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Find Weak Financials or Fraud - 8 Red FLAGS for Investors to Watch

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2_Lecture 1_Overview of Financial Statement Analysis 20212

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1_LESSON 2 - FINANCIAL STATEMENT ANALYSIS ANALYTICAL PROCEDURES -Quantitative analysis (student)

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1_LESSON 3 - FINANCIAL STATEMENT ANALYSIS ANALYTICAL PROCEDURES -Qualitative analysis (student)

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Lecture 2 - Financial Statement Analysis

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Definition of Vertical Analysis

Vertical analysis expresses each amount on a financial statement as a percentage of another amount.

The vertical analysis of a balance sheet results in every balance sheet amount being restated as a percent of total assets.

The vertical analysis of an income statement results in every income statement amount being restated as a percent of net sales.

Example of Vertical Analysis of a Balance Sheet

If a company's inventory is $100,000 and its total assets are $400,000 the inventory will be expressed as 25% ($100,000 divided by $400,000). If cash is $8,000 then it will be presented as 2%($8,000 divided by $400,000). The total of the assets' percentages will add up to 100%. If the accounts payable are $88,000 they will be restated as 22% ($88,000 divided by $400,000). If owner's equity is $240,000 it will be shown as 60% ($240,000 divided by $400,000). The sum of the liabilities and owner's equity will also be 100%. The vertical analysis of the balance sheet will result in a common-size balance sheet. The percentages on a common-size balance sheet allow you to compare a small company's balance sheets to that of a very large company's balance sheet. A common-size balance sheet can also be compared to the average percentages for the industry.

Example of Vertical Analysis of an Income Statement

If a company's net sales were $1,000,000 they will be presented as 100% ($1,000,000 divided by $1,000,000). If the cost of goods sold amount is $780,000 it will be presented as 78% ($780,000 divided by sales of $1,000,000). If interest expense is $50,000 it will be presented as 5% ($50,000 divided by $1,000,000). The restated amounts result in a common-size income statement, since it can be compared to the income statement of a competitor of any size or to the industry's percentages.

Definition of Horizontal Analysis

Horizontal analysis looks at amounts from the financial statements over a horizon of many years. Horizontal analysis is also referred to as trend analysis. The amounts from past financial statements will be restated to be a percentage of the amounts from a base year.

Examples of Horizontal Analysis

To illustrate horizontal analysis, let's assume that a base year is five years earlier. All of the amounts on the balance sheets and the income statements will be expressed as a percentage of the base year amounts. The amounts from five years earlier are presented as 100% or simply 100. The amounts from the most recent years will be divided by the base year amounts. For instance, if a most recent year amount was three times as large as the base year, the most recent year will be presented as 300. If the previous year's amount was twice the amount of the base year, it will be presented as 200. Seeing the horizontal analysis of every item allows you to more easily see the trends. It will be easy to detect that over the years the cost of goods sold has been increasing at a faster pace than the company's net sales. From the balance sheet's horizontal analysis you may see that inventory and accounts payable have been growing as a percentage of total assets.

Vertical analysis, horizontal analysis and financial ratios are part of financial statement analysis.

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What is the difference between vertical analysis and horizontal analysis? | AccountingCoach

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Definition of Vertical Analysis Vertical analysis expresses each amount on a financial statement as a percentage of another amount. The vertical analysis of a balance sheet results in every balance sheet amount being restated as a percent of total assets. The vertical analysis of an income statem...

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MOOC Article - Horizontal Vertical Analysis

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What is Earnings Management?

Earnings management is a practice followed by the management of a company to influence the earnings reported in financial statements. It is executed to match a set target and is different from managing the underlying business of the company. An earnings management strategy uses accounting methods to present an excessively positive view of a company's financial positions, inflating earnings.

Earnings management is used by companies to flatten out earnings variations and present profits that are consistent each quarter or year. Variations in earnings may be common for the operation of a large company. However, they create doubts among investors, as they prefer to invest in stocks of companies that show growth and stability.

Earnings Management Approaches

Companies use several strategies used for earnings management. The most commonly used strategies are as follows:

1. Earnings-focused decisions

Certain activities - such as research, advertising, or staff training - can be suspended temporarily. Companies suspend such activities for a short time, assuming that the business will perform better in the upcoming periods, and the suspended activities can be resumed thereafter.

However, for companies that are performing well, the management focuses on the long-term success of the business and does not usually resort to artificially enhancing the earnings.

2. Biased accounting judgments

Accrual accounting presents opportunities for earnings management; however, a company's management needs to exercise some difficult judgments when accrual accounting is applied.

There are formal policies, accounting manuals, and processes followed at well-performing companies to ensure that the judgments are bias-free. Earnings management happens when the management team distorts judgments and mends policies to meet expectations.

3. Altering accounting principles

U.S. accounting standards provide different rules of accounting for the same transactions. For example, both the inventory cost and fixed asset cost can be accounted for in three different but acceptable ways.

The management of well-run companies chooses the accounting rule that best reflects the implicit economic factors. Earnings management happens when a company's management selects an alternative of a certain accounting standard, which will cause the earnings number to meet the expectations.

Identifying Earnings Management

Investors should perform due diligence before investing in the stocks of any company. Some investors analyze a company's financial reports and can identify earnings management.

Listed below are the signs that an investor needs to look for to determine if a company is exercising earnings management to manipulate its financials:

1. The company claims an increase in revenue without a corresponding increase in cash flows.

2. The company reports an increase in earnings only in the final quarter of the fiscal year.

3. The fixed assets of the company are expanding beyond the normal standard for the industry or company.

4. The net worth of an asset is inflated by ignoring the use of the true depreciation schedule.

Related Readings

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Earnings management is a practice followed by the management of a company to influence the earnings reported in financial statements. It is executed to match a set target and is different from managing the underlying business of the company. An earnings management strategy uses accounting methods to present an excessively positive view of a company's financial positions, inflating earnings.

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This Course

Video Transcript

Accounting Analytics explores how financial statement data and non-financial metrics can be linked to financial performance. In this course, taught by Wharton's acclaimed accounting professors, you'll learn how data is used to assess what drives financial performance and to forecast future financial scenarios. While many accounting and financial organizations deliver data, accounting analytics deploys that data to deliver insight, and this course will explore the many areas in which accounting data provides insight into other business areas including consumer behavior predictions, corporate strategy, risk management, optimization, and more. By the end of this course, you'll understand how financial data and non-financial data interact to forecast events, optimize operations, and determine strategy. This course has been designed to help you make better business decisions about the emerging roles of accounting analytics, so that you can apply what you've learned to make your own business decisions and create strategy using financial data.

View Syllabus

Skills You'll Learn

Accounting, Analytics, Earnings Management, Finance

From the lesson

Big Data and Prediction Models

This week, we'll use big data approaches to try to detect earnings management. Specifically, we're going to use prediction models to try to predict how the financial statements would look if there were no manipulation by the manager. First, we'll look at Discretionary Accruals Models, which try to model the non-cash portion of earnings or "accruals," where managers are making estimates to calculate revenues or expenses. Next, we'll talk about Discretionary Expenditure Models, which try to model the cash portion of earnings. Then we'll look at Fraud Prediction Models, which try to directly predict what types of companies are likely to commit frauds. Finally, we'll explore something called Benford's Law, which examines the frequency with which certain numbers appear. If certain numbers appear more often than dictated by Benford's Law, it's an indication that the financial statements were potentially manipulated. These models represent the state of the art right now, and are what academics use to try to detect and predict earnings management. By the end of this module, you'll have a very strong tool kit that will help you try to detect financial statements that may have been manipulated by managers.

Taught By

Brian J Bushee

The Geoffrey T. Boisi Professor

Christopher D. Ittner

EY Professor of Accounting

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Discretionary Accruals: Model 3.1 - Big Data and Prediction Models | Coursera

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Loading... This Course Video Transcript Accounting Analytics explores how financial statement data and non-financial metrics can be linked to financial performance. In this course, taught by Wharton's acclaimed accounting professors, you'll learn how data is used to assess what drives financial performance and to forecast future financial scenarios.

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What is Third Party Fraud?

This is a fraud committed by people outside an employee employer relationship. They can be committed against individuals, businesses, companies, the government or any other entity. Third party frauds are not as common as occupational frauds, but on average each fraud is for a larger amount.

Some third party frauds are not meant to remain hidden forever. Some only remain hidden long enough for the fraudster to make their get-away. The fraudster may not care if the fraud is eventually discovered as they do not have a continuing relationship with the victim and they cannot be found.

What is Financial Statement Fraud?

Financial statement fraud is the manipulation of the information used to prepare the financial statements released to the public and financial institutions. Manipulating these statements allows the business to portray a better but false financial picture, or to hide a disbursement of money, liabilities or assets.

Major Headings

Description of Financial Statement Fraud

1. Manipulating Timing

(i) Early Recognition of Revenues
(ii) Postponing Expenses

2. Falsifying Entries

(i) Fictitious revenues
(ii) Manipulating liabilities and expenses
(iii) Valuing assets

Lessons to be Learned

Description of Financial Statement Fraud

These frauds involve the manipulation of the information used to prepare the financial statements released to the public or other interested parties. The frauds are generally done to show that some financial target, sales or budget projections have been fulfilled. The intended result is usually either to increase share prices of publicly listed companies, or obtain finance on more favorable conditions that would have otherwise been available. Alternatively, the results may be manipulated to show a lower taxable income in order to reduce a tax liability.

Many investors and advisors rely on quarterly or monthly results produced by a company, particularly public companies. Company officers know that special attention is paid to these results and some of them may do everything they can to achieve the desired results. Sometimes those actions are fraudulent.

These frauds have a number of forms and can be companywide or limited to an area or person within the business. Generally they fall into either sales and expense manipulation (profit and loss figures), or asset valuation and hiding liabilities (balance sheet items). These frauds focus on one of two main objectives:

1. to make the performance look better than reality (to entice investment or to 'make the figures'); or
2. to make the performance look worse (to lower the company's tax liability).

The victims of these frauds are usually investors, shareholders or financiers. They lose the value of their investments especially when share prices fall after the frauds are discovered. The offender is not the company itself, but some of the people within the company, whether top company officers or other managers in divisions of the business.

The majority of these frauds fall into two major categories:

1. Manipulating Timing
2. Falsifying Entries

1. Manipulating Timing

The matching principle in accounting provides guidelines for when transactions should be recognized and recorded. In its most basic form, revenues and expenses should be recorded in the period in which the transaction occurred or the period in which the benefit is obtained and, where possible, the expenses associated with a revenue item should be recorded in the same period.

There are two ways of manipulating timing. Both methods make the current period look good, but will cause problems in the next period.

(i) The early recognition of revenues - bringing revenues from a later period into the current period, increasing revenues for the current period.
(ii) Postponing expenses - delaying booking expenses to the next period, decreasing the expenses and raising profits for the current period.

The alternative is to reverse these methods to make the current period look worse and the next period look better.

(i) Early Recognition of Revenues

Businesses will have a policy stating when revenue (sales) should be recorded. The early recognition of revenues is achieved by manipulating these policies to either record sales that were made in the early part of the next period in the current period, or record transactions that should not yet be recognized as sales.

Sales may be recorded when stock is shipped to customers, so some schemes involve shipping stock to customers when that stock has not been ordered and knowing that it will be returned. The sale is recorded when the stock is shipped, and reversed when the stock is returned early in the next quarter, but the earlier period has been closed and the results reported. If you cannot ship the stock directly to the customer - for fear or raising suspicion - you may ship it to a third party warehouse to 'hold' for the customer. It can stay there almost indefinitely.

A sale may be recorded when the invoice is issued. To be able record a sale early, an invoice is issued early, even when there is no sale and no transfer of stock. Sending the invoice to the wrong address, so that it will be returned to you some days later, or holding it in a bottom draw, will save sending the invoice to the customer. This is commonly used when the stock is to be delivered in a later period, but someone wants the sale recorded in this period.

A sales may be recorded when an order is received even if the order is not to be filled, and the actual sale will occur, until a later period.

If the recording policy cannot be manipulated, the fraudster may simply record a sale based on some other action. The more common approaches are:

(a) recording a sale when there are still items or services to be provided;
(b) recording a sale before the sale contract has been finalized and before shipment to customers:
(c) recording a sale when items are sent on consignment, on approval, or with a right of return;
(d) recording a sale to associated parties; or
(e) recording a sale when an order is received
(f) issuing invoices for non-existent sales and recording the transaction.

(ii) Postponing Expenses

Recording expenses in a later period is just as simple. Accounting standards state that expenses should be recognized in the period in which the related benefit is recognized. Expenses and their associated liabilities should be recorded when a legally binding obligation has been created. Most businesses will also have policies about when expenses should be recorded and paid.

The fraud involves postponing the recording of expenses until the next period. The business may only record expenses after the invoice arrives from the supplier. To postpone the expenses, the receipt of the invoice is not recognized. It may be held in an Inbox until the start of the new period.

Expenses may be recorded when the expense is finally paid, in which case the expense is not paid until the next period and recorded at that time. Large expenses may be improperly capitalized and written off over a period instead of being expensed in the current period, or capitalized expenses may be written off (depreciated or amortized) over a longer period than appropriate. This lessens the amount recorded as expenses in the current period and puts some of the expense is later periods.

These actions raise the profits in the current period. Doing the scheme in reverse (delaying recording sales and recording expenses early) lowers a profit in order to reduce a tax liability.

2. Falsifying Entries

Schemes that manipulate the timing of recording transactions affect real transactions. The schemes detailed in this section involve and produce false entries on either real or fictitious assets or liabilities. They commonly fall into the following areas:

(i) Fictitious revenues
(ii) Manipulating liabilities and expenses
(iii) Valuing assets

(i) Fictitious revenues

Fictitious revenues can be created by:

(a) inventing sales transactions; or
(b) classifying other incomes or gains as sales.

A business may enter into transactions that on paper appear to be sales, but when the whole transaction is considered, they either lack any substance or do not create any gain. The method used may depend of the trigger used to record sales. If that trigger is the shipment of stock, you ship stock to someone and record a sale, albeit that the stock was never ordered and will be returned. The account receivable associated with that sale will be reversed at some later stage. Recording the return of the stock as an expense and not against sales will maintain the high sales level.

If sales are recorded when orders are placed by suppliers, fictitious orders may be created. Stock may be sent on consignment, but booked as a sale. Issuing fictitious invoices for sales that never happened can create recordable sales in the current period. They can be reversed in a future period.

Entire transactions may be invented that give the illusion of a transaction that creates revenue. Small nonpublic companies do not have the regulatory bodies look at their records. A entry into Sales (Cr) and Debtors (Dr) as an end of period adjustment makes the company look healthier. This is usually done when the company needs to send information to a financier to support loan applications. This is easier in a service industry company, as there is no movement of stock in any transaction.

Other non-revenue gains may also be recorded as sales. Investment income, capital gains on the sale of assets and other onetime gains may be recorded as sales revenue to make the core business appear healthy. Items like discounts and rebates from suppliers and other non-revenue injections of money from loans etc. may also be recorded as sales.

(ii) Manipulating liabilities and expenses

Manipulating or falsifying liabilities and expenses is done for the same two reasons as the other schemes:

1. to make the company look better to increase share prices or for investment purposes; or
2. to reduce the tax liability.

This can be done in a variety of ways.

Moving a short term liability to long term liability improves the working capital figures on the balance sheet. It is also used to indicate solvency when that may not be the fact.

Capitalizing expenses and writing them off slowly creates an asset that does not exist and reduces the expenses in the current period. These capitalized expenses can then be written off over an extended period spreading the expense.

Not writing off assets when appropriate - usually debtors that become uncollectible, or investments, stock or other assets that will depreciate or fluctuate in value - keeps an 'asset' in the balance sheet when it has no or little worth. These assets should be expensed when their value decreases.

Moving reserves from the balance sheet reduces expense accounts on the profit and loss account.

Understating provisions for contingent expenses makes a balance sheet appear healthier. A business must either calculate various provisions (for bad debts, sales returns, employee entitlements, tax etc.) and make allowance for them in the balance sheet; or allow for known provisions that will cover more than one accounting period (e.g. rectification work on a capital project, ongoing Court actions etc.).

These schemes may be used in reverse if the aim is to reduce a tax liability.

(iii) Valuing assets

There are many ways of inflating the values of or creating assets. The ones mentioned below are just a few of them.
Inventory
Inventory can be the major asset owned by a business and can be one of the easiest to manipulate. There are a few ways of doing this.

1. Value the inventory at a higher price than appropriate (at an inflated selling or cost price) and count the correct amount.
2. Value the inventory at the correct amount and inflate the number of items.
3. Do both.

There may be some limitations on placing very high values on physical items of inventory. Generic items would have a recognizable value. Valuing work in progress has less limitations.

Gaining extra inventory for stock takes is done by either counting empty boxes stacked high on shelves, moving inventory between warehouses so that it is counted multiple times, obtaining inventory from a supplier on consignment or under some right of return, or borrowing inventory from a friendly supplier.

Assets or expenses may be manufactured to hide money that has been misappropriated, or 'investments' in other entities may disguise loans to various parties. This is not done to manipulate the financial position of the company, but to hide the real nature of certain transactions.
Accounts Receivable
Accounts receivable are amounts that are due to the business, and that are expected to be paid. This makes it a flexible concept as the expectation of payment is subjective. Some businesses have debtors that have been with them for years. In fact, the debts have never been written off as uncollectible. This practice improves the balance sheet as the asset stays on the balance sheet and the bad debt expenses is not recorded.

Creating debtors and sales is a simple credit sales / debit debtors entry. This has the same effect. Small businesses that do not have their accounts audited may be able to get away with is when seeking finance. Creating false sales will usually have the effect of increasing debtors.

Alternatively, writing off good debtors at the end of a period creates an expense and lowers profits. You can simply write them back on when collected.

Lessons to be Learned

The role of auditing was created so that an independent person could look behind the financial statements and discover whether they were accurate. This is not an exact science and the cost of an audit can be large. As costs constraints make test sample sizes smaller, the chances that misstatements will slip through the examination increases.

Financial statement frauds are committed within the business, not on the business. The best way of preventing or detecting these frauds is a strong internal and independent audit function. Internal and independent can seem contradictory, but it is an idea that must become a reality.

Some of these frauds have originated from the pressure to get short term results. If the consequences of not getting the results are too great, improper or illegal behavior will increase. Corporate ideals have a large role to play in deterring these activities, by making them unnecessary.

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What is Third Party Fraud? This is a fraud committed by people outside an employee employer relationship. They can be committed against individuals, businesses, companies, the government or any other entity. Third party frauds are not as common as occupational frauds, but on average each fraud is for a larger amount.

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edited2_Lecture 5 ACCOUNTING QUALITY ANALYSIS - lecturer slides