Professional Skepticism - Beware of financial reporting fraud !

One of the important pillars of investment analysis is company analysis.

Let's say we analyse the account, we find that the account is audited by some famous audit firm. Everything points to a "strong buy". Can it be wrong ?

Yes, it can go wrong, even extremely wrong too.
We will be surprised by how many cases of accounting frauds that are uncovered (not counting those that are not surfaced yet).

Areas of reporting most susceptible to fraud
report pursuant to section 704 of Sarbanes-Oxley Act of 2002

In this SEC study, areas of reporting most susceptible to fraud, inappropriate manipulations and earnings management mentioned are:

• improper revenue recognition,
• improper expense recognition,
• improper accounting in connection with business combinations,
• inadequate disclosure in MD&A & elsewhere,
• failure to disclose related party transactions,
• inappropriate accounting for non-monetary & rountrip transactions,
• improper accounting for foreign payments,
• improper use of off-balance sheet arrangement,
• improper use of non-GAAP financial measures.

The number of cases in the report can shock you. Real cases for different types were mentioned.

Fraud risk factors
Frauds take time to be uncovered.

Often when it is uncovered, it is already too late for the investors. Share price plummets, "trapped" investors suffer big losses.

It is better to avoid them in the first place.

Look for the warning signs and red flags.
If we see the warning signs and red flags, if we are in doubt, avoid the firm.

3 conditions generally present when financial reporting fraud occur:

• incentives/pressures
• opportunities
• attitudes/rationalizations

Refer to Appendix (page 300-7 onwards) of the following document for list of fraud risk factor.
"(AICPA SAS 99) Consideration of fraud in financial statement audit"

(AICPA is American Institute of Certified Public Accountants.)

Though "areas of reporting most susceptible to fraud" and "fraud risk factors" are mentioned, be always aware that the list is not exhaustive. New instruments, new environment, make possible new ways of frauds. Buyer bewares !