Investors trying to digest the current crop of quarterly reports have plenty to keep them up at night. An underfunded Securities and Exchange Commission, regulatory changes reducing auditor oversight of newly public companies, and executive compensation structures that favor short-term profits all foster a hothouse environment for accounting fraud. The good news is that even investors without forensic accounting expertise might be able to spot clues regarding potential problems before any scandals erupt.
At least in retrospect, even the most complex corporate accounting frauds are sometimes preceded by warning signs. In the case of Enron, there were some puzzling features to the company's financial disclosures before the energy giant imploded in 2001. For example, Enron's reported sales grew to $100 billion by 2000 from $13 billion in 1996, a rate vastly disproportionate to those of its peers. Furthermore, a closer look at Enron's financial statements reveals that while its annual sales growth in 2000 was 150%, its annual earnings perplexingly grew only 10%.
Growth rates inconsistent with peer performance are just one warning sign that accountants examining corporate books look for in their daily practice. Specifically, Statement on Auditing Standards 99 outlines a set of 42 “risk factors” or red flags to aid external auditors in their fraud analyses. While internal auditors, securities analysts, portfolio managers and other financial professionals use these factors, savvy investors can incorporate these tools into their evaluations as well. While the presence of such red flags cannot themselves reveal accounting fraud, they can be a valuable tool in assessing the quality of information provided by companies.
Newly acquired companies combined into a core operating segment: Companies can use merger transactions to mask a slowdown in their core business. The combination of new acquisitions into the same reporting segment as a core business can sometimes be used to mask declining profits in a core business. This red flag can be spotted by reviewing the segment data section in the financial statement footnotes and observing favorable public statements about the core business.
High restructuring costs: Companies can also use merger transactions to manipulate earnings. At the time the target company is booked in the acquirer's statements, the acquirer may take inflated charges to income for corporate restructuring costs that can be reversed later to pad earnings. In essence, the acquirer has created a cookie jar at the time of the acquisition and draws cookies from the jar to fraudulently manage earnings. Therefore, unusually high restructuring costs found within the financial footnotes can be a signal that closer scrutiny is warranted.
Unusual growth in accounts receivables: If accounts receivables grow at a faster pace than the company's revenue, it can indicate the company is making bad sales to customers who are unable or unwilling to pay, which could result in a future write-down of bad debt. It also suggests the company is booking revenue before the proper time, which is one of the most common forms of accounting fraud. If this red flag is present, an evaluation of the company's justifications for this divergence might be warranted.
Inventory growth out of line with sales trends: A substantial rise in inventory over time may indicate a company is holding on to slow-moving or obsolete assets that should be written off its books. By letting inventories rise over time, companies may be avoiding write-downs and income charges they should be taking. If inventory growth is outpacing sales growth over a considerable period of time, an asset write-down may be looming. The appearance of this warning sign may call for an evaluation of the company's disclosures to determine the reasons for this variance.
Excessive use of operating leases: Under Generally Accepted Accounting Principles, leases are classified as either “capital leases” or “operating leases.” During the early years of a lease term, operating leases generally result in higher earnings on the lessee's books than capital leases. In addition, operating leases make companies appear less leveraged than capital leases. Therefore, companies sometimes misclassify leases to artificially inflate their earnings and present the appearance of a lower credit risk. After determining that a company has classified its major leases under the operating classification, financial statement footnotes may provide clues as to potential accounting violations. For example, an extremely long operating lease term may indicate it should have been classified as a capital lease.
Investors will not be alone in looking for these kinds of hints in new corporate filings. Recently, the SEC has indicated it will assign more resources to accounting fraud investigations. On June 17, co-Director of Enforcement George Canellos stated the SEC would give fraud-related cases more attention and that the agency's accounting specialists would focus on red-flag issues in financial disclosures. While this new focus from federal regulators brings crucial new firepower to the fight against corporate fraud, knowledge may still be the best weapon investors have to protect themselves.
Michael Stocker is a partner and William Schervish is the director of financial analysis at law firm Labaton Sucharow.