How to Detect Fraudulent Financial Statements (#217)
/In this podcast episode, we discuss the particulars of how to detect fraudulent financial statements. Key points made are noted below.
Be aware that none of these methods will tell you for certain that the financial statements are false. What they can do is raise some red flags. And if you have a lot of red flags, there’s a good chance that there’s something wrong with the financials.
Excessively Smooth Profits
First up, reported profits are too smooth. In a real business, profits bounce around. Maybe a few customer orders are unusually early or late, maybe there were a lot of repairs this year. Who knows? The point is that these issues cause profits to be up a bit, down a bit, and maybe sometimes up or down a lot. What you should not be seeing is a great deal of consistency over time. And especially if the growth rate is about the same percentage every year. If so, earnings are being managed.
Commission Percentage is Declining
As another example, if the income statement has a separate line item for sales commissions, track it as a percentage of sales. If the commission percentage keeps going down, it could mean that management is making up fake sales. After all, why would management pay commissions on fake sales?
Deferred Charges are High
Another possibility is when deferred charges are really high. This is the prepaid expenses line item, but there could be a few other lines in the balance sheet that are similar. If management is trying to avoid recognizing expenses, it’ll stick them into some kind of current asset account. If the balances in these accounts are continually going up, the reported profit level is probably too high.
DSO Figure is Increasing
Or, what if the days of sales outstanding figure keeps getting longer and longer? It could mean that management is creating fake sales, which need to be offset with fake customer invoices. And, of course, the invoices are never paid. This is a real concern if the aging trend keeps going up, since it means that more fake invoices are being piled onto the books, month after month.
Cash Flows and Profits Differ
Another possibility is to compare the cash flows from operations figure to the net profit figure. There’re lots of valid reasons why these two numbers will vary from each other somewhat, but not that much. If the net profit figure keeps going up while the cash flow from operations number stays about the same, there may be fraud.
Metrics are No Longer Reported
This next one is a bit more subtle. A company – especially a public one – may include key metrics in the disclosures that are released along with the financial statements. Compare the most recent disclosures to the ones from prior periods, and see if any of these metrics are no longer being reported. If so, management may be trying to keep people from seeing a decline in the business.
Proportion of Reserves to Sales
Another possibility is to look at the proportion of reserves to sales. A business might have an allowance for doubtful accounts, for obsolete inventory, for sales returns, and so on. The percentage of these items to sales should be fairly consistent over time. When you see these percentages declining – and especially when they’re all declining – then there’s a good chance that management is under-reporting expenses in order to generate fake profits.
Horizontal Analysis
So far, I’ve made a few tips that aren’t related to each other. If you want to conduct a more methodical investigation, transfer the company’s financials to a spreadsheet for as many reporting periods as you can, and do a horizontal analysis. This means comparing the numbers in each line item for a lot of reporting periods. Also throw in some percentages, such as the gross margin and the operating margin. Then start scanning across the rows, looking for changes in the interrelationships. For example, if there’s an increase in sales, there should be proportional increases in receivables and the cost of goods sold. If not, why not? Maybe the sales are fake.
Another interrelationship is between the amount of inventory and accounts payable. If inventory has increased, the company should have incurred a liability to pay for it. So if accounts payable did not increase, why not? Perhaps the inventory is fake.
And at a higher level, if sales are going up, how is management funding the increase? Unless profits are really high, the chances are good that any increase in sales will require some funding for working capital, which means that the business has to sell shares or add debt. If this didn’t happen, why not? Maybe the sales are fake.
Some management teams can be really clever. They know about all of the different financial interrelationships, and so they falsify all of them, so the financials seem to hang together pretty well. If so, compare financial results to a company’s non-financial information.
Non-Financial Information Analysis
For example, for a retailer, the amount of sales per retail store really shouldn’t change that much from period to period. Or, the amount of assets per store shouldn’t change much. Or, if you’re looking at a manufacturing business, the amount of sales shouldn’t exceed the production capacity of the business, and the amount of ending inventory shouldn’t exceed the storage capacity of its warehouses. And for any business, the amount of sales per employee should be fairly consistent.
This non-financial information could be hard to come by. But if you’re really suspicious, it could be worthwhile to independently dig up this information and run a comparison against the financial statements.
A Word of Warning
And I’ll finish with a word of warning. You may see some of these issues crop up in a company’s financial statements, but it doesn’t always mean that the financials have been falsified. For example, there might be a big increase in sales and receivables go up a bunch. Your first thought might be that management has just faked some sales. But what actually happened is that the company entered into a deal with a large retailer, sold through a lot of goods, and the retailer is demanding long payment terms – so payment of the receivable is delayed. Which means that the sales figure is justified, and so is the receivable figure. In short, what I’ve been talking about are indicators – not dead certain ways to spot fraud.