USC Expert: Spotting Fictitious Financial Statements

The biggest fraud scandals to rock Wall Street over the past decade -— from Enron to Worldcom to Adelphia – took analysts, investors and employees by surprise. Even now, new scandals continue to make headlines.

In a new book called Business Fairy Tales: Grim Realities of Financial Reporting, USC Marshall School of Business accounting expert Cecil W. Jackson, uses these examples and many others to show readers how to possibly protect themselves against future scams by demonstrating the biggest accounting schemes and the tell-tale signs manipulated financial statements leave behind.

Jackson, an authority on aggressive financial reporting issues, examines the 20 most common accounting schemes, based on an analysis of the frequency of Securities and Exchange Commission enforcement actions, and uses real-life examples of deception, aggressive accounting and outright fraud at WorldCom, Enron, Sunbeam, Xerox, Adelphia and Krispy Kreme, among other companies, to illustrate them.

Among the Top 20 Accounting Schemes:

• Holding books open after the close of a reporting period for the purpose of improper timing of revenue recognition, as Sensormatic did in 1994 where all quarters received significant assistance in boosting numbers by recording the next quarter’s sales early.
• Improper capitalization of expenses or losses as evidenced by WorldCom when they recorded money spent on expenses as though it had been spent on acquiring assets which would have held their value into following reporting periods.
• Improper use of restructuring and other liability reserves. The overstated reserves are released in future periods to fictitiously understate future periods’ expenses as illustrated by Sunbeam after its restructuring in 1996.
• Improper use of off-balance sheet arrangements. Enron used a multiplicity of off-balance-sheet entitites to generate false profits with contrived sales and to deep debt off its balance sheet. By the time Enron collapsed it had a confusing jumble of more than 3,000 inter-related “special purpose entities,” that were used to overstate earnings and understate debt via contrived transactions.
• Failure to disclose related-party transactions. Adelphia used a network of off balance sheet partnerships that hid debt, boosted earnings and looted Adelphia for the Rigas family’s personal gain.

  Using the story of each company as a framework, the book also provides the signals indicating possible fictitious reporting in financial statements, arming employees, investors, retirees and others who depend on reliable fiscal information from public companies to become their own detectives.

  Among the Top 20 Signals:

• The quality and track record of company leaders. The quality of a company’s leadership is the primary signal as to whether its financial statements are likely to be fraudulently reported.
• Accounts receivable increase as a percentage of sales. If the next period’s sales have been accelerated into the current period, or if the sales are fictitious, the company will debit accounts receivable and credit sales.
• A sudden change in the gross margin percentage – sudden increases or decreases — could indicate illegitimately reported sales.
• Cash flow from operations falls or lags behind operating income or net income could indicate overstatement of revenue or understatement of expenses.
• Large amounts of money allocate to goodwill on the acquisition of other companies may indicate false reserves may have been created and released back into earnings in order to falsely boost post-acquisition profits.

  Jackson is a Certified Public Accountant and professor of clinical accounting in the Marshal School of Business and Leventhal School of Accounting, and the director of the USC Center of the California Council on Economic Education. He teaches courses on fraudulent financial reporting, forensic accounting and managerial accounting at the graduate and undergraduate levels.

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  Contacts:
  James Grant (213) 740-6156 or james.grant@usc.edu
  Evelyn Jacobson (213) 740-7915 or news@marshall.usc.edu