Irrational ratios.The numbers raise a red flag. "Financial statements tell a story," says accounting professor W. Steve Albrecht, "and the story should make sense." If not, it's possible the story is a fake. By standing far enough back from the numbers to get a good picture of the client's business, auditors frequently can detect signs of financial statement frauds. Because the balance sheet, income statement and statement of cash flows are interrelated in·ter·re·late tr. & intr.v. in·ter·re·lat·ed, in·ter·re·lat·ing, in·ter·re·lates To place in or come into mutual relationship. in , such frauds can pop out when certain numbers don't make sense. The inescapable logic of the accounting equation ensures that any major overstatement o·ver·state tr.v. o·ver·stat·ed, o·ver·stat·ing, o·ver·states To state in exaggerated terms. See Synonyms at exaggerate. o of assets or profits, such as in the infamous ZZZZ Best ZZZZ Best A company owned by Barry Minkow in the 1980s. Through such means as forgery and theft, Minkow appeared to be building a multimillion dollar corporation. ZZZZ Best went public in December of 1986, eventually reaching a market capitalization of over $200 million (U.S. case, will show up over time. Riding in the back of a taxi from the Federal Correctional Institute in Englewood, Colorado Englewood is a city in Arapahoe County, Colorado, USA. As of 2005, the city is estimated to have a total population of 32,350.[5] It is part of the Denver-Aurora Metropolitan Area. , to the Denver airport, I held a videotape in my hand. Two hours earlier, I had recorded the story of the legendary Barry Minkow Barry Minkow (born March 17 1967) is an American religious leader and ex-convict. As a young teenager Minkow was a fraudulent entrepreneur who managed to present the front of a successful businessman for a number of years during the 1980s. , the "boy wonder" who, in the mid-1980s, had conned his investors and auditors in a $100 million financial-statement fraud scheme. I planned to use the video to train auditors. Minkow, who had volunteered for the interview, told me everything--something he'd not done even for "60 Minutes." For the briefest moment I thought, Minkow really is a pretty nice guy; then I smiled ruefully rue·ful adj. 1. Inspiring pity or compassion. 2. Causing, feeling, or expressing sorrow or regret. rue and shook my head. One of the greatest con artists of all time had just charmed an experienced (read: cynical) fraud examiner. But that is the nature of such tricksters: they appear bright, articulate, sincere and likable lik·a·ble also like·a·ble adj. Pleasing; attractive. lik  a·ble·ness, like . Barry Minkow was certainly
that--and much more.Minkow had started a carpet-cleaning business in his parent's garage when he was only 13. Within five years, ZZZZ Best Carpet Cleaning Service went public. But the company was built entirely on Minkow's lies. By the time he was 20, the fraud had been uncovered and Minkow was sentenced to 25 years in federal prison (he served eight years before being paroled). BORN TO COMMIT FRAUD? Minkow said that, although he didn't know exactly why, he'd been committing fraud almost since the day he opened for business. In the early days, when he couldn't meet payroll, he'd steal checks and deposit them in his bank account. He also would kite checks, overbill customers and overdraw TO OVERDRAW. To draw bills or cheeks upon an individual, bank or other corporation, for a greater amount of funds than the party who draws is entitled to. 2. his checking account--whatever it took to stay afloat. What made Minkow believable be·liev·a·ble adj. Capable of eliciting belief or trust. See Synonyms at plausible. be·liev  a·bil was his verbal ability. After three decades of meeting and dealing with
white-collar criminals, I would put Minkow at the very top; he is
without question one of the most persuasive crooks I have ever met.Minkow's early frauds had escalated to the point where, to keep from being discovered, he had to get outside financing. The first time he borrowed money, it was on the strength of inflated, unaudited financial statements and altered tax returns. When that loan came due, he borrowed from another bank using the same method. He did the same with the next bank--and the next. Finally, when his bank financing ran out, Minkow came up with the idea of going public. It was the only choice he had to avoid discovery. So he and his lieutenants created a mountain of phony documents to fool the auditors. The bulk of the fraud was concentrated in ZZZZ Best's sales and receivables, most of which were fictitious Based upon a fabrication or pretense. A fictitious name is an assumed name that differs from an individual's actual name. A fictitious action is a lawsuit brought not for the adjudication of an actual controversy between the parties but merely for the purpose of . The silver-tongued Minkow managed to get past the audit. With the millions raised in the public offering, he was able to cover his previous frauds, and ZZZZ Best seemed poised to grow even bigger. Then he had a piece of bad luck. A disgruntled dis·grun·tle tr.v. dis·grun·tled, dis·grun·tling, dis·grun·tles To make discontented. [dis- + gruntle, to grumble (from Middle English gruntelen; see carpet-cleaning customer--suspicious of Minkow's business practices--contacted a Los Angeles Times Los Angeles Times Morning daily newspaper. Established in 1881, it was purchased and incorporated in 1884 by Harrison Gray Otis (1837–1917) under The Times-Mirror Co. (the hyphen was later dropped from the name). investigative reporter. The deeper the reporter dug into Minkow's background, the more sinister the story became. When a front-page article detailing Minkow's questionable past and his attempts to bilk bilk tr.v. bilked, bilk·ing, bilks 1. a. To defraud, cheat, or swindle: made millions bilking wealthy clients on art sales. b. numerous carpet-cleaning customers through double and phony billings hit the newsstands, Wall Street reacted. Trading in ZZZZ Best stock was suspended. With no further funds to cover the frauds, the company quickly collapsed. The audit firm paid millions for its failure to uncover Minkow's crimes. Investors lost a reported $100 million. When it was over, the assets of ZZZZ Best--all of them--were sold for less than $50 thousand. THE NUMBERS DON'T LIE The most basic analytical techniques An analytical technique is a method that is used to determine the concentration of a chemical compound or chemical element. There are a wide variety of techniques used for analysis, from simple weighing (gravimetric) to titrations (titrimetric)to very advanced techniques using (vertical, horizontal and ratio analyses) might have given the auditors for ZZZZ Best some important clues. Since these techniques compare changes in the numbers from year to year, they can point out significant discrepancies. In the ZZZZ Best case, look at what a simple ratio analysis would have revealed (see exhibit 1).
Exhibit 1: Selected Ratios From ZZZZ Best
1985 1986
Current ratio of assets to liabilities 36.55 0.10
Working capital: Total assets 0.59 (0.0080)
Collection ratio N/A 26.13
Asset turnover 0.14 1.04
Debt to equity ratio 0.02 1.49
Receivables turnover N/A 6.98
Times interest earned N/A 43.14
Cost of sales: Sales 0.47 0.42
Gross margin percentage 53.51% 57.68%
Return on equity 183.75% 46.58%
These numbers make no sense at all--they are all over the place. Particularly revealing are the current ratio and the debt to equity and return on equity ratios. The current ratio shows a company with no cash in 1986 despite record "revenues." The 1986 debt to equity ratio The debt to equity ratio (D/E) is a financial ratio indicating the relative proportion of equity and debt used to finance a company's assets. It is equal to total debt divided by shareholders' equity. is up 8600% from the prior year; return on equity has dropped by more than 75%. These are not indicators of a legitimate business. A NEW APPROACH? Since the ZZZZ Best case, there have been attempts to develop new analytical techniques to better assist the auditor. In his 1999 article, "The Detection of Earnings Manipulation," (Financial Analysts Journal, Sep./ Oct.99), Messod D. Beneish--an associate professor at the Kelly School of Business, Indiana University--researched the quantitative differences between public companies that had committed financial statement manipulations and those that had not. Beneish theorized there may be up to five useful predictors of earnings manipulation, which he defined as "an instance in which a company's managers violate generally accepted accounting principles The standard accounting rules, regulations, and procedures used by companies in maintaining their financial records. Generally accepted accounting principles (GAAP) provide companies and accountants with a consistent set of guidelines that cover both broad accounting (GAAP GAAP See: Generally Accepted Accounting Principles GAAP See generally accepted accounting principles (GAAP). ) to favorably represent a company's financial performance." Beneish's ratios, which he labeled "indexes," used figures he obtained from financial statements. DAYS' SALES IN RECEIVABLES INDEX This sales variable index (see equation below) measures whether receivables and revenues are in or out of balance in two consecutive reporting periods. A material increase in the index could indicate a company's receivables are phony. That was exactly the situation with ZZZZ Best. By creating counterfeit To falsify, deceive, or defraud. A copy or imitation of something that is intended to be taken as authentic and genuine in order to deceive another. A counterfeit coin is one that may pass for a genuine coin and may include a lower denomination coin altered so that it may documents, Minkow's employees manufactured receivables and sales out of thin air. Beneish determined that companies that had not manipulated sales (non-manipulators) had a mean index of 1.031; companies that had manipulated sales (manipulators) had a mean index of 1.465, a 42% increase. In the case of ZZZZ Best, the index was a whopping 177,622. The reason for this huge difference is that in year one, ZZZZ Best had no accounts receivable accounts receivable n. the amounts of money due or owed to a business or professional by customers or clients. Generally, accounts receivable refers to the total amount due and is considered in calculating the value of a business or the business' problems in paying but in year two it had nearly $700,000--all fictitious. Some of the condensed con·dense v. con·densed, con·dens·ing, con·dens·es v.tr. 1. To reduce the volume or compass of. 2. To make more concise; abridge or shorten. 3. Physics a. financial statement numbers for ZZZZ Best are shown in exhibit 2.
Exhibit 2: ZZZZ Best Financials
1985 1986
Sales $1,240,524 $4,845,347
Cost of goods sold $576,694 $2,050,779
Accounts receivable 0 $693,773
Current assets $107,096 1,727,973
Total assets $178,036 $5,045,671
Fixed assets $125,519 $2,564,532
Accumulated depreciation $68,029 $163,145
Net fixed assets $57,490 $2,401,387
General expenses $306,016 $1,125,541
Depreciation $95,116
Cash $30,321 $87,014
Current liabilities $2,930 $1,768,435
Notes payable--current 0 $780,507
Income taxes payable 0 $28,027
Working capital $104,166 ($40,462)
The formula for the days' sales in receivables index is [Accounts receivable.sub.t]/[Sales.sub.t] / [Accounts receivable.sub.t-1]/[Sales.sub.t-1] = days' sales in receivables index (Note: Current-year income statement and balance-sheet items are indicated with a subscript (1) In word processing and scientific notation, a digit or symbol that appears below the line; for example, H2O, the symbol for water. Contrast with superscript. (2) In programming, a method for referencing data in a table. and prior year items have a t-1 subscript. The change in account balances from one yearend to the next is denoted by [Delta], delta. Delta is used to calculate total accruals Accruals Accounts on a balance sheet that represent liabilities and non-cash-based assets used in accrual-based accounting. These accounts include, among many others, accounts payable, accounts receivable, goodwill, future tax liability and future interest expense. , which are discussed later in the article.) Using numbers from the ZZZZ Best financials, the index is calculated as follows: 693,773/4,845,347 / 1/1,240,524 = 177,622 Two observations: First, material increases may not be the result of receivables manipulation, but rather could be caused by legitimate factors, such as liberalized credit policies from one period to the next. Second, this index and the others here are not foolproof: In Beneish's research they correctly identified predictors in about one-half to three-quarters of the cases. GROSS MARGIN INDEX One sign that a company's performance is suffering relates to its gross margins. If an entity's gross margins on sales shrink from Verb 1. shrink from - avoid (one's assigned duties); "The derelict soldier shirked his duties" fiddle, shirk, goldbrick avoid - refrain from doing something; "She refrains from calling her therapist too often"; "He should avoid publishing his wife's one period to the next, the risk is higher that management will engage in fraud to create artificial profits or decrease losses. In Beneish's research, the mean for non-manipulators was 1.014; for manipulators 1.193, an increase of 18%. However, in the ZZZZ Best case, the gross margin index produced no useful comparisons. The formula for the gross margin index is [Sales.sub.t-1]-[Cost of sales.sub.t-1]/[Sales.sub.t-1] / [Sales.sub.t]-[Cost of sales.sub.t]/[Sales.sub.t] = gross margin index ZZZZ Best's numbers in this equation were 1,240,524-576,694/1,240,524 / 4,845,347-2,050,779/4,845,347 = .92781 Note: This index will not tell you whether a company is engaging in financial statement fraud: It is designed to alert you that the risk of earnings manipulation is higher when gross margins drop. But, if the company is already engaging in attempts to inflate inflate - deflate earnings, gross margins will be just the opposite: higher than normal. ASSET QUALITY INDEX The asset quality ratio derives from dividing noncurrent assets Noncurrent asset Any asset that is expected to be held for the whole year, not sold or exchanged, such as real estate, machinery, or a patent. noncurrent asset (minus property, plant and equipment) by total assets. It measures the proportion of total assets for which future benefits may be less certain. For the purpose of evaluating earnings manipulation, an increase in the asset quality index may indicate a company's propensity to capitalize costs. In the Beneish study, nonmanipulators had a mean of 1.039, manipulators 1.254, an increase of 21%. ZZZZ Best's index was 2.043, a 97% increase over the mean for non-manipulators. This index could have alerted auditors to irregularities. The formula for the asset quality index is 1 - [Current assets Current Assets Appearing on a company's balance sheet, it represents cash, accounts receivable, inventory, marketable securities, prepaid expenses, and other assets that can be converted to cash within one year. .sub.t]+[Net fixed assets fixed assets npl → activo sg fijo fixed assets npl → immobilisations fpl fixed assets fix npl → .sub.t]/[Total assets.sub.t] / 1 - [Current assets.sub.t-1]+[Net fixed assets.sub.t-1]/[Total assets.sub.t-1] = asset quality index ZZZZ Best's numbers were 1 - 727,973+2,401,487/5,045,671 / 1 - 107,096+57,490/178,036 = 2.0435 SALES GROWTH INDEX By using the sales growth index, which is computed by dividing the current period's sales by the last period's, the auditors should be able to tell whether a company is adding fake sales. The mean for nonmanipulators in this study was 1.134; for manipulators 1.607, a 42% increase. An increase in the index reflects a rise in sales, which may or may not be legitimate. The formula for the sales growth index is [Sales.sub.t] / [Sales.sub.t-1] = sales growth index The ZZZZ Best numbers were 4,845,347 / 1,240,524 = 3.905 Note: The sales growth index can detect potential fraud only when sales have increased. The sales growth index of a company that is adding fictitious revenues just to stay even with last year will not be out of line. In ZZZZ Best's case, the index was 3.905, compared to 1.134 for nonmanipulators. Clearly, this could have been a warning sign for auditors. TOTAL ACCRUALS TO TOTAL ASSETS INDEX For purposes of this index, total accruals are calculated as the change in working capital accounts (other than cash) less depreciation. In Beneish's study, the mean index of nonmanipulators was (.018), compared with manipulators (.031), a 72% increase. An increase in accruals from one period to the next may indicate management is attempting to manipulate earnings through its discretionary authority over accrual policy. The formula for the total accruals to total assets index is [Delta]Working capital-[Delta]Cash-[Delta]Current taxes payable-Depreciation and amortization / Total assets For ZZZZ Best, the numbers were -144,628-56,693-28,027-95,116 / 5,045,671 = -.064 The presence of higher accruals and a corresponding decrease in cash often can be an attempt by management to internally finance its losses. In the ZZZZ Best case, the index of.064 is almost four times the study's mean for nonmanipulators, another possible clue of fraud. A FINAL WORD OF CAUTION Fraud, by its nature, is easy to conceal and difficult to detect; an entity that manipulates its earnings only once might avoid discovery altogether. But manipulating financial statements is usually a continuous process that grows and deepens. So the indexes discussed above--along with vertical, horizontal, and ratio analyses--can give the auditor tools to help identify fraud. You should be cautioned, though, that no one irregularity A defect, failure, or mistake in a legal proceeding or lawsuit; a departure from a prescribed rule or regulation. An irregularity is not an unlawful act, however, in certain instances, it is sufficiently serious to render a lawsuit invalid. is a sign of financial statement manipulation. Rather, you should carefully observe patterns over a period of time. Step back, assess the numbers, look at the big picture and see if it tells the right story. Days' Sales in Receivables Index This sales index (or ratio) measures whether receivables and revenues are in or out of balance in two consecutive reporting periods. A material increase in the index could indicate a company's receivables are phony. Professor Messod D. Beneish determined that companies that had not manipulated sales had a mean index of 1.031; companies that had manipulated sales had a mean index of 1.465, a 42% increase. JOSEPH T. WELLS, CPA (Computer Press Association, Landing, NJ) An earlier membership organization founded in 1983 that promoted excellence in computer journalism. Its annual awards honored outstanding examples in print, broadcast and electronic media. The CPA disbanded in 2000. , CFE CFE Conventional Forces in Europe (treaty) CFE Cash Flow to Equity (finance/accounting) CFE Comisión Federal de Electricidad (México) CFE Certified Fraud Examiner , is founder and chairman of the Association of Certified Fraud Examiners Established in 1988 the Association of Certified Fraud Examiners is the professional organization that governs professional fraud examiners. Its activities include producing fraud information, tools and training. , Austin, Texas. Mr. Wells' article "So That's Why They Call It a Pyramid Scheme Pyramid Scheme An illegal investment scam based on a hierarchical setup that relies on new recruits' funding as the source of money, or so-called returns, to be provided to those earlier investors/recruits above them in the pyramid. " (JofA Oct.00, page 91) has won the Lawler Award for best article in the JofA in 2000. His e-mail address See Internet address. e-mail address - electronic mail address is joe@cfenet.com. |
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