Do you remember Enron? Executives of this Texas energy company (formed in 1985) decided that providing electricity and natural gas to homes and businesses was not exciting enough. In the 1990’s management began trading natural gas and electricity contracts to hedge the cost of producing power. Their business model soon transitioned into offering trading services to customers and third parties and their reported trading profits became more meaningful to the company than their original power business. Enron became a growth stock that everyone wanted to own and its stock price soared.
Unfortunately Enron’s tale ended unhappily. To keep stock market analysts and investors happy management knew that the company had to continue to report robust profitability and a strong balance sheet. They began to report their financial condition deceptively by moving losses and debt out of Enron and into off-balance sheet Special Purpose Entities (SPE’s). Enron’s management did not keep these SPEs a secret but implied that they were no different than standard industry practice. Unfortunately their auditor, Arthur Andersen LLP was either also misled or not diligent enough to discover the burden that these SPEs (and other financial distortions) would have on their client. In 2001 Enron was bankrupt resulting in serious losses to lenders, customers and others. Ultimately Arthur Andersen LLP was convicted of a felony and had to give up the practice of auditing which effectively put the company out of business.
No fraud scheme is easy to uncover but financial statement fraud is unusually difficult because it relies on the detailed analysis of financial statements created using GAAP (Generally Accepted Accounting Principles). While CPA audited statements are the most reliable documents even those cannot prove that fraud is not occurring. In many companies financial statements may not be audited and may only be prepared by the company itself. In the following sections I will discuss some of the difficulties in looking for financial statement fraud and identify general tips to keep in mind while searching for this elusive activity.
To begin the search for fraud several years of financial statements should be obtained. At a minimum the balance sheet, income statement and statement of cash flows are necessary. The statement of cash flows ties the balance sheet and income statement together. Without it the job of finding fraudulent activity becomes nearly impossible.
The person behind a financial statement fraud is usually someone with access to the company’s accounting system allowing that person to create or approve transactions. In companies with poor internal controls one person may be able to both create and approve entries. The fraud requires a combination of creating fraudulent transactions in the accounting system and altering or creating fake business documents to back up the transactions.
It is rare for one person in a company to know how to manipulate the accounting system, create fraudulent documents and have access without oversight so frequently these frauds are carried out by several persons working in collusion. On occasion a “trusted” senior executive may be behind the fraud. Both of these were in evidence with Enron.
Before analyzing the financial statements two common sense tests can be performed. First, a company with significantly higher sales and/or profitability than other companies in the same type of business (especially continuing over several years) points to the need for a deeper investigation. At a minimum the reason the company is performing better than their peers should be clearly understood. It is even more likely when the growing company seems to have no unique product or service being offered.
A company that exhibits both high sales growth with high profitability over time is very rare. Remember, high sales growth is often caused by lower pricing which typically results in lower profitability. A good example is Amazon.com which uses a low pricing strategy to take market share from other companies at the cost of its profitability. Conversely, higher profitability is frequently the result of higher pricing but high prices tend to decrease sales.
The second common sense test is whether a company with strong growing profitability is exhibiting positive cash flow from operations. Highly profitable companies will normally have strong operating cash flow. If the “Cash Provided by Operating Activities” section of the Statement of Cash Flows does not exhibit positive cash flow then another caution signal may be flashing.
The complete analysis of financial statements and supporting documents is beyond the scope of this post and an actual analysis of suspected fraud will require the support of trained and experienced forensic accountants. However, the use of the common sense tests can help identify company financial statements that may be suspicious and warrant additional scrutiny. Remember, it is rare to find companies with both
- High sales growth and high profitability over several years relative to their peers, and
- Positive cash flow from operations over several years (again relative to peers)
If your company has been a victim of fraud let me know if you are willing to discuss it with me. It would be helpful to other entrepreneurs to hear about real life examples of fraud, loss and recovery.