In the last 15 years, multiple accounting scandals have roiled the financial markets. One of the most infamous firms associated with accounting fraud is Enron. The US-based energy, commodities, and securities company employed a creative system of financial tricks to show revenue growth while hiding debt and losses. When Enron gradually ran out of tricks and had to admit its deception, executive management faced prosecution and prison sentences.
The wide-scale fraud Enron perpetrated spurred the US government to implement additional accounting regulations. Yet the effects of the scandal—and the many others like it worldwide—continue to affect:
- Your business.
- The availability of capital for good and bad projects.
- How people view management and corporations in general.
- All these factors influence the cost of capital—that is, the price of taking risks.
For investors, managers, and financial analysts, it is crucial to know the truth behind reported accounting numbers. Without this information, you cannot make appropriate business decisions. To help you assess the probability of financial scandal better, the United States’ Securities and Exchange Commission (SEC) has developed the fraud triangle. The fraud triangle comprises the incentives, opportunities, and rationalizations for dishonest reporting. You can use the triangle to maintain awareness of factors that allow or even instigate trickery and fraud—that is, to identify red flags.
The SEC classifies improper accounting techniques into revenue, expenses, business combinations, and other accounting and reporting issues. You can use the financial statements of a business to analyze the revenue, cost, and liability tricks that firms may use to inflate their statements. To evaluate these numbers, you should ask:
Are there incentives and opportunities for a firm to engage in accounting fraud?
What are the ways in which management can rationalize the reported results?
Has the firm employed low-quality revenue, expenses, earnings, liability, and other disclosure techniques that should be red flags?
Are the figures predictive of poor future results?
The legacy of Enron suggests we all feel the effects of financial trickery and must take responsibility to promote ethical practices. Is your company prepared to identify the red flags of financial fraud? The Accenture Academy course Introduction to Forensic Accounting can help you evaluate financial truths to protect your company from accounting scandal.