11 How to Detect Financial Statement Fraud? Focusing on warning signals.

Some students cheat in exams to get a higher score.

During earnings seasons, listed companies also take exams in the market.

Just like some students who cheat on exams to get better grades, some listed companies may alter their financial data during earnings season to 'pass' their market test and avoid being ditched.

Among them, some try to make their financial results appear more favorable, known as engaging in “earnings embellishment.”

But for struggling companies that are like bad students reluctant to be expelled from school, they might go to great lengths to appear successful by any means necessary. Such serious cases are called financial frauds.

Companies that commit fraud may escape regulation and scrutiny in the short run and make their earnings appear attractive to boost share prices.

However once detected, their share prices may drop dramatically, which can lead to significant losses for those who are heavily invested in the company.

So how to detect financial embellishment and financial fraud?

And how to perceive the warning signals?

In this video, we'll look into some types of financial statement fraud and how to spot them as soon as possible.

It's better to be safe than sorry.

If we find the following warning signs on reports, we'd better pay attention to the risks involved.

There are mainly two types of financial embellishment or fraud.

No.1, revenue manipulation.Revenue is the source of profit, and they might increase simultaneously.

There are two common forms of revenue manipulation:

First, fictitious sales.

This occurs when a company creates fake sales transactions with its clients to inflate its revenue numbers.

Let’s break these transactions down into capital inflow and outflow.

In the first part, the company sells products at a high price and receives payments from clients.

Then, the company may offer returns to clients who participate in fraudulent activities, such as buying their products at a higher price or providing discounts on other purchases.

Let's look at an example.

A company may sell a product worth $20 million for $50 million, and then buy an asset worth only $20 million from the customer for $60 million. Despite incurring a loss in essence, the company's income and profit can be artificially improved through such practices, which may involve manipulating the valuation of assets in the financial report.

The second form of revenue manipulation is early revenue recognition.

Typically, a company recognizes revenue after the customer has taken delivery of the product.

Moreover, revenue associated with a long-term or complex project might be recognized over a series of accounting periods based on the stage of completion.

Some companies commit fraud by recognizing revenue before the trade is completed, which overstates operating revenue on the current financial statement.

So, what can be the red flags that indicate suspicious practices?

No.1, high gross margin from high-priced products.

You should be mindful when a company sells average products but has a much higher gross margin compared with its peers.

No.2, large cash outflows from investing activities.

Though with steady net cash inflow from operating activities, perpetrators of fraud may have large cash outflows from investing activities.

It is a warning sign if the situation has existed for years.

No.3, sharp changes in operating revenue and rapidly decreasing prepaid expenses.

If a company accelerates revenue recognition, its operating revenue on the income statement might change considerably, while on the balance sheet, you might be able to identify sharp declines in prepaid expenses.

Another form of financial fraud occurs when the company inflates income by understating costs and expenses, known as cost and expense manipulation.

One way of achieving this is to shift current costs to a later period.

For example, firms may defer the transfer of construction-in-process to the completed asset account, resulting in decreased depreciation expense.

They may also record no impairment or under-impairment for potentially impaired assets such as accounts receivable, inventories, or goodwill.

Companies may also use tactics like the "big bath," which involves a huge one-time write-off to make poor results look worse, but can result in a big rise in future earnings after recovery.

While technically not illegal, this tactic is unethical and may cause investors significant losses.

Additionally, it is important to pay attention to assets that are likely to be manipulated to detect unusual expenses.

For example, Investors should carefully evaluate a company’s risks, when its accounts receivable accounts for a higher percentage of revenue, while its bad debt provision percentage is far lower than its peers, or its inventories consisting of easily obsolete items are increasing rapidly, while there are minimal impairment charges.

To sum up, financial falsifications can lead to substantial losses for investors.

We might be able to identify some potentially risky companies early on by discovering anomalies in their financial statements.

But the good news is, there are still many good companies in the US stock market that deserve attention.

Choosing the right companies to invest in can potentially help boost our investment returns in the long run.