by Michael Lodge
In my past blogs I have provided you with information on how to read your financial statements and your cash flow. If you have not read them go back and read them so you really understand your income statement, balance sheet and statement of cash flows. I encourage you to really understand what you are looking at, just don’t look at your bank account and how much cash is there. Your financial statements tell the story of what is going on in your company.
The aspect of understanding financial statements is also what to look for as possible fraud or just bad accounting. A lot of fraud happens in the area of cash, that happens a lot in small businesses when you get so busy in trying to keep your company alive and other people are taking cash away, not in the good way. So we will talk about several issues that you may not have thought of.
ETHICS OF BUSINESS AND ACCOUNTING: Ethics is the most important part of running a business. If a business is changing tax accountants every year or their auditors, a big red flag should go up. We have had clients that have changed their tax accountant every single year, when it got to us we found that prior years were so badly misstated that there were activities that were highly questionable. Once the client was done with us they moved onto another firm with a bad tax liability in the end because of trying to hide income and over stating expenses for several years. So if you are moving from tax firm to tax firm, or from auditor to auditor, firms are now questioning why and may no longer take you on as a client, they see you as a risk. The (AICPA) Committee of Sponsoring Organizations of the Treadway Commission (COSO) prepared an analysis of fraudulent financial reporting occurrences between 1998 and 2007 and found that 26% of the firms that experienced fraudulent reporting also changed auditors between prior clean financials and the issuance of fraudulent financials. All of the changes happened in either the year of the fraudulent reporting or in the year just prior. So keep in mind that ethics in the way you run your business and report your business results can send up a red flag.
The AICPA has stated, “Probably the most important deterrent to financial fraud is that senior management creates a culture in the business that lets all employees know fraud will not be tolerated. Top managers need to go on record that they expect to work in an ethical environment and expect employees to conduct themselves in an ethical manner.”
TYPES OF FRAUD: 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 (taken from Investopedia):
- 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
To know your financials statements is vital, and sometimes it is good to bring in outside accountant to look at your financial statements from time to time independently. Have the accountant review the financial statements, ask questions on things that are a red flag, and resolve issue before they get out of hand. But it all starts with the business owner taking a lead in ethical business practices and monitoring their financial statements. Don’t be afraid to ask questions, ask and keep asking.