Financial statement manipulation is the costliest type of occupational fraud. The latest Report to the Nations published by the Association of Certified Fraud Examiners found that the median loss from financial statement fraud was $800,000, compared to median losses of $114,000 for asset misappropriation and $250,000 for corruption.
With any type of fraud, the sooner it’s detected, the more likely losses can be mitigated. One tool management and fraud experts might use to assess the likelihood of earnings manipulation is the Beneish model.
The Beneish model measures the probability that a company’s revenue has been inflated and its expenses have been understated. The model generally computes an “M score” from comparisons between consecutive financial reporting periods of various metrics, including:
- Days sales in receivables,
- Gross margin,
- Asset quality,
- Sales growth,
- Sales general and administrative,
- Leverage and
- Total accruals to total assets in the current reporting period.
These metrics are designed to capture the effects of earnings manipulation or preconditions that can prompt a company to engage in earnings manipulation.
The economics professor who created the Beneish model admits there are some important limitations to the technique. Notably, the model can’t reliably be applied to privately held businesses because it was developed using public company data. Additionally, his sample involved manipulation to overstate earnings. Therefore, the model isn’t useful in circumstances where it could prove advantageous to reduce earnings — for example, to push revenue into the next quarter to help meet a target for that quarter.
Some distortions in financial statement data also could have a cause that’s unrelated to earnings manipulation. A metric might be distorted by, say, a material acquisition during the period examined, a material shift in the company’s strategy for maximizing value or a significant change in the relevant economic environment.
Simply a red flag
Because it’s relatively easy to use, the Beneish model can be an efficient screening tool for earnings manipulation. It’s important to note, however, that a high M score doesn’t prove fraud. Rather, it suggests that further investigation, preferably by forensic accounting experts, is necessary.
© 2020 Covenant CPA
Ask many entrepreneurs and small business owners to show you their financial statements and they’ll likely open a laptop and show you their bookkeeping software. Although tracking financial transactions is critical, spreadsheets aren’t financial statements.
In short, financial statements are detailed and carefully organized reports about the financial activities and overall position of a business. As any company evolves, it will likely encounter an increasing need to properly generate these reports to build credibility with outside parties, such as investors and lenders, and to make well-informed strategic decisions.
These are the typical components of financial statements:
Income statement. Also known as a profit and loss statement, the income statement shows revenues and expenses for a specified period. To help show which parts of the business are profitable (or not), it should carefully match revenues and expenses.
Balance sheet. This provides a snapshot of a company’s assets and liabilities. Assets are items of value, such as cash, accounts receivable, equipment and intellectual property. Liabilities are debts, such as accounts payable, payroll and lines of credit. The balance sheet also states the company’s net worth, which is calculated by subtracting total liabilities from total assets.
Cash flow statement. This shows how much cash a company generates for a particular period, which is a good indicator of how easily it can pay its bills. The statement details the net increase or decrease in cash as a result of operations, investment activities (such as property or equipment sales or purchases) and financing activities (such as taking out or repaying a loan).
Retained earnings/equity statement. Not always included, this statement shows how much a company’s net worth grew during a specified period. If the business is a corporation, the statement details what percentage of profits for that period the company distributed as dividends to its shareholders and what percentage it retained internally.
Notes to financial statements. Many if not most financial statements contain a supplementary report to provide additional details about the other sections. Some of these notes may take the form of disclosures that are required under Generally Accepted Accounting Principles — the most widely used set of accounting rules and standards. Others might include supporting calculations or written clarifications.
Financial statements tell the ongoing narrative of your company’s finances and profitability. Without them, you really can’t tell anyone — including yourself — precisely how well you’re doing. We can help you generate these reports to the highest standards and then use them to your best advantage. Call us today at 205-345-9898.
© 2019 Covenant CPA
With millions of dollars at stake, an overextended real estate developer has a lot to lose if lack of funds causes a project to collapse. To attract investment capital, some developers have been known to resort to financial statement fraud. If you’re considering financing a project, you need to know how to spot such deception.
Ample opportunity to cheat
There are many ways to falsify a financial picture. For projects in the planning phase, a company seeking financing may provide overstated appraisals of the completed property. Or it may fail to mention its inability to secure utility access or approval from local authorities to rezone the property’s intended location.
For projects already under construction, the developer may inflate the percentage of development completed or amount of materials already purchased. Or a developer could neglect to report funds received from previous lenders or investors.
Sweat the small stuff
To avoid shady deals, review project proposals carefully. For example:
Look at supporting documents. In their rush to “improve” financials by manipulating income statements, balance sheets and cash flow statements, some companies may overlook supporting documents such as project-related budgets and forecasts. Compare these to the company’s primary financial statements and, if you find discrepancies, ask for a detailed explanation.
Scrutinize line items. Certain financial statement line items tend to correspond to each other. For example, labor expense and the accounts payable balance should increase at a rate similar to the percentage of construction completed to date. If line items appear out of sync, ask to see the books of original entry such as the accounts payable aging reports or salary expense reports.
Employ analytical techniques. Common size analysis can help you verify the integrity of specific line items. The process converts each item to a percentage of a base number. For example, to analyze wages and benefits expense, you would divide wages and benefits expense by revenue. Once you’ve converted every line item on the income statement to a percentage of revenue, you can compare the percentages within a reporting period and against prior and subsequent reporting periods.
Given the inherent complexity of commercial and residential construction projects, there are plenty of ways for unscrupulous developers to con lenders and investors. Contact us at 205-345-9898. We can help you determine whether a project’s financial statements appear sound.
© 2018 Covenant CPA