Fraud Flashcards
(37 cards)
Detecting accounting fraud using quantitative techniques
Nirali Singh and Oriol Amat
August 2020
The product sales were entered in the books without the delivery of the products and service revenues were recognized without completion of the projects. Delivery of products were done to parties with wrong addresses and cut-out company sales were carried out, where Ricoh purchased its own products at double price from a company, thus making 71 percent of the reported revenues from the “IT services”.
Differences between profit and cash
One of the best red flag of accounts manipulation is the difference between earnings and cash, using information from the cash flow statement. In general, earnings and cash should have a similar evolution. When differences appear, it is because of the accruals which are contained in the earnings of a company. These non-cash parts are revenues or expenses that do not have impact in cash. Examples of accruals are invoices owed by customers that have not been paid or increase in inventories that have not been sold. An increase in the difference between earnings and cash, means an increase in accruals. When the difference is positive, because profits are higher than the cash generated, it can be a signal that the company has inflated the earnings, for example to show a better economic image. If the difference is negative, because the profits are lower than the cash generated, it can be a signal that the company has reduced the earnings, for example to pay less taxes. These differences can signal a higher probability of accounts manipulation because earnings and expenses are easier to manipulate than cash movements12.
Net Profit before Tax
- Net Cash from Operating Activities
Difference between profit and cash
Sloan Ratio: Sloan stipulated that the higher amount of accruals a company has, the lower would be the level of performance because the accruals determine the quality of earnings of a company13. Moreover, accruals are more susceptible to subjective judgements and assumptions that provide a huge margin for account manipulation. The Sloan ratio is given as the difference of Net profit and the cash generated by operations divided by total assets:
Sloan Ratio = (Net Profit before Tax – Net Cash from Operating Activities) / Total Assets
According to Sloan, a value higher than 10% reflects that there is a huge difference between the reported profit and the cash generated, and this can be suspicious.
Liquidity Ratio: Insufficient solvency has always been associated with the likelihood of fraud. Companies that have a high amount of short-term debt have been observed to give in to temptations of manipulating accounts because their short-term solvency issues threaten their company’s value and may lead them to bankruptcy. Hence, evaluating liquidity ratio (Current assets/Current liabilities) is a simple yet effective measure in identifying fraud. In general, when this ratio is much lower than 1, and gets lower along the years, can be a signal of liquidity problems.
Debt Ratio: This ratio is calculated dividing total debt by equity (Total Debt / Equity). Excessive debt always signals a red flag in company’s accounts. Excessive debt indicates multiple issues. For example, is a signal that the company is unable to sustain its operations with its own earnings and needs continued refinancing through loans. The way in which the debt is being used in the company (either as an investment or buy-outs, for example) determine its financial health. If the company is highly leveraged, it might present a motivation for managers to perform accounts manipulation and report profit of the company.
Benford’s Law of anomalous numbers
The law of “anomalous numbers” is used by auditors and accountants to determine a chance of account manipulation. Benford analysis can reveal bizarre patterns in the accounts in case the numbers have been “cooked”. According to this law, in a naturally occurring collection of the numbers, the leading digit should likely be small, and with increase in the value of the digits the probability of them occurring naturally in the dataset decreases logarithmically (base 10). Nigrini explained the use of Benford’s law in accounting. The law can be applied to a small dataset with 50 datapoints, however, the larger the data set the better.
Altman Z Score: Altman proposed the Z Score formula for predicting bankruptcy for publicly traded companies20. The Altman model could predict the “possibility” of a company going into bankruptcy in the next two years. However, the model did not fit for the private companies, hence, in 2000 a revised model was introduced by Altman, that replaced the market value of equity in 1968 model to book value of equity21. This model consists of five crucial ratios that are used as discriminants to identify potential bankruptcy. These ratios can also signal underlying issues in a company’s accounts that can lead to malpractices in accounting. The ratios used in this model are:
a) (Current Assets – Current Liabilities)/Total Assets (X1)
b) Retained Earnings/Total Assets (X2)
c) Earnings before interest and taxes / Total assets (X3)
d) Book value of equity / Total liabilities (X4)
e) Sales / Total Assets (X5)
The final Z Score for private companies is given by the formula:
Z = 0.717 x (X1) + 0.847 x (X2) + 3.107 x (X3) + 0.420 x (X4) + 0.998 x (X5)
After substituting the values of the ratios and adding the coefficients a Z Score can be obtained which can be interpreted as follows:
> 2.9: Bankruptcy not likely
1.23 - 2.9: Grey Area
<1.23: Bankruptcy very likely
Beneish M Score: Beneish introduced a statistical model that could predict the possibility of account manipulation in company’s accounts. According to Beneish: “The evidence indicates that the probability of manipulation increases with: (i) unusual increases in receivables, (ii) deteriorating gross margins, (iii) decreasing asset quality, (iv) sales growth, and (v) increasing accruals.” There are eight variables in the model. Seven of the variables are ratios that compare changes from the previous year to the reported year, to capture any changes resulting from the manipulation. These ratios are:
a. Receivables Index (DSRI): This ratio shows the change in account receivables from the reported year (t) to the corresponding previous year (t-1). If there is a high increase in the amount of receivables of a company, this can indicate the changes in credit policy of the company and can predict the likelihood of inflated sales.
b. Gross Margin Index (GMI): This is the ratio of Gross margin (Net sales – Cost of goods sold) from the previous year (t-1) and the reported year (t). Harrington states that a GMI of 1.041 or lower indicates no manipulation, but a GMI index of 1.193 or higher indicates manipulations. A deteriorating financial health of a company can prompt the managers to artificially inflate earnings.
c. Asset Quality Index (AQI): Asset quality is the ratio of non- current assets (other than PPE, property, plant and equipment) to total assets in a given year. Hence, AQI captures the change in asset quality in the reported year in comparison to previous year. An increase in AQI indicates that additional expenses are being capitalized to avoid losses.
d. Sales Growth Index (SGI): This ratio denotes the increase in sales in the reported year as compared to previous year sales. Intuitively, a disproportionate increase in sales in one year could indicate manipulations.
e. Depreciation Index (DPI): DPI shows the change in depreciation of PPE in previous year (t-1) as compared to year (t). Since, depreciation is “not” physical cash inflow or outflow, manipulators tend to change the policies by which they calculate depreciation of their assets in the accounts to adjust earnings.
f. Sales General and Administrative Expenses Index (SGAI): It is calculated as ratio of SG&A to sales in year t to the corresponding measure in the year (t-1). If these expenses increase disproportionately, it might be a signal of manipulation because higher expenses may predict worse future prospects29.
g. Total Accruals to Total Assets (TATA): This ratio measures the change in working capital (other than depreciation) with respect to total assets. Accruals refer to accrued earnings that are still unpaid and therefore can be included as assets. However, the higher number of accruals can indicate the probability of manipulation because the accruals are still not converted to real cash and thus, are easier to manipulate than actual cash transactions.
h. Leverage Index (LVGI): LVGI is the ratio of total debt to assets in current year (t) to previous year (t-1). If the LVGI is higher for the year t, it indicates that the company heavily relies on debt to sponsor its operations and the probability of it being a manipulator increases in order to showcase a healthy growth.
The Beneish M Score is given by the formula:
M Score = −4.84 + 0.92 × DSRI + 0.528 × GMI + 0.404 × AQI + 0.892 × SGI + 0.115 × DPI −0.172 × SGAI + 4.679 × TATA − 0.327 × LVGI
M Score is less than -2.22: Low probability that the company is a manipulator. M Score is greater than -2.22: High probability that the company is a manipulator.
Beneish M Score has an accuracy rate of 76%, in identifying manipulators
Vladu, Amat and Cuzdiorean Z Score: This is a Z index useful to detect companies that have committed accounting fraud. The formula uses four ratios.
a) Index of customers to sales (R1): Calculated as the ratio of increase in account receivables with respect to sales from the previous year to the current year. If the increase in receivables is too high it can be a sign of manipulation.
b) Index of inventory to cost of sales (R2): If the ratio of inventory level with respect to cost of goods sold increases from the previous year to the current year, manipulation could be a possibility.
c) Index of depreciation compared to PPE (R3): Any abrupt changes in the policies of the company by which they calculate depreciation can indicate possible manipulation.
d) Index of debt to assets (R4): Intuitively, if the ratio of debts with respect to the total assets increase asymmetrically from previous years to current year, we can deduce the possibility of manipulations. Debt has been a huge factor in determining the likelihood of bankruptcy which has been found as a strong motivator for accounts manipulation.
Z score : -4.5 + (0.03 x R1) + (0.15 x R2) – (0.17 x R3) + (4.23 x R4)
Z > 0.20: High probability that the company is a manipulator.
-0.24 < Z < 0.20: Grey Zone
Z < - 0.24: Low probability that the company is a manipulator.
The accuracy of this model in identifying manipulations is between 72% and 77%
Percentage of soft assets (%SFT): Soft assets are defined as total assets minus the cash and the residual values of long-term tangible assets such as PPE and investment property etc. Barton et al, stipulate that more creative accounting techniques could be applied to net operating assets, and hence, companies that have more percentage of soft assets will have more opportunities to manipulate accounts
Changes in cash revenue (deltaCashSales): This ratio defines the changes in cash revenue from previous year to this year. The cash revenue is calculated as a difference of sales and account receivables
Uncovering Creative Accounting
KEVIN AMOR AND ALAN WARNER
Creative accounting in a publicly quoted company is about manipulating the financial numbers to arrive at an answer that meets the needs of the company management, rather than providing objective information for the external recipients – primarily shareholders.
In the case of the Balance Sheet, the fundamental purpose of the financial statement is less clear-cut, because there have been conflicting views about the purpose of the balance sheet, particularly in recent times. This has arisen because of the desire of some modern accounting thinkers to make the balance sheet into a statement that records the value of the business, or at least parts of it. In the past there was no dispute about whether the balance sheet was a valuation statement – it was clearly understood and accepted that it was not.
What the leaders of the accounting profession sometimes seem to overlook is that the more you try to make
accounting more ‘sophisticated’ and achieve objectives that it was never designed for, the more you open doors to creativity.
Once you change the question to ‘how much is it worth?’ instead of ‘how much did it cost?’ – you are into complex judgement areas which depend on many assumptions and challenge the intellect of the producer, auditor and interpreter of accounts. It is ironic but true that the desire to disclose and report more relevant information often leads to more manipulation and less understanding.
The balance sheet is not a valuation statement!
Under this simple but logical view of things, the purpose of the balance sheet could be quite clearly stated. Whatever the layout – assets equals liabilities as in the US, or net assets equals shareholders funds as in the UK – it is a document of control. It shows the shareholders and others appraising the accounts, where the money to fund the business has come from and what has been done with it. The fact that the two sides balance, shows that every penny has been accounted for and that there is control within the business. All assets are accounted or at their historical cost.
‘Marking up to market’ is the norm for companies trading in marketable financial instruments and commodities, a treatment that seems both logical and workable. It is one of the few occasions where it is justifiable to show assets in the balance sheet at anything other than historical cost. A failure to mark to market would not provide the shareholders of a trading company with a true and fair view of the profitability of their operations.
This simple view of life (that the balance sheet is a document of control and not a valuation statement) has changed and there are now many in the accounting profession – the UK and internationally – who believe that the balance sheet can and should value the business and its assets, tangible and intangible. This desire to achieve what we would regard as a doubtful goal had its origins in the 1970s when ‘asset strippers’ first came on the scene. Companies like Slater Walker took advantage of companies that had undervalued property assets in their balance sheet, taking them over and making a profit on their subsequent disposal. The tendency was to place the blame on the accounting principle of cost-based asset valuation, rather than where it really lay – on the under-performance of the companies concerned.
As a result of this change, no longer was the purpose of the balance sheet clear – a new door to creativity was pushed open.
The 1999 ASB paper mentioned above, and a later Financial Reporting Standard FRS 18, have questioned the modern relevance of some of these principles (prudence, matching, consistency and going concern-accounting at cost less amortisation). For instance it is suggested that the prudence principle should sometimes be waived in favour of new concepts of ‘reliability and relevance’ and the consistency principle in favour of ‘comparability’. Our view is that these challenges are more about the use of words than about real changes of principle and are unlikely to change the prudent, consistent, common sense approach of good, experienced auditors. This must be a good thing. If the management and auditors of Enron had put prudence before their perception of ‘relevance’, the results might have been very different. Our view is that the likely fall-out from recent scandals is that there will be a return to the old values and principles.
The principle of ‘substance over form’ is also validated by the UK Companies Act 1985. It is closely related to ‘true and fair view’ except that it goes even further. It states that good accounting and auditing should be based on the view that it is the real impact and intention of the transaction or situation that matters, not its
technical or legal status. For example, it should not be possible to hide an asset from the balance sheet by an agreement which, though legally a lease, is really a financial vehicle to borrow money.
In the UK the concepts of ‘true and fair view’ and ‘substance over form’, provide the ongoing framework, while Financial Reporting Standards (FRSs) are published to deal with specific issues.
One problem about the emphasis on accounting standards and their enforcement by the auditors, is that it gives the impression that good accounting practice is all about technical issues which only accountants with their ‘professional’ expertise can understand. Technical arguments about esoteric issues sometimes endorse that impression. The reality is that the responsibility for good, honest accounting must rest clearly and unequivocally with the top management and directors of the companies concerned.
The Companies Act goes even further and makes an interesting and remarkable provision to justify the true and fair view and to authorise the directors (and auditors) to make subjective judgements. It says that where compliance with other specific provisions of the Act would go against the principle of ‘true and fair view’ the directors should go for the option that is true and fair. This is a clear justification of ‘substance over form’ – even to the extent of providing authority to avoid compliance with legislation and with accounting standards.
Bad Debt Provision
In practice the auditor can do no more than check the assumptions behind the provision, ask probing questions and assess the credibility of the answers. It is here that the accounting principle of consistency comes into play. The major part of the bad debt provision is usually based on some kind of formula, based on the
age of the debts and the percentage probability of collection. The auditor should first check that this formula is reasonably rigorous and has been consistently applied, then try to assess whether there is a sufficient further ‘general provision’ to cover other unforeseen defaults. The latter will be judged on a combination of past experience, an assessment of current trading conditions and the application of the prudence concept.
Exceptional ITems and Pro-Forma Earnings
Exceptional items are defined by FRS 3 as ‘material items which derive from
events or transactions … which … need to be disclosed by virtue of their size or incidence if the financial statements are to give a true and fair view’. A definition like that is bound to lead to differences of view and to temptations for managers who want to massage the profit figures. Typical examples of exceptional items would be expenses connected with an acquisition which did not eventually take place, payments to lawyers for fees relating to a legal restructuring of the holding company, or profits from selling off property.
FIve areas where ‘judgement’ is used which can have a material impact on the financial statements and in particular the Income Statement are:
Capital or revenue expenditure - especially high value repairs
Bad debt provisions - look for consistency
Stock valuation - FIFO or LIFO, unusable stock write-downs
Assessment of liabilities - non-disclosure
Exceptional items - ‘Profit before all bad things’