Please read the following note on fraud to broaden your understanding of the topic and to guide your responses. [More guide]

Fraud

Fraud is a deception deliberately practiced in order to secure unfair or unlawful gain (adjectival form fraudulent; to defraud is the verb). As a legal construct, fraud is both a civil wrong (i.e., a fraud victim may sue the fraud perpetrator to avoid the fraud and/or recover monetary compensation) and a criminal wrong (i.e., a fraud perpetrator may be prosecuted and imprisoned by governmental authorities). Defrauding people or organizations of money or valuables is the usual purpose of fraud, but it sometimes instead involves obtaining benefits without actually depriving anyone of money or valuables, such as obtaining a driver’s license by way of false statements made in an application for the same (Nigrini 2011).

Financial Statement Fraud

Financial statement fraud is one of the biggest challenges in the modern business world. This is when corporations engage in certain practices designed to hide or maneuver the accounts of a corporation to help it continue to remain attractive to investors. To counter financial statement frauds, especially in the aftermath of the Enron scandal in 2001-2002, the US Congress introduced the Sarbanes Oxley Act, the compliance with which is mandatory for US corporations. A financial statement fraud may be actionable under both the False Claims Act and the Dodd Frank Act as well. You may have suffered a financial statement fraud or may have original information about a financial statement fraud, which means that you may be able to bring either a financial statement fraud lawsuit or a whistleblower lawsuit depending on the facts peculiar to your case.

The most common occurrence of financial statement fraud is when losses are underplayed or deliberately hidden by corporations. Financial statement fraud comprises deliberate misstatements or omissions of amounts or disclosures of financial statements to deceive financial statement users, particularly investors and creditors, outright falsification, alteration, or manipulation of material financial records, supporting documents, or business transactions, material intentional omissions or misrepresentations of events, transactions, accounts, or other significant information from which financial statements are prepared, deliberate misapplication of accounting principles, policies, and procedures used to measure, recognize, report, and disclose economic events and business transactions and also intentional omissions of disclosures or presentation of inadequate disclosures regarding accounting principles and policies and related financial amounts. There are massive issues that emanate from financial statement fraud. Financial statement fraud undermines the reliability, quality, transparency, and integrity of the financial reporting process and jeopardizes the integrity and objectivity of the auditing profession, especially auditors and auditing firms. Financial statement fraud diminishes the confidence of the capital markets, as well as market participants, in the reliability of financial information and as a consequence makes the capital markets less efficient. In the bigger picture it adversely affects the nation's economic growth and prosperity, results in huge litigation costs, destroys careers of individuals involved in financial statement fraud and causes bankruptcy or substantial economic losses by the company engaged in financial statement fraud. It causes devastation in the normal operations and performance of alleged companies and erodes public confidence and trust in the accounting and auditing profession. Ultimately financial statement fraud translates to massive stockholder losses and debts to creditors, not to mention emotional trauma to employees who lose their jobs and retirement funds. Financial statement fraud may be committed by the senior and mid-level management of a corporation to fraudulently enhance the financial health of a business and enrich one's own net worth. Senior management may indulge in fraudulent cover-ups to exceed the earnings or revenue growth expectations of stock market, to comply with loan agreements, to increase the amount of financing available from asset-based loans and to meet a lender's criteria for granting/extending loan facilities. They may also fudge the statements to create a rosy picture for the shareholders.

Financial Statement Fraud Red Flags

Financial statement red flags provide a general overview of the warning signs investors should take note of. They do not necessarily indicate an undoubted occurrence of financial statement fraud, but merely signal that further in-depth research must be conducted to assess the validity of the corporate documents. Creditors would find such information useful to ensure that loans are not provided to firms operating with an elevated amount of risk. Investors, on the other hand, may want to take note of the following factors to discover new shorting opportunities. Government regulators, however, aim to catch and punish fraud to ensure the transparency and reliability of the financial markets.  Five basic types of financial statement fraud exist:

· fictitious sales

· improper expense recognition

· incorrect asset valuation

· hidden liabilities and

· unsuitable disclosures

Effectively spotting these fraudulent disclosures involves keeping an open eye for the most common financial statement fraud red flags: 

· Accounting anomalies, such as growing revenues without a corresponding growth in cash flows. Sales are much easier to manipulate than cash flow but the two should move more or less in tandem over time.

· Consistent sales growth while established competitors are experiencing periods of weak performance. Note that this may be due to efficient business operations rather than fraudulent activity.

· A rapid and unexplainable rise in the number of day's sales in receivables in addition to growing inventories. This suggests obsolete goods for which the firm records fictitious future sales.

· A significant surge in the company's performance within the final reporting period of fiscal year. The company may be under immense pressure to meet analysts' expectations.

· The company maintains consistent gross profit margins while its industry is facing pricing pressure. This can potentially indicate failure to recognize expenses or aggressive revenue recognition.

· A large buildup of fixed assets. An unexpected accumulation of fixed assets can flag the usage of operating expense capitalization, rather than expense recognition.

· Depreciation methods and estimates of assets' useful life that do not correspond to the overall industry. An overstated life of an asset will decrease the annual depreciation expense. 

· A weak system of internal control. Strong corporate governance and internal controls processes minimize the likelihood that financial statement fraud will go unnoticed.

· Outsized frequency of complex related-party or third-party transactions, many of which do not add tangible value (can be used to conceal debt off the balance sheet).

· The firm is on the brink of breaching their debt covenants. To avoid technical default, management may be forced to fraudulently adjust its leverage ratios.

· The auditor was replaced, resulting in a missed accounting period. Auditor replacement can signal a dysfunctional relationship while missed accounting period provides extra time to "fix" financials.

· A disproportionate amount of managements' compensation is derived from bonuses based on short term targets. This provides incentive to commit fraud.

· Something just feels off about the corporation's business model, financial statements or operations.

Financial Statement Fraud Detection Methods

Spotting red flags can be extremely challenging as firms that are engaged in fraudulent activities will attempt to portray the image of financial stability and normal business operations. Vertical and horizontal financial statement analysis introduces a straightforward approach to fraud detection. Vertical analysis involves taking every item in the income statement as a percentage of revenue and comparing the year-over-year trends that could be a potential flag cause of concern. A similar approach can also be applied to the balance sheet, using total assets as the comparison benchmark, to monitor significant deviations from normal activity. Horizontal analysis implements a similar approach whereby rather than having an account serve as the point of reference, financial information is represented as a percentage of the base years' figures. Likewise, unexplainable variations in percentages can serve as a red flag requiring further analysis.  Comparative ratio analysis also allows analysts and auditors to spot discrepancies within the firm's financial statements. By analyzing ratios, information regarding day's sales in receivables, leverage multiples and other vital metrics can be determined and analyzed for inconsistencies. A mathematical approach, known as the Beneish Model, evaluates eight ratios to determine the likelihood of earnings manipulation. Asset quality, depreciation, gross margin, leverage and other variables are factored into the analysis. Combining the variables into the model, an M-score is calculated; a value greater than -2.22 warrants further investigation as the firm may be manipulating its earnings while an M-score less than -2.22 suggests that the company is not a manipulator similar to most other ratio-related strategies, the full picture can only be accurately portrayed once the multiples are compared to the industry and to the specific firm's historical average. 

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