Study Finds About 20% of US Public Companies Cheat On Earnings Reports


Can also happen anywhere.

 

I am a little surprised that the fraud number came in that high in a survey. I do not know many CFOs that would readily self-identify their work as fraudulent in nature. So therefore I also think that in actuality the number is rather low, given what I have seen for myself and the vagaries of human nature. When cheating becomes accepted and profitable almost everyone does it.

It should not surprise that so many of the CFO’s chafe under the rules from FASB, which is the accounting industry self-regulator. They complain of too many restrictive rules, and yet they also admit fraud is pervasive. And it is their own organization that sets the standards.

Since 1973, the Financial Accounting Standards Board (FASB) has been the designated organization in the private sector for establishing standards of financial accounting that govern the preparation of financial reports by nongovernmental entities.

I cannot speak for the current period, but during the build up to the tech bubble the manipulation of earnings was almost par for the course, as certain industry leaders set standards of consistent returns that were obviously based on questionable accounting practices.

From what I have seen, the same is true for the financial sector which had its own bubble and collapse. As a rule of thumb, any genuine bubble conceals a cesspit of fraud and criminal activity amongst insiders.

Here are the red flags that the study derived:

The three most common flags are persistent deviations between earnings and the underlying cash flows, deviations from industry and other peer experience, and large and unexplained accruals and changes in accruals.

There are also a number of red flags that relate to the role of the manager’s character and the firm’s culture, which allow and perhaps even encourage earnings management.

That last sentence is a polite way of saying that some companies become almost indistinguishable from criminal enterprises in their values and methods.

Probably the most easily identifiable red flag is an improbable consistency, the ‘beat by a penny’ quarter after quarter syndrome. If something looks too good to be ‘real’ then it is probably based on a fraud, in either the accounting or the market activity, and often both. It may not be illegal, but it certainly may be a material misrepresentation of the health of the business that will bite down the road.

From my own experience and stated as a non-professional accountant the key areas I would look for are in writedowns of inventory that can then be used to supplement profits later, holding back the realization of revenues in an arbitrary manner, shifting of tax and depreciation numbers, transfer pricing from foreign subsidiaries, and the manner in which one accounts for acquisitions.

The key point is that in the US for the past twenty years the numbers are often phony and the game is rigged, because greed in the financial and managerial elite has overcome any fear of prosecution. When the rewards are great and the risks incidental, dishonesty thrives.

The consequence is that the financial sector has become a largely extractive, outsized activity that thrives on the fraudulent manipulation of risk and value, distorting the real economy, and transferring wealth from the productive to the clever and unscrupulous.

This may serve during a period of endless financial expansion, but when the hard times come the frauds collapse quickly.

Regulators and politicians turn a blind eye to this, when the good times are rolling. And when the hard times come, even more wealth is extracted from the public to cover their bets and maintain their grand illusion. And then comes the deluge.

The complete paper can be downloaded here.

Earning Quality – Evidence From the Field

ORIGINAL ARTICLE HERE