that bought and sold gas. Their profits soared through the roof as their ability to predict future prices with the industry outpaced that of their competitors.

During their last 5 years they posted increasing income each and every quarter, while avoiding hundreds of millions in taxes through the creative use of stock options, which were claimed as a compensation expense. This allowed them to pay fewer taxes, report higher earnings, and manipulate earnings and stock price all at the same time.

Many executives at the time believed that Enron was pushing the industry forward, which, they believed, allowed them to bend or push the rules farther than they had been before. The company reported a $618 million loss in October of 2001, but did not disclose that it had written down equity by $1.2 billion. In November, the company announced that they would be restating earnings for the previous 5 years, and come December they filed for bankruptcy and closed their doors. This was preceded by a mass-exodus of Enron executives in the year prior, many of whom likely saw the writing on the wall.

Enron is a prime example of how corporate culture and arrogance can lead to fraudulent actions. It is important that organizations place fraud prevention as a high priority, and make the proper cultural changes within an organization.