'Income smoothing' becomes fraud

A team of fraud fighters uses three different analytical tools for measuring accruals (amounts that aren't cash transactions) in a company and finds that some managers had added fraudulent loans to boost the numbers and keep the shareholders happy.

Solzarity Inc. was a mid-sized, well-respected community company that provided loan services to individuals. All looked fine on the surface. The financial statements painted a rather rosy future. However, the shareholders eventually questioned the financial information. Some of the financial ratios — such as the current ratio, working capital and working capital turnover — suggested lower liquidity issues. (This is an actual case, but we've changed the name of the firm.)

Now, the combination of lower liquidity and higher profitability isn't necessarily indicative of financial statement manipulation. For example, a company may be using cash earned from the profits to increase and/or improve capital assets. However, at some point, the available cash must be used to pay its bills and capital assets must shrink.

Yet in Solzarity's operations, capital assets weren't increasing so there wasn't a reasonable explanation for the inconsistency. Our team used various analytical tools to measure the accruals within the financial statements to determine if the company was manipulating the financial statements that caused the inconsistency or if management needed to revise its strategic plans for the upcoming year.

Ultimately, after we analyzed seven years of loan portfolio actions we found multiple management misrepresentations. When we reviewed our findings with the company, it said that some managers had added fraudulent loans during the years in which earnings had slipped from previous years. Some members of management felt that the shareholders' and the company's reputations were at risk if the company hadn't shown growth. Unfortunately, they had decided that they were going to grow only on paper — not in reality. (For more information on common financial ratios, see the sidebar at the end.)

WHAT ARE ACCRUALS AND HOW CAN WE TEST THEM?

Accruals in financial statements play an important role in determining the overall financial health of a company, but they also open opportunities for misrepresentation of a company's performance. An accrual is any amount that isn't a cash transaction, such as accounts receivable and accounts payable. Allowances and reserves also are considered accruals and are based upon management's estimates. All of these areas are subject to financial statement manipulation, so measuring accruals concentrates on their effects on current income and future cash flow.

Analysts generally use three techniques to measure the impact of accruals in financial statements: Dechow-Dichev Accrual Quality, Sloan's Accruals and Jones Nondiscretionary Accruals. These methods can identify manipulation of earnings or possible "income smoothing" — better known as earnings management. While income smoothing might not constitute fraud, intentional manipulation of financial statements to mislead the readers of those statements does.