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FORENSIC INVESTING: RED FLAGS

NICHOLAS G. APOSTOLOU, DBA, CPA, Cr. FA
D.LARRY CRUMBLEY, Ph.D., CPA, Cr. FA, CFD, FCPA

Accounting, investing, forensic, mutual funds, investors, shares, stock market, inventory, and finance

(Copyright 1990)

 

Forensic Investing

Forensic investing involves looking beyond the obvious. A normal investor acts like a watchdog, but a forensic investor acts like a bloodhound looking for red flags. Investors must look beyond the numbers on financial statements and dig into the corpse of a company or a mutual fund. The author and creator of Sherlock Holmes [Sir Arthur Conan Doyle] said that "detection is, or ought to be, an exact science, and should be treated in the same cold and unemotional way."

Many investors and creditors are discouraged from using financial statements and the related footnotes because of their complexity. And, indeed, a thorough knowledge of financial statements of a company of any size can required considerable time and effort. But it is possible to glean important information about a company's prospects by spending time looking for specific indications of potential problems or red flags.

But suppose the financial statement is wrong? Some companies use creative accounting techniques to disguise damaging information, to provide a distorted picture of the financial health of the business, to smooth out erratic earnings, or to boost anemic or no earnings. Investors should have a healthy skepticism when reading and evaluating financial reports. Businesses are often clever in hiding these accounting tricks and gimmicks, so investors must be ever alert to the signs of outright financial shenanigans. Investors must attack financial statements and company information the way the fictional Sherlock Holmes approached murder cases.

According to Howard M. Schilit, "financial shenanigans are acts or omissions intended to hide or distort the real financial performance or financialconditions of an entity." Schilit provides seven shenanigans; the first five boost current year earnings, and the last two shifts current-year earnings to the future:

  1. Recording revenue before it is earned
  2. Creating fictitious revenue
  3. Boosting profits with non recurring transactions
  4. Shifting current expenses to a later period
  5. Failing to record or disclose liabilities
  6. Shifting current income to a later period
  7. Shifting future expenses to an earlier period
[H.M. Schilit, Financial Shenanigans, New York: McGraw-Hill, Inc., 1993]

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Red Flags

Clues that a company may be heading for trouble include: Back to the top
 

Statements on Auditing Standards No. 82 and 99

Before the Sarbanes-Oxley Act, the American Institute of Certified Public Accountants was responsible through its Auditing Standards Board in developing auditing standards that had to be satisfied by public accounting firms. The SEC required publicly traded firms to be audited by public accounting firms to provide reasonable assurance of presentation in conformity with generally accepted accounting principles. In conducting an audit, public accounting firms had to observe generally accepted auditing standards as promulgated by the Auditing Standards Board. Today the PCAOB is responsible for developing auditing standards.

One of the most highly publicized statement on fraud auditing standards in recent years was published in early February of 1997. Statement on Auditing Standards No. 82, Consideration of Fraud in a Financial Statement Audit, provided guidance to the auditor in the detection of financial statement fraud. This statement, effective December 15, 1997, clarified the auditorís responsibility to detect fraud.

The statement is rather lengthy but it has an interesting discussion of what it calls risk factors (what we call red flags) that should be of interest to our readers. Although subsequent SAS No. 99 replaced SAS No. 82, the following section of SAS No. 82 is still of particular relevance:

Risk Factors relating to managementís characteristics and influence over the control environment. Examples include:

A motivation for management to engage in fraudulent financial reporting. Specific indicators might include:

  • A failure by management to display and communicate an appropriate attitude regarding internal control and the financial reporting process. Specific indicators might include:
  • Risk factors relating to operating characteristics and financial stability. Examples include: Back to the top
     
     

    Green Flags/ Yellow Flags

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    Last Updated: May 31, 2006

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