There are basically only three ways that someone can cook the books if they want to falsely show more positive results than truth. Better stated, there are only three categories of book-cooking, with innumerable specific adjustments within those categories that can be made with the result of creating intentionally misleading financial reports.
Overstating revenues or assets or accelerating their recognition.
Understating expenses or liabilities, or deferring their recognition.
Misstating or omitting other material facts which have financial impact.
Two wonderful communicators remind us of the very best ways to discover financial mischief: Warren Buffett loves to say that "you should never invest in a business that you don't understand," and Ronald Reagan often nodded and said "Trust, But Verify." Usually, the more complicated the financial statements, the easier they are to manipulate for an improper purpose, and usually the more that specific entries can be confirmed by undisputed, third-party evidence, the less likely that a false number can survive for long.
A perfect place to start the process is Statement on Auditing Standards No. 99, Consideration of Fraud in financial statements. If the team uses this basic checklist, then at least the possibility of fraud will have been actively discussed early in the review process, and the team will have concentrated on the ways in which these particular books might be cooked, with increased alertness hopefully resulting.
Some other general caveats:
First, if the company uses "SPEs," - special purpose entities, immediately put them under a special microscope until you are confident that there is a really critical business purpose for an SPE to exist at all, and not just an attempt to make the balance sheet look better than simple reality would dictate.
The same automatic skepticism should be triggered when one assesses any transaction or expense involving any affiliate, not just an SPE. Expect always to see "sunshine and oversight," meaning voluntary and entirely full disclosure of all details, supported by third-party receipts or other equivalent evidence, and independent review and supervision to confirm the entire fairness of every expenditure. And remember that credit card vouchers are not receipts; they are only some, often inaccurate, evidence that someone paid something, not whether the payment was proper or was not later reversed.
Second, think about why someone would falsify entries, and whether he has the chance to do so, and whether he is under pressure to do so. Usually false financial statements start with someone convincing himself that these numbers really need changing, or that these assets really need misappropriating, and this rationalization often results in modest false adjustments at first, intended to be corrected later or earned away. If the managers think that only reported results are important, then they are far more likely to create them one way or the other. To do this, there must be the opportunity to do it, and almost always there is some pressure to change the numbers, sometimes internally generated, and sometimes for personal benefit, but perhaps resulting simply from misguided good intentions, to make the company look better than reality, often in reaction to a domineering senior executive.
Third, have the outside auditors recently been changed? Ask why. And confirm why. This is key, since very often a company that cooks the books also has had a recent change in auditors, or has very weak auditors to begin with. And think about the Internal Audit Department. Are they highly qualified? Are they properly staffed? Do they report around the management directly to a really independent (and really qualified) Audit Committee? Are their reports first cleared with Management and only released after massage? Exactly just how trustworthy are their reviews?
So let's look at 10 Red Flag Areas, a "Top 10 List" which would highlight and, hopefully, expose most instances of financial chicanery if they are carefully considered and applied:
Revenues and Assets Can be Fabricated; Cash Rarely
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