Financial Statement Analysis and Fraud

Financial Fraud

For companies and organizations to remain as successful as possible, they must maintain a strong understanding of the firm’s financial health. Financial statement analysis has long been one of the most trusted and powerful procedures for developing insight on a firm’s financial health. Although financial statement analysis is primarily conducted by accountants or financial professionals, it is important that users of financial statements possess a general understanding of accounting, financial statements, and analysis, particularly to help prevent cases of financial fraud.

Benefits of Financial Statement Analysis

The benefits of this analysis vary depending on the user and their personal preferences. Some of the most common benefits of financial statement analysis include more personal understanding of their company’s financial health, deeper insight for decision-making, quicker insight for identifying market trends and patterns and the ability to identify potential financial problems or cases of fraud.

Cases of Fraud

According to a recent study conducted by Cornerstone Research, accounting-related fraud cases have been steadily increasing. In 2015, 71 cases were opened in comparison to 69 and 47 in the previous two years. Some believe this expansion may be due to increased awareness as the U.S. Securities and Exchange Commission has made accounting-fraud a priority after two decades of numerous high-profile cases.

One of the most publicized accounting-fraud cases involved the energy conglomerate Enron, who spent years practicing fraudulent and corrupt accounting procedures. Enron’s fraudulent activity was first reported by Fortune journalist Bethany McLean in 2001 with her article, “Is Enron Overpriced?” At the time, Enron was a Wall Street powerhouse with trades at approximately 55 times price-earning (PE) ratio. Despite their veneer of success, Enron was internally falling apart. Yet, internal accountants and the powerhouse accounting firm, Arthur Andersen LLP, had a clever way of hiding losses through a form of accounting called mark-to-market accounting where security is determined by its market value as opposed to the standard book value as well as transferring assets to firms off their books. Enron also used special purpose vehicles (SPVs), which allowed the company to hide massive amounts of debts and unfavorable assets.

Thus, with the help of mark-to-market accounting and SPVs, losses were hidden and the company appeared to be doing remarkably well, much to the joy of investors. Their primary financial interests may have actually blinded investors, for had they or other financial statement users had taken an in-depth look at Enron’s financial statements, they likely would have been able to identify a number of questionable accounting practices. At the time, questioning two major Wall Street giants was unheard of though, which left the whistle-blowing opportunity available for the young McLean.

Ran in March of 2001, McLean’s article was the first step in the eventual demise of Enron’s accounting scheme. The article created a stir amongst reporters and Wall Street analysts, so much so that by August, new CEO Jeffrey Skilling suddenly resigned and in October, Arthur Andersen LLP advised Enron to burn all of their files except the most basic documents. By November, Enron admitted to inflating earnings by nearly $586 million since 1997, sending a huge shock through Wall Street and resulting in a series of penalties, fines, and suspensions from the New York Stock Exchange.

McLean’s initial investigation sparked a series of U.S. Security and Exchange Commission investigations on Wall Street giants. The following year after Enron’s scandal, the telecommunication company Worldcom was given penalties for accounting fraud after an internal auditing session uncovered $3.8 billion in fraud. Worldcom generated most of these fraudulent funds by inflating assets, which resulted in losses of $180 billion for investors, misreporting line costs listing them as capital than expense and corrupting the books with made-up accounting entries to spike revenues.

Similar to the Enron case, if financial statement users had just analyzed or better understood accounting and their financial statements, they would have been able to quickly identify and bring attention to these corrupt accounting practices. Thus, no matter whether it’s a C-suite executive or an investor, users of financial statements should not only request for frequent financial statement analyses, but also to personally take the time to develop an understanding of financial statements so they can be well equipped to make the best financial decisions and ultimately prevent fraudulent activity from occurring and disrupting the entire firm.

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