Forensic Accounting - Finding Red Flags in Financial Statements

Section One - Background

• Differentiating between fraud, aggressive accounting and incompetent accounting
• What is the purpose of the fraud or aggressive accounting?
• Forensic accounting analysis by external analysts versus fraud detection by auditors
• Management incentives and earnings smoothing
• Auditor relationships and restatement history
• MD&A language and footnote analysis
• Key Audit Matters & going concern statements
• Management background checks
• Corporate governance warning signs
• Management actions that may signal underlying problems
• Information sources – financial statements, presentations, earnings calls
• The importance of sector and macro-economic data
• The use of short-seller reports (MuddyWaters, Iceberg etc)
• Can AI help accountants, management and auditors detect fraud?
• Can AI help external analysts detect fraud?
• The importance of sector-wide comparisons and analysis

 Section Two - Red Flags in Financial Statements – The Income Statement

• Revenue recognition issues
• Repurchase agreements
• Deferred revenues
• Analysing reported EBITDA and quality of earnings assessments
• Moving EBITDA losses off balance sheet
• Expense manipulation
• Accounting choices and estimates (depreciation, reserves, provisions)
• Capitalisation of operating and interest expenses
• “Other operating income”
• Trends in interest expense
• Financial expense of certain hybrid instruments
• Related party transactions to enhance earnings
• The statement of other comprehensive income

Section Three - Red Flags in Financial Statements – The Balance Sheet

• Overstated tangible and intangible assets and impairment avoidance
• Management valuations
• Developments in net working capital
• Analysis of receivables – impairments and collections
• Service contracts versus IFRS 16 leases
• Off balance sheet leases and other off balance sheet liabilities
• Hybrid securities
• “Other creditors”
• How much cash is really available to the firm? Assessing restricted cash and advance payments
• Working out the true levels of gross and net debt
• How less than 100% ownership of subsidiaries can distort debt metrics
• Full consolidation versus investment accounting versus equity accounting
• Provision liabilities
• Related-party transactions
• Cash balances versus capital raisings
• Overview of ROIC versus WACC
• Offering the same security to multiple lenders
• Covenant breaches and liquidity problems

Section Four - Red Flags in Financial Statements – The Cashflow Statement and Scoring Models

• Manipulation of operating cashflow
• Manipulation of net working capital changes
• Understatement of capital spending
• Exaggeration of capital spending
• Related-party transactions
• Dividend leakage to NCIs
• M-score (Beneish model), Altman Z-score, and other screening tools

Section Five - Conclusions

• Discussion of what was missed by analysts versus what flagged suspicions
• Post-mortem of activist and short-seller reports

Methodology

The teaching methodology used on this course combines formal theoretical instruction with frequent reference to financial statements, reports and case studies. The case studies are based on real situations and are designed to help delegates implement new analytical techniques and to learn from empirical experience. Delegates are expected to know how to use Excel at a basic level and should bring a personal computer with them. The course is intended to be practical and interactive, with delegates encouraged to ask questions. The techniques taught to delegates are intended to be of immediate practical use in the workplace.

The trainer has worked as a financial trainer for over ten years for many major financial institutions in Europe, Asia, the Middle East and Africa. She trains in financial and credit analysis, company valuation, financial modelling and distressed debt. The delegate profile ranges from graduates to board members. She has a degree in economics from the London School of Economics and stock exchange qualifications from London and New York.

Prior to her career in financial training, the trainer spent seventeen years working as an investment banker in Europe and the US. She started her career as a graduate trainee at Kleinwort Benson and later became an Executive Director of CSFB and Lehman Brothers. She has principally worked in the credit markets and has experience of the US and European high grade and high yield markets, the European new issue markets, the Asian convertible bond markets and of  corporate restructurings of distressed credits. She specialised in the telecoms sector and was closely involved in the structuring, raising and/or trading of bank and public debt for telecoms companies in many countries, including Europe, South Africa, Asia and Latin America. She also has extensive experience of corporate finance transactions, including mergers, disposals, privatisations, IPOs and capital raisings. She has also worked as an expertise witness in financial lawsuits.

The course training objectives include teaching delegates about:

• Standard practices for overstating revenues, earnings, operating cashflow, assets and net assets whilst also understating costs and actual and potential liabilities;
• How to amend reported figures to derive key underlying metrics including revenues, earnings, operating cash flow, net debt and available cash balances, in order to show a more realistic and conservative perspective;
• The importance of reading the notes and picking up signals from presentations and earnings calls;
• How management actions may indicate that there are underlying problems; and
• The importance of benchmarking financial ratios, management commentary, strategies and key trends to the peer group and to sector/macro-economic data.

The course uses recent corporate financial statements from various sectors and countries to illustrate accounting manipulation and malpractice.  We analyse situations where the majority of analysts/investors failed to spot any red flags or early warning signs and look back to see what evidence, if any, was available that could have predicted subsequent problems and issues.

The course is suited to a wide range of finance professionals including, investment banking, equity and fixed income analysts and investors, such as equity asset managers, credit funds and hedge funds. It is also suitable for commercial bankers to help avoid or reduce loan losses.  Investment bankers involved in debt and equity capital raisings would benefit from the course, in order to avoid underwriting losses and reputational damage from failing to fully understand their client’s financial position and performance. Compliance officers and internal auditors who monitor the above-mentioned professionals would also gain valuable insights, helping them to become more effective in their roles.

This course is aimed at a wide range of analysts and investors: those who are looking to sell short securities that may be over-valued; those who are concerned that a firm’s true credit quality is worse than perceived, such that rating downgrades and spread widening may occur in future; and those who are looking to avoid investing in firms whose valuation and credit profiles are based on an over-optimistic assessment of the firm’s current performance and financial situation.

Under the IFRS framework and accounting standards, firms are required to present their financial statements in a manner that is clear, relevant, reliable, comparable, transparent and conservative.  Nonetheless, the financial statements will also be based on a wide range of management assumptions as well as differing interpretations and applications of the standards. Most firms do present their accounts in a transparent and conservative manner. However, there are some firms that pursue aggressive accounting policies and practices, including distorting consolidation techniques, that may lead to the overstatement of revenues, earnings and assets and the understatement of costs and actual or potential liabilities.

The most likely candidates for aggressive accounting include firms that are deteriorating, distressed, trying to avoid covenant breaches, trying to avoid adverse credit rating moves and/or trying to reach earnings targets that are expected by equity investors and analysts.  In a worst-case scenario, the aggressive accounting practices may be borderline or definitively fraudulent. 

Whilst it can be very difficult to spot outright fraud, there are techniques that analysts can use to help find evidence of red flags, including of overstated revenues, earnings and assets and understatement of actual or potential liabilities. It may also be possible to spot other signs of deterioration. During the course, we will review a wide range of financial statements from different sectors. We will undertake a detailed analysis of the notes and a benchmark peer group ratio analysis to gain a better understanding of the firm’s operations and financial situation.