Detecting Fraudulent Financial Reporting

 

Recently I came across a very interesting paper on detection of fraud in financial reporting. This paper “Major Financial Reporting Frauds of the 21st Century: Corporate Governance and Risk Lessons Learned”, authored by Hugh Grove and Elisabetta Basilico was published in Journal of Forensic & Investigative Accounting (Vol. 3, Issue 2, Special Issue, 2011 of).

Authors of this paper start by explaining 10 red flags in corporate governance. Their premise is that if one was looking at these flags or factors, it should have been possible to detect several large corporate accounting scandals. Authors discuss nine accounting frauds (Citigroup, Worldcom, Enron, Qwest, Tyco, Global Crossing, Lehman Brothers, Satyam and Paramlat) to illustrate their idea.

I liked very user friendly tone of this article which doesn’t assume prior knowledge of complex accounting ideas. However, best part of this article is its appendix. Authors have provided a very readable and concise summary of important accounting metrics and ratios.

When I read it, this paper was available at following link.

http://www.bus.lsu.edu/accounting/faculty/lcrumbley/jfia/Articles/FullText/2011_v3n2a7.pdf

I look forward to your feedback, suggestions and comments.

Evaluating financial statements–few important metrics

I have burnt my fingers few times by blind reliance on analyst reports or my own intuition. Today I will like to discuss few financial metrics that I have found of immense help in navigating through maze of financial numbers and analyst reports. These metrics allow me to view financial numbers in perspective and identify areas that need further exploration.

Before I delve further into what I know so far, I must caution that these metrics are empirical & should be used only for guidance. They should not be treated as an absolute statement on a stock’s worthiness. 

First metric that I find very useful is Beneish M-Score. This number, devised by Professor Messod Beneish, highlights probability of earning manipulation. This number, in its larger form, is based on a weighted sum of eight factors (called indexes) that are derived by comparing past and current financial statements. Another version of this number uses five of those indexes. Professor Beneish’s analysis showed that there is a very high probability of manipulation in financial statements if Beneish number is greater than -2.22. One should analyze financial statements with much caution and further dig into each of 8 factors if Beneish analysis raises an alert. It is also important to do this analysis over several years to identify a pattern and to check any possibility of financial manipulation in past. Further details of 8 factors are available from multiple sources on internet.

Second metric that I like is Altman Z score. This score measures financial health of a company and indicates probability that a firm will go into bankruptcy within two years. This score depends on four or five business ratios. There are few variants of Altman-Z formula for different industry segments. In general, a score above 3 indicates that a company is unlikely to enter bankruptcy. A score below 1.8 indicates a highly likelihood of financial distress within next two years.

Third metric that I will like to discuss is Piotroski F-score. This score measures relative financial health of firms. It is based on 9 factors. A score of 0 or 1 is assigned to each of these factors and total of all 9 factors if F-score for the firm. For example, Net income is one of the Piotroski factors. It will get a score of 1 if net income for that year is positive. A score of 7 or more indicates a financially strong company.

Three metrics written above should be used during preliminary analysis to identify areas that need deeper investigation. One should look at those factors of these scores that indicate any kind of distress. Ideally, these scores should be calculated over several years. These scores, coupled with other financial ratios are helpful in weeding out risky companies.

In near future I will share my spreadsheet tool that I created for my own use. Till then,  Arivederchi!

PS: Following is result on an analysis I did on September 27 2012

My favorite web sites on investing and finance

 

I routinely struggle with my savings and investments. Few months ago I found few excellent sources of information that have helped me in navigating maze of confusing financial statements. I would like to share these sites with whoever is reading this blog. I hope that you will also benefit. If you know of other sites, please feel free to share that information.

1. Grumpy old accountants - http://blogs.smeal.psu.edu/grumpyoldaccountants/ - I can’t stop praising this site. Professor Anthony H. Catanach, and Professor J. Edward Ketz do an excellent job of explaining nuances of financial statements. Check for series of blogs on groupon. Also look for a recent blog on intangible assets.

2. Seeking Alpha –http://seekingalpha.com - This site is actually a complete portal on financial information. You should subscribe to their newsletters. Check an excellent article on “Dividend paying companies” at http://seekingalpha.com/article/836971-not-all-dividends-are-worth-it?source=yahoo.

3. Old School Value - http://www.oldschoolvalue.com – This site, owned by Jae Jun, is another excellent source of education for newbie investors. His newsletters contain excellent implementable information. Jae Jun also provides several free stock evaluation spreadsheets. For more serious and professional investors it has an option of upgraded priced version of tools. Best section of this site is blog at http://www.oldschoolvalue.com/blog/. While you are at this site, look for blog on financial ratios.

This is all for today. I will share more on what I learnt through next few blogs. Till then, ciao!